For most folks, it is the little taxes that bite the most, not the big tax: the federal personal income tax. Hotelier Leona Helmsley once said, "We don't pay taxes. Only the little people pay taxes." That's not quite true, as "the little people" often don't pay the big tax. The bottom 40 percent of income earners have a negative income tax rate. The only people in the bottom 40 percent who actually pay the personal income tax are anomalies. For Leona, they'd be "the little people." But others might see them as the collateral damage of an insane tax system.
In a June 2016 report from the Congressional Budget Office, we see at the bottom of page 11 that the four lowest before-tax income quintiles in 2013 had average effective tax rates of -7.2, -1.2, +2.6, and +6.1 percent. That translates into an average effective tax rate for the bottom 80 percent of personal income earners in 2013 of just +0.075 percent -- not even one tenth of one percent!
Of course, that average is brought down by the bottom two quintiles, which receive a ton of refundable tax credits, like the EITC. But when one looks at the third and fourth quintiles (i.e. the 41st percentile through the 80th), their average effective tax rate is only 4.35 percent, not even half of the lowest statutory tax rate.
One can use the IRS's Tax Table only if one's taxable income is below $100,000. Back in 2013, an unmarried income earner who took only the standard deduction could have used the Table only if her total income was below $110,000. A total income one penny below that would have gotten her a tax bill of $21,286, the highest liability on the 2013 Tax Table (see page 37). That amounts to an effective income tax rate of more than 19.35 percent.
Back in 2013, an income of $110K would not get one into the Top Quintile of incomes. However, our taxpayer above has an effective rate that is 3.85 percentage points higher than the average of the Top Quintile, 15.5 percent. $110K might have put one in the Fourth Quintile (see Table 1 on page 31 of the CBO report). Which means our income earner would have been paying the IRS at a rate more than three times the average of her quintile. Some might say that if you don't want to pay three times the average to the IRS, then you should borrow money to buy a house, get married, or start a family, so you can take advantage of the breaks. But what if you're trying to amass some startup money to start up a business?
Most Americans pay more in payroll taxes (for Social Security and Medicare) than they do in income taxes. Many also pay more in sales, gasoline, property, or other taxes than they do in income taxes. Even so, Congress is talking about middle class tax cuts, and they're not referring to those other taxes, they're talking about the personal income tax, the big tax, the tax that many Americans don't pay.
If Congress isn't ready to address the glaring inequalities of the personal income tax that produce the anomalies, if all they want to do is cut tax rates; then they should leave the personal income tax alone and focus on business income taxes. But concentrating just on business income taxes is complicated because some businesses -- S corporations, partnerships, limited liability companies (LLCs); i.e. flow-through entities (FTEs) -- are taxed under the personal income tax. (Check it out on Line 17 of Form 1040; it requires attaching Schedule E.)
On May 20 at Forbes, Tim Worstall addressed these issues in "To Explain The Corporate Income Tax To Elizabeth Warren." Liz, you see, thinks corporate income taxes aren't so very high. But since America has the highest statutory tax rates for corporate income in the industrialized world, our corporations must put themselves through costly Herculean labors to get their effective tax rates down to something reasonable. So, for the last 60 years or so, fewer and fewer businesses incorporate as C corporations. Worstall explains to Liz (link added):
In more detail, only C corporations pay the corporate income tax. Pass throughs pay the individual income tax. And if people change from C corporations to S corporations as a method of organising a business then the share of GDP, the share of revenue, coming from the corporate income tax is going to fall. […]We've moved from near 100% of business income coming through C corporations and so subject to the corporate income tax to only half of business income moving through them and thus subject to the corporate income tax. And therefore revenues from the corporate income tax have halved as a percentage of GDP.
Worstall's short article is worth reading, especially for his treatment of Warren, (one of our more overrated members of Congress.) But despite the fact that the share of revenue from corporate taxes has fallen so much over the last decades, it is the corporate income tax that is the more urgent tax to reform. It's the income tax that hits Big Business, like Boeing, Ford, and IBM, that needs to be rewritten first. In August 2016, the Tax Foundation ran "The Corporate Income Tax is Most Harmful for Growth and Wages" by Scott A. Hodge:
The evidence shows that the corporate income tax is not only harmful for workers' wages, it is harmful for overall economic growth. In a landmark 2008 study Tax and Economic Growth, economists at the Organization for Economic Cooperation and Development (OECD) determined that the corporate income tax is the most harmful tax for economic growth. Personal income taxes were found to be second-most harmful for growth.
But harm comes not only from the high tax rates; it is also due to the cost of compliance. A 2016 report at the NTUF, National Taxpayer's Union Foundation, pegs the economic loss due to compliance at $234.4 billion:
High U.S. tax rates are certainly an impediment to economic growth. The corporate income tax is a drag on America's competitiveness around the world. When ranked against some of our biggest trading partners, American businesses face much bigger compliance headaches than their counterparts in other countries.
On May 4, 2016, the Washington Times ran an article by Jennifer Harper that cited a study by the Competitive Enterprise Institute that said the cost of regulations in America is now more than the revenue the feds get from individual and corporate income taxes combined. Harper also wrote: "The actual price of complying with the tax code expected to reach $316 billion this year."
And why is America paying so much to comply with federal taxes? Well, I'll tell you: it's to lower our effective tax rates. Congress needs to muck out the Augean Stables that is the Internal Revenue Code. Get rid of the complexity in the Code and Congress could lower the statutory rates accordingly without hurting revenue. Is that so much to ask of our overlords?