[This article is intended to be a neutral education of the USA federal income tax system and how it affects the wealthy. If you find this helpful, pass it on so that others may learn from it as well.]
The Conclusion wraps up many of the highlights and the Summary cuts all the details for a quick… well, summary. Reading the Introduction and Summary first will give you a good idea of what to expect since the whole article is about answering the Introduction and explaining the Summary.
Politicians talk about income taxes on the “rich” and “millionaires” all the time (they often use “rich” and “millionaires” interchangeably). But, I don’t think most people really realize what politicians mean by “rich” or “millionaires.” They are not talking about the “top 1%” or the “top 400”. Moreover, Presidents have not taken effective action to change the federal income tax for the wealthy in nearly a decade. Before I can continue, I need to give a basic explanation of how the graduated federal income tax works.
==== The Graduated Federal Income Tax
The federal income tax is a rate, a percent of income. It is “graduated” in that the rate is gradually increased with income. To determine the rate for a certain income, each rate is associated with a range of income.
If someone makes $0 to $8,700, (s)he will pay 10% of that in taxes, or $870. For any amount from $8,701 to $35,350, an individual will pay the 10% on the $8,700 plus 15% on the excess up to $35,350. Someone earning $30k will pay $870 plus 15% on the amount earned above $8,700: $870 + $3195 = $4065. Even though $30k is within the 15% income bracket, note that the individual only pays 13.55% in federal income tax because (s)he is not paying 15% on the entire income. Only the excess above the previous tax brackets is paid at the rate of the gross income’s tax bracket.
An individual earning $60k will pay $4,867.50 for the previous tax brackets plus 25% on the excess over $35,350 in federal income tax. That amounts to $11,029.50 or 18.39% of the individual’s income, even though the $60k income is within the 25% tax bracket.
==== The Highest Tax Bracket
The highest federal income tax bracket is at $388,351+ ($194,176+ for married filing separately). $388,351 is no doubt good money; however, that is by no means the income of a millionaire. The terms “rich” and “millionaire” when referring to federal income tax are not talking about Trump, Gates, or wealthy movie stars. Considering the relative costs of living in certain regions (such as Los Angeles, CA and NYC), $388,351 starts to look less exorbitant.
The point I’m trying to make is not the value of $388,351. The point that I’m trying to make is that $388,351 hardly means super wealthy. It might mean rich, but not super rich. Many people get the idea that the politicians are talking about taxes on corporate owners or CEOs with unjustly amounts of disposable income.
Moreover, the federal income tax bracket bellow $388,351+ is only 2% less in rate and applies to income between $178,651 and $388,350. That is well within the range of a successful small business owner or a skilled brain surgeon (or other highly skilled individual that invested a large amount of time and effort getting to that income). It is still highly subjective if that qualifies as exorbitantly wealthy, but it makes the point that we are not talking exclusively about CEOs, “capitalists”, celebrities, and the super rich (top 1% or top 400).
By the way, the top 1% make $1.3M+ (over $1,300,000 a year). The top 400 make $340M+ (over $340,000,000 a year). That’s per person in case the numbers threw you off.
==== How Much The “Rich” Actually Pay
While the movie stars, sports players, and some others are affected by federal income taxes, the “rich” escape a tone of taxes and usually end up paying less (by percentage) than those making <$1M. How? It’s a combination of municipal bonds (which are tax exempt) and legal loopholes.
One of those loopholes has to do with a special lower tax for long-term capitol gains, gains from an individual selling an asset that (s)he owned for more than one year. President Clinton lowered it to 20%. President W. Bush lowered it from 20% to 15% for individuals in the 15% federal income tax bracket or higher (currently ~$8.7k+ a year) and from %5 to 0% for individuals making less than that. President Obama extended those rates through 2010 and signed an additional law in 2010 that retained those rates until the end of 2012.
As a result of the lower tax on long-term capital gains, many millionaires are paying closer to 20% in taxes rather than 30%. In lower tax brackets, which are more greatly affected by deductions for dependents, effective federal income taxes as percentages of income are commonly 15% - 20%. As income increases, deductions of that nature would have less and less effect on the overall federal taxes, effectively approaching 35%. However, this 20% is sustained by income from long-term capitol gains and interest and dividends.
This 20% applies to the top 1% as well. The top 400 effectively pay less than 17% in federal income taxes, though.
==== How Lowering or Raising Taxes Works
Another point regards lowering income tax for middle-class and lower-class Americans. They lower the tax by shifting the range of incomes within different tax rates: the actual rates remain the same. An individual making $40k a year paid $157 (0.39%) less in federal income taxes in 2012 than in 2009 thanks to tax cuts. When lowering taxes, they basically only change the percentage rate for a few thousand dollars (<$2k) by 2%; they change the tax rate brackets rather than the tax rates. Any changes of this nature hardly affects an individual making $400k.
==== Can It Be Changed?
The only ways to truly tax millionaires or the “rich” more are to create another (higher) income bracket with a higher tax rate AND/OR to increase taxes on long-term capital gain and institute a tax on interest from municipal bonds. Of course, you’d have to close general loopholes as well.
The basic point that I’m making is that politicians who speak of raising federal income taxes for the rich or millionaires (they use the terms interchangeably) are not speaking about the same people we commonly associate with the term “rich.” The super wealthy (top 1%, top 400, etc) are evidently not who they are talking about. The highest federal income tax bracket is only $388,351+, with the second highest bracket being only 2% less in rate and starting at $178,651 in income. However, when they do lower or raise federal taxes, they alter the brackets rather than the percentages, which affects the middle-class and higher-class increasingly negligibly with increasing income.
Moreover, as a result of the methods by which the super rich earn income, they effectively pay only 20% of their income in federal income taxes (similar to most middle-class) compared to the 30-35% you’d expect to see. Income from long-term capital gain is only taxed at a rate of 15%. Interest from municipal bonds is tax exempt, but long-term capital gain is the greatest factor.
President W. Bush decreased long-term capital gain tax to 15%, and President Obama kept it at that percent both times he had a chance to increase it to President Clinton’s previous 20%. Both Presidents slightly altered the tax brackets (conventionally speaking, those changes lowered taxes for all everyone, including the rich), but, as mentioned earlier, this has little effect on higher incomes, even if they were “increasing” taxes on the “wealthy”.
When politicians speak of millionaires or the rich, they are effectively talking about people earning ~$180k to ~$400k. The way those politicians would theoretically increase taxes for these rich people has negligible effect on their income. The long-term capitol gain federal tax could be decreased or increased to effectively change taxes for the wealthy, but it has remained the same for nearly a decade. Even still, that would significantly affect the income of all individuals earning ~$300k+, still not the super rich or only millionaires.
Rich is relative, but it should be apparent that “the rich” or “millionaires” does not refer to the “top 1%” or the “top 400” in politics. It generally refers to the top two federal income brackets (~$170k+).
Again, “lowering” or “increasing” taxes is a political phrase referring to tax tweaks that affect wealthy individuals negligibly. Effectively increasing taxes on the wealthy (~$250k+ in this case) would require increasing the long-term capitol gain federal tax, which has remained the same for nearly a decade and has been kept low (lower than ordinary federal income tax) by a President twice (2008 and 2010) since then.