Wondering about your taxes after you graduate?

I used the National Bureau of Economics Research's handy-dandy TaxSim simulator to figure out the 2009 federal tax bill (income tax, payroll tax, and total federal tax) for a single person with no dependents and only wage income. The result is the graph above.

A single person with 40K in wage income will pay about 25% in federal payroll and income taxes. With 100K in wage income, that single person will have a federal tax bill totaling almost 35% of income.



Of course, as I pointed out in class, if that same single person with no dependents could figure out a way to have his income arrive in the form of dividends and long-term capital gains, he would pay ZERO in federal payroll tax and a much lower federal income tax as well. With 40K in income, such a person would have a zero dollar total tax bill. At 100K in income, the total tax bill for such a person is still less than 9% of income.

If Congress gets serious about addressing the deficit and/or funding expanded health care programs, many taxpayers can expect their rates to rise, and the highly preferential rates on dividends and capital gains are likely to be a prime target. If Congress does nothing, the graphs for 2010 will look much the same as the 2009 graphs I've shown above. However, many tax rates will automatically increase substantially in 2011, when the Bush tax cuts are set to expire, so Congressional inaction means your tax rates will go up for sure in 2011.

Of course, if you're budgeting for your total tax bill, you should also figure in state taxes as well. State income taxes in some states have top rates in the 10% range. You'll also be paying sales taxes in most states. If you don't own a home, you won't pay property taxes directly, but when we do tax incidence analysis, you'll see that your rent is likely to reflect some of those property taxes indirectly.

Why is the IRS doing everybody else's job?

Professor Maule recounted a recent locker room conversation as follows:

When he asked me what the latest book covered, I explained that it dealt with tax incentives for hiring and retaining employees. To his inquiry, "like what?" I rattled off the work opportunity credit, the Indian employment credit, the various disaster employee retention credits. He asked about the previous books. Those, I explained, dealt with tax incentives for energy production and conservation and with family and household transactions. Again, I listed some of the provisions, and he stopped me and asked why the tax law was filled with so many provisions that weren't a matter of revenue collection but expenditures. The answer is an easy one, because it's asked every semester by students in the basic tax course. Why not have the Department of Energy write checks to companies and individuals who are doing things to develop or conserve energy instead of administering the grants through tax refunds? Why not have the Department of Labor reimburse employers who hire members of targeted groups? The answer rests in the Congress' confidence with those other agencies and with the supposed speed with which tax refunds can put money in the taxpayers' hands in contrast to check-writing programs.

As Professor Maule points out, Congress has been loading more and more and more work onto the shoulders of the IRS. Originally, it was just asked to collect revenue for the government, and it's remarkably efficient at that purpose. In fiscal year 2008, the IRS spent an average of 41 cents to collect each $100 of tax revenue.

But Congress is asking the IRS to use that 41 cents to do a lot more than just collect tax revenue. It's also asking the IRS to stretch that 41 cents to do work that would previously have been carried out by many other government departments.

Just to take a few more examples beyond those listed by Professor Maule, the IRS administers:

* refundable credits for low-income working families
(IRS doing the work of Health & Human Services)

* tax credits, exclusions, and deferrals for employee retirement savings under ERISA (IRS doing the work of the Department of Labor)

* tax credits, deductions, and exclusions for education
(IRS doing the work of the Department of Education)

* tax deductions and credits for home ownership
(IRS doing the work of the Department of Housing and Urban Development)

* tax deductions, exclusions, and credits for health expenses
(IRS doing the work of Dept of Health and Human Services)

Over the years, Congress has piled more and more responsibilities on the shoulders of the IRS, but it has not given the IRS much additional funds to carry out these responsibilities. As a result, the IRS has been forced to reallocate some of the resources previously used for its traditional activities of enforcement and taxpayer assistance. For example, when Congress decided--on very short notice, in the middle of peak tax filing season!--to suddenly order the IRS to issue "Economic Stimulus Payments" to 130 million taxpayers, the IRS had to divert employees from other purposes, including enforcement, to dealing with the huge volumes of calls and correspondence from taxpayers asking about their stimulus payments.

Why is Congress asking so much of the IRS?

I guess it's a case of "no good deed goes unpunished."

The IRS is impressively efficient in getting tax refund checks out very promptly, probably faster than any other agency could do it. The IRS has a remarkably ambitious schedule for processing these returns.



As the IRS schedule above shows, tax returns e-filed on Thursday morning can result in direct deposits of refunds 8 days later. If the taxpayer wants a check mailed instead of direct deposit, it will take an additional week. The IRS doesn't guarantee these dates (because sometimes a return will require extra scrutiny before the check is mailed), but the experience of taxpayers at our VITA site is that the IRS has been able to deliver promptly on their schedule 99% of the time. In the 1% of cases where there's been a delay, it's almost always been resolved within an additional week.

That's a very impressive track record, by any standard, private or public. Think about the last time you bought an item with a manufacturer's rebate offer, and you sent in the forms required to get the rebate. How long did it take to get your rebate money back in the mail? Probably slower than most IRS refunds.

I'm proud to say that the person in charge of all this speed and efficiency at the IRS is my former student, Dave Williams, who is now IRS Director of Electronic Tax Administration and Refundable Credits.

For several reasons, it's appropriate for the IRS to be speedy and efficient in processing legitimate tax refunds.

1) In most cases, the refund money is going back to people who overpaid their taxes through withholding. They've given the government an interest-free loan, and it's their right to get their overpayment back promptly.

2) In some cases, the refund money is going to low-income working families to whom Congress has promised, in essence, "matching money" for wages, in order to increase work incentives, education incentives, retirement savings incentives, and other things that Congress has deemed worthy. These refundable credits were designed to help people take steps towards getting off traditional welfare (the old AFDC now relabelled as TANF) and into jobs that will hopefully lead to self-sufficiency. The legitimate recipients of these credits face many economic hardships, and Congress wants them to get these credits in a timely and predictable way.

3) In still other cases, Congress has decided that the IRS should be delivering refundable tax credits to stimulate the economy. Economists don't always agree about whether a stimulus is needed, but there is general agreement that IF one is needed, it ought to be delivered in a timely way. The IRS is the only government agency with the track record and infrastructure in place to deliver the stimulus fast, either by issuing rebate checks or by instructing employers to modify withholding schedules.

All this is a lot to pile on to the shoulders of the IRS. They're not perfect (and, who among us is), and surely there are some bad apples there, but the American people, via their elected representatives, have piled a lot of work onto the IRS. By piling on all these other responsibilities, the American people haven't given the IRS the resources it needs to do its traditional job of adequately scrutinizing, deterring, and/or catching the dishonest taxpayers and dishonest tax preparers who have exploited the weaknesses in the IRS system.

A variety of data shows that the majority of American taxpayers comply remarkably well with their tax laws, especially considering the complexity, and especially compared to many other countries. (In some countries, cheating the government seems to be something of a national sport, unfortunately! But not here.) It's right that taxpayers legitimately entitled to refunds should get their money back promptly, but the IRS also needs the resources to catch the illegitimate returns filed by the dishonest--or even better, to deter people from filing illegitimate returns in the first place.

Finally, in this year's budget, the IRS is getting a significant increase in enforcement resources (to catch and deter the dishonest) and in taxpayer assistance (to help the honest understand their tax obligations and comply with the law.)

But, Congress could do a LOT more to make the IRS job easier and more straightforward. All the unnecessary complexity in the tax law makes the IRS waste a lot of its time (and taxpayers' time too!) on trivial minutiae with no possible public policy purpose.

Reasonable people can differ about whether encouraging higher education and retirement savings are legitimate public policy objectives, and, if so, whether the IRS is the right agency to administer government programs to encourage those goals. But no sane person can explain why the government should have such a convoluted and unnecessarily complex tax code with 16 different tax incentive programs to save for retirement and 11 different incentive programs for higher education, all with slightly different rules, as the National Taxpayer Advocate Nina Olson has pointed out.

She estimates that American individuals and businesses spent 7.6 billion hours on their end complying with the tax law last year--that's the equivalent of 3.8 million full-time workers doing nothing but complying with the tax law.

And it's not the IRS fault they spend that much time. It's primarily Congress fault--they are the ones that write the laws. And, ultimately, it's our own fault for not sending Congress a clearer message that we don't appreciate all the time that the overlapping and convoluted provisions of the tax code it writes is making us waste so much time and money on compliance--and making the IRS waste its resources as well.

On their end, the IRS has about 80,000 full-time and 10,000 seasonal employees to do their part of tax administration, trying to keep up with all the responsibilities that Congress heaps on it--creating and updating forms and instructions as Congress changes the law each year, doing taxpayer outreach and education to help them comply, answering taxpayer questions, processing their returns, collecting payments, issuing refunds, catching honest errors, auditing returns, trouble-shooting difficult cases, and more.

Congress, you've been complaining about all the fine print and hidden "gotcha's" in credit card agreements, mortgage contracts, and health insurance applications--and rightly so, in my opinion. Consumers deserve to have a clearer picture of what they are getting into when they sign one of those forms.

But, Congress, you ought to lead by example and clean up your own house as well--and simplify all the unnecessary fine print in the tax code! That would make it easier for honest taxpayers to comply and it would also enable the IRS to devote its resources and formidable efficiency to more important priorities--like assisting the honest and catching and deterring the dishonest who take advantage of the honest.

Congress, if you're going to make the IRS do everybody else's job, please do YOUR part to be efficient about it when you write the tax code!

Facing reality head-on

“There is no way we can pay for health care and the rest of the Obama agenda, plus get our long-term deficits under control, simply by raising taxes on the wealthy,” said Isabel V. Sawhill, a former Clinton administration budget official. “The middle class is going to have to contribute as well.”

Quote from Obama’s Pledge to Tax Only the Rich Can’t Pay for Everything, Analysts Say in the New York Times

Provocative Tax Policy Questions for Mr. Geithner

Treasury-Secretary-designate Timothy Geithner is facing confirmation hearings today. If confirmed as Treasury Secretary, he would oversee the IRS and advise the President on tax policy issues, among other responsibilities. The NYT published some suggested questions for Mr. Geithner, several of which related to tax policy:

1. The American tax code is so complex that even Treasury secretary nominees can easily make mistakes on their returns. Furthermore, while income tax rates are 10 percent to 35 percent for individuals and 35 percent for corporations, because of the proliferation of deductions, credits, exclusions and loopholes, the revenue from income tax amounts to only 10 percent of gross domestic product. Should you give priority to simplifying the code and enforcing compliance before raising rates?

— CHARLES O. ROSSOTTI, the commissioner of internal revenue from 1997 to 2002

(NOTE: Mr. Rossotti is referring to statutory marginal tax rates. As we have seen, effective marginal tax rates can easily be as much as 50%, even on taxpayers with very modest incomes, due to phase-outs and clawbacks.)

1. The income tax code favors those with employer-provided health insurance over those who buy their own health insurance or pay medical bills out of pocket. It also favors homeowners over renters, through the mortgage interest deduction. Is this tax treatment efficient or fair? Might you favor a more level playing field?

2. President Obama supports the estate tax. Why should a person who leaves his money to his children pay more in taxes than another person with the same lifetime income who spends all his money on himself?

— N. GREGORY MANKIW, a professor of economics at Harvard

Note: Both of Professor Mankiw's comments raise questions about horizontal equity. His first question also raises the issue of economic efficiency.

Tax rates on the rich?

As the NYT points out, tax rates on the rich are much lower than they used to be, both at the federal and state level:

Over the last 30 years, the trend has been to pare back income tax rates on the rich, federally and in the state. Since the mid-1970s, the state has cut its top tax rate from 15.375 percent to 6.85 percent. The top income tax rate in New Jersey is 8.97 percent, and in Connecticut it is 5 percent, according to data from the Fiscal Policy Institute, a liberal research group.

The same New York Times article then goes on to point out an apparent paradox:

That said, the richest 1 percent of New Yorkers paid more than 40 percent of the income tax in 2007, up from about 30 percent in 1996, according to state data, though that figure is declining as the financial crisis makes the rich less so.

You might wonder how the percentage of tax revenues paid by the rich could be increasing if the top tax rates have been decreasing? The answer to the paradox: at least up until very recently, the rich have been getting richer so much faster than the rest of the population that their tax payments increased as a share of the total, despite the decline in the tax rates they faced.

Of course, as the New York Time also points out, the incomes of many of those at the top have plummeted during the financial crisis, so even if rates are raised on the richest taxpayers, the share of tax revenue coming from the rich may decrease.

Sharing the wealth, spreading the burden

Yesterday, the Congressional Budget Office released a report showing how effective federal tax rates have changed over the years. It makes for some interesting reading and it helps to put tax policy in perspective.

Joe-the-plumber's famous question to President-elect Obama during last fall's campaign highlighted an ever-present conundrum in public policy: how should the burden of paying for government be spread across people with different incomes? Should our tax system redistribute wealth, and if so, how much?

One useful starting point is to look at some hard numbers from this CBO study.

As you are learning from your study of tax law, many low-income taxpayers have negative effective federal income tax rates, due to refundable tax credits such as the Earned Income Credit and Additional Child Tax Credit. The CBO numbers confirm this. However, the CBO numbers also show that low-income households pay other types of taxes, e.g., Social Security, Medicare, and excise taxes (gas, tobacco, alcohol). In addition, as we will discuss in incidence analysis, they may indirectly bear the burden of other types of taxes. For example, to the extent that corporate income taxes are passed on to consumers in the form of higher prices or passed along to workers in the form of lower wages, low-income taxpayers may indirectly bear some of the burden of corporate income taxes.

The CBO numbers show that the highest income taxpayers have received a disproportionate share of income in recent years and have also paid a relatively high share of taxes. However, the effective federal income tax rates paid by the richest taxpayers have actually fallen somewhat compared to 30 year ago.

In the late Carter years and just prior to the Reagan tax cuts, the CBO numbers show that top 5% of the population paid an effective federal tax rate (for all federal taxes combined) of about 28%. The big Reagan tax cut dropped that rate to as low as 24% in the mid 1980s. However, increasing concerns about the deficit drove the rate back up to around 26% in the later Reagan years, where they pretty much stayed during the first President Bush years. During the Clinton years, the rates on that top 5% group rose back to 28%, and during the years of the second President Bush they fell as low as 25%. In the most recent year for the CBO study, the rate for that group had risen somewhat to 26%.

Looking at Table 1, we can also see that effective federal tax rates have fallen for all income groups since 1979, and, in fact, they have fallen most for the most vulnerable segment of the population, the lowest 20% of the income distribution. Many of us would say this is a good thing.

However, most economists believe that these tax cuts for everyone are not sustainable indefinitely. The federal government is running a large and growing deficit, and demographic trends mean that Social Security and Medicare will require increasingly large amounts of tax revenues in the decades ahead. Somebody will have to pay eventually.

So, the question is: how should the burden of raising those additional necessary revenues be spread across the different income segments of the population?

President-elect Obama initially proposed to cut taxes for everyone but the top 5% and to raise the tax rates for the top 5% by a rather modest amount. In view of the current economic situation, he now suggests that he may wait a while before increasing anybody's taxes.

Although the federal government is in a position to put off tax increases for a while (since the rest of the world is happy to lend the US Treasury money at phenomally low interest rates, in some cases very close to 0% interest!), this situation is clearly not sustainable indefinitely.

So the question remains: how should we spread the burden across different income segements? We'll talk more about this in class.

Bed Buffalo Alert: The CBO numbers all refer to a concept they call the "effective tax rate," which is an average tax rate. That's appropriate for thinking about equity and tax burden distribution questions. The numbers President-elect Obama was using in his discussion with Joe the plumber were actually marginal tax rates, which are a very different concept, and one that we will discuss in the context of efficiency questions. The distinction between effective average rates and marginal rates is a frequent source of confusion and definitely qualifies as a "bed buffalo." There is a mathematical relationship between the two concepts, but they are quite different and distinct. While a person in the top 5% of the income distribution might have a marginal income tax rate of 35%, their effective average income tax rate might well be around 20%. Again, we'll talk more about this in class.