You Decide: Can We Agree On Some Tax Concepts?

By Dr. Mike Walden

Taxes are almost always a big part of political elections. Questions about who pays taxes, whether taxes are too high or too low, and complexities in the tax system are usually parts of debates and campaign ads.

Most ads are not educational, in that the purpose is to not teach about tax concepts and how they work. Instead, the ads are designed to promote a candidate’s position with the goal of gaining voters’ support.

I understand that, but here I do want to take the educational route and provide some information and context to tax concepts. Hopefully I’ll be able to provide background that better enables you to decide if you favor or oppose various tax proposals.

I’ll use concepts from the federal income tax and Social Security tax since these are the largest taxes paid by most people.

Federal Income tax Rate: The tax rate of the federal income tax is the percent of taxable income (defined below) paid in taxes. For example, if your taxable income is $10,000 and the tax rate is 25 percent, you pay $2500 in taxes.

However, there is not one tax rate; there are seven. Each rate applies to a specific range of your taxable income. For example, the lowest 10 percent rate is paid on taxable income from $0 to $19,750 for a married couple, while the highest rate of 37 percent is paid on taxable income above $622,050 (there are slightly different rates for single person taxpayers). Every taxpayer, regardless of her or his taxable income, has their income sliced into the seven ranges with the corresponding tax rate applied.

Many tax proposals focus on the highest tax rate (today 37 percent). People who want the richest taxpayers to pay more argue to increase the rate. Opponents worry raising the highest rate could backfire by reducing the motivation of rich taxpayers to earn, spend and hire workers.

Taxable Income: Federal taxable income is your income – mostly from working and investing – minus the deductions you are allowed to take. And what are these deductions? They are expenditures made by a taxpayer that Congress and the President – who jointly approve the tax code – want to encourage. A good example is interest paid on a home loan, as well as many others related to education, saving for retirement and health care.

For taxpayers who don’t have any of these favored expenditures, there is the “standard deduction”. Taxpayers only use the deductions they are entitled to (called “itemization”) if their sum is greater than the standard deduction.

Business owners have an entirely separate set of deductions related to their costs, investments, profits and losses. There’s been a long-standing debate about the fairness of some business deductions that can result in modest taxes paid by high-income owners.

One way for a candidate to support a particular type of spending is to propose a tax deduction for it or to expand an existing deduction. Sometimes a candidate will want to limit a deduction to taxpayers making under a specified level of income so as to focus the benefit on those earners.

Tax Credits: Tax credits are the “gold standard” for reducing a tax bill. Like tax deductions, tax credits are based on spending favored by the tax code. Unlike tax deductions, tax credits reduce taxes dollar for dollar with the favored spending. This can mean a tax reduction 3 to 10 times more than for a comparable tax deduction.

There are a variety of tax credits related to child care, renewable energy, health care, education and others. If a politician really, really, really wants to support a particular kind of spending, a tax credit for that spending will be proposed.

Social Security Income Limit: Social Security is the federal program that pays a retirement pension for most workers. The program is funded by taxing the earnings of workers, with both the worker and employer paying a tax rate of 6.2 percent, for a total tax rate of 12.4 percent.

Sounds simple enough, right? Not really. There is controversy over the fact there’s an income limit to which the 12.4 percent tax rate is applied. This year that limit is $137,700. What this means is that after a worker’s income reaches $137,700, the worker is done paying Social Security taxes.

Is this fair? Actually, there is a logic to the limit. Workers with higher earnings while working receive higher Social Security pensions when retired. But after a certain level of earnings is reached, pension payments don’t increase. The two limits are the same – $137,700 this year.  Workers don’t pay additional Social Security taxes on earnings above $137,700 because their pension benefits don’t change when earnings rise above $137,700.

Still, with Social Security facing a funding crisis in another decade, there are advocates who want those earning over $137,700 to pay more Social Security taxes without seeing their benefits increased. Opponents see this moving Social Security to more of a welfare system and perhaps losing public support.

There are many more tax concepts – these were just some top ones. Hopefully my commentary will help you decide where you stand on each one.

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook and public policy.