Dear U.S. Millionaires,
Tax parlance is confusing. For example, realized and recognized gains are two very different things. So too are marginal and effective tax rates. As a result, sometimes even the most seasoned tax adviser can use a hand understanding how a relatively straight forward word applies to the tax law.
Case in point: along the way you may have found yourself embroiled in a conversation when the other party referenced the ”progressive” nature of the U.S. individual income tax system. At the time, you nodded along, but you were only feigning comprehension. Because while you’re familiar with the word “progressive,” you have no idea how it applies to the tax law.
Put simply, a progressive tax system is one that intends to collect more tax as a taxpayer’s income increases. It’s the opposite of a “flat tax;” rather than taxing every American at the rate of say, 15% of their gross income, under a progressive system the tax rate increases as the taxpayer’s income increases. It’s effectively a means of income redistribution, as the extra tax that’s collected from high-income taxpayers is used to fund social welfare programs that primarily benefit low-income taxpayers.
You can argue all you want as to whether it’s the best system, but it’s the one we’ve got. And the reason the progressive nature of the tax system is important — particularly during this next six months, when proposed tax legislation is sure to come fast and furious — is that any large-scale change to the Code, when implemented, must maintain the progressivity of the current tax system. Stated differently, if changes to the Code result in more tax savings for the rich than the poor, well…that’s a problem.
Now as we’ve discussed numerous times, Republican presidential candidate Mitt Romney has proposed making sweeping tax cuts if he prevails in November. These cuts can largely be broken down into four categories:
1. The current individual income tax rates of 10/15/25/28/33/and 35% would each be reduced by 20%, resulting in rates of 8/12/20/22.4/26.4/ and 28%.
2. For taxpayers earning less than $200,000, the tax rate on interest, dividends, and capital gains would be 0%.
2. The AMT would be eliminated.
3. The estate tax would be eliminated.
Importantly, Romney has long promised that any lost revenue resulting from these rate reductions would be made up elsewhere in the tax law, making his plan “revenue neutral.” The only way this could be accomplished would be to eliminate many of the popular deductions currently found in the Code, including those for mortgage interest, state and local taxes, and charitable contributions.
At first, we were curious whether it was mathematically possible for enough deductions and preferences to be cut to make up for the revenue reductions resulting from the rate cuts. Ultimately, we concluded — thanks to more than a little help from the Tax Policy Center – that it was indeed mathematically possible, if politically implausible.
With that settled, we now move on to the next issue: Assuming 1) Romney’s four tax changes listed above are enacted, and 2) he eliminates enough deductions to offset the revenue reductions, will the Code maintain its progressivity, as Romney has promised throughout his campaign?
To find the answer, we again look to the geniuses at the Tax Policy Center, who have crunched the numbers for the benefit of those of you scoring at home (and even for those of you who are by yourselves). The results, to say the least, are damning to the Romney campaign.
The Center’s analysis uses the following assumptions:
First, the Tax Policy Center quantified the average tax savings by income class in 2015 resulting from nothing more than reducing the tax rates as proposed. The results are as follows:
|Income level||Average federal tax change|
|$500,000 – $1,000,000||($41,506)|
|$50,000 – $75,000||($984)|
Obviously, a couple of things stand out. First, the wealthiest taxpayers benefit the most from the reduction in rates. This makes total sense, as the drop from a 35% to a 28% top rate effects each dollar of income in excess of the start of the top tax bracket, which may be extremely significant. On the other end of the spectrum, those earning less than $30,000 actually see their tax burden increase due to the scheduled expiration of certain tax preferences that target lower-income taxpayers, like the refundable child tax credit and the expanded earned income credit. For these taxpayers, the reduction in tax rates is more than offset by the expiration of some of their favored tax preferences.
Perhaps more meaningful, however, is understanding the total, rather than the average, change in tax liability for each class of income resulting from the rate reductions. The results are as follows:
|Income level||Total Revenue Lost (Tax Savings)|
|$500,000 – $1,000,000||($45,000,000,000)|
|$50,000 – $75,000||($20,000,000,000)|
Again, we can see that the big winners are those earning more than $1,000,000, as the reduction in the top rate from 35% to 28% reaps big dividends. Of the $360 billion in total lost tax revenue resulting from the tax cuts, $105 billion of it inures to the nation’s millionaires.
In the second step of the analysis, the Tax Policy Center determines the extent to which Romney must cut tax preferences and deductions in order to recoup the $360 billion of lost revenue resulting from the rate reductions. To do so, the Center takes certain items “off the table,” such as the preferential LTCG and dividend rates, tax-exempt state and local bond interest, and tax-favored retirement plans. Left “on the table” are such deductions as all “above the line deductions,” state and local taxes, mortgage interest, charitable contributions, and many credits.
After totaling all the “on the table” preferences, the Tax Policy Center purposely ignores the fact that taking even one, let alone all, of these items out of the Code would be a political impossibility, and instead determines how much revenue could be recovered if all of these deductions were in fact eliminated. The result: $551 billion. Thus, in order to make up the $360 billion in lost revenue from the rate cuts, 65% of all of these popular deductions would have to be eliminated.
In order to determine how progressive these combined changes to the law would be, the Center next takes a conservative approach, and assumes that these deductions are first eliminated for those earning in excess of $1,000,000 until the cut in deductions for those taxpayers recovers as much revenue as possible. At some point, however, you can only recover so much revenue from this income class by removing their deductions for contributions, state and local taxes, and the like. Once the > $1,000,000 group is fully maxed out, the tax deductions are then eliminated at the next highest income level, and so on.
After doing so, the revenue is recovered for each group as follows:
|Income level||Total Revenue Lost (Tax Savings)||Revenue Raised From Eliminating Deductions (Tax Increases)||Net (Tax Savings)/Tax Increase|
|$500,000 – $1,000,000||($45,000,000,000)||$30,000,000,000||($15,000,000,000)|
|$50,000 – $75,000||($20,000,000,000)||$62,000,000,000||$42,000,000,000|
As you can see, even when you start by eliminating all the “on the table” deductions for those earning more than $1,000,000, the benefit that group receives from the rate reductions more than offsets the benefit they were getting from the deductions that would be removed from the Code. Stated numerically, they will save $106 billion in tax from the rate cuts, but only give back $50 billion through the elimination of deductions.
The same net benefit can be seen for the $500K – $1 million group and the $200-$500K group. In total, the three highest-earning groups enjoy a total net benefit of $86 billion in tax savings even after most of the tax deductions in the Code are eliminated.
The problem doesn’t stop there. Logically speaking, if taxpayers earning more than $200K are saving $86 billion, and the tax plan in total must be revenue neutral, then someone stands to lose $86 billion. And as you can see here, that someone is everyone earning less than $200K. For those taxpayers, the reduction in tax rates, elimination of the AMT and estate tax, and even the elimination of the tax on LTCG and dividends will be more than wiped out by the tax effect of the deductions that will have to be removed from the Code to pay for the rate cuts. For those taxpayers, the rate cuts — if paid for by the removal of tax deductions and preferences — will actually increase their tax burden.
Shown in an “average tax liability” context, it would look as follows:
|Income level||Average federal tax change from rate reduction||Average federal tax change from removal of deductions||Net Change|
|$500,000 – $1,000,000||($41,506)||$24,370||($17,136)|
|$50,000 – $75,000||($984)||$2,672||$641|
The numbers don’t lie. Even in the highly unlikely scenario that Mitt Romney’s rate cuts would be 1) able to be offset by eliminating countless popular tax deductions, and 2) those deductions would somehow be able to first be eliminated for the highest earners before making their way down to lower-income taxpayers, the tax plan would substantially reduce the progressivity of the Code. Those earning over $1,000,000 would save on average $87,000, while those earning between $100K – $200K would see their tax increase by $1,339. That, as we learned in our opening, is not in keeping with a progressive tax code.
So if you or someone you know earns less than $200,000, you may have to think twice before embracing Romney’s tax proposal. While a reduction in rates sounds great, if those reductions are paid for through eliminated deductions, it may well be you who ultimately loses, while the nation’s wealthiest pocket substantially more cash.