Yesterday I read an article written by Paul Krugman that made me hurl. Called The Twinkie Manifesto, the title of the article was the best part; it was all downhill after that. Krugman wants us to return to the day when the top marginal federal income tax rate was 91%.
And his argument is as dead wrong as it is dead simple. He notes correctly that we once had a top federal tax bracket of 91% (circa 1950) and we did just fine. Therefore, high tax rates don’t hurt the economy, he claims. He’s not the first to compare today’s tax brackets with those from a bygone era. He’s also not the first to confuse marginal tax rates with effective tax rates. Here’s what he had to say–
Consider the question of tax rates on the wealthy. The modern American right, and much of the alleged center, is obsessed with the notion that low tax rates at the top are essential to growth. Remember that Erskine Bowles and Alan Simpson, charged with producing a plan to curb deficits, nonetheless somehow ended up listing “lower tax rates” as a “guiding principle.”
Yet in the 1950s incomes in the top bracket faced a marginal tax rate of 91, that’s right, 91 percent, while taxes on corporate profits were twice as large, relative to national income, as in recent years. The best estimates suggest that circa 1960 the top 0.01 percent of Americans paid an effective federal tax rate of more than 70 percent, twice what they pay today.
Did you see the slight of hand? If not, it’s time to look at effective vs. marginal tax rates. Then we’ll return to Krugman’s claim.
Marginal Tax Rates
Marginal rates refer to the tax brackets we’re all familiar with. Today, the top marginal rate is 35%. That doesn’t mean, however, that the wealthy actually pay 35% of their ordinary income in federal taxes. And there are several reasons for this.
First, federal tax rates are progressive. As you make more money, the rate on your incremental income goes up. Today, for example, a married couple filing a joint return will pay 10% on their first $17,000 of income. That’s true whether their total taxable income is $25,000 or $250,000. In other words, the wealthy don’t apply 35% to 100% of their income. For a married couple filing a joint return, they would apply 35% only to that portion of their taxable income that exceeds $388,350.
Second, the tax code has countless deductions. Some of the more common deductions include home mortgage interest, state and local taxes, and charitable contributions. And these deductions have changed over time. You may recall a time when you could actually deduct the interest you paid on credit card debt. But the point is that your taxable income never equals your actual income.
Finally, the tax code offers a number of exemptions and tax credits that also reduce your tax liability. Exemptions for dependents and tax credits for adopting a child are just two examples.
Effective Tax Rates
So how much does a person actually pay in taxes? That question brings us to the effective tax rates. If you take the actually taxes you pay and divide it by your total income, the result is your effective tax rate. And this is a critical distinction.
For example, a tax code could have a marginal rate of 91% but result in the wealthy paying less in taxes than with a marginal rate of 35%. How? If it offered the wealthy enough deductions and credits to bring down the actual taxes they had to pay. In fact, before 1986 there were a lot more ways to avoid taxes than there are today. As a result, comparing tax brackets after 1986 with those before is like comparing apples to oranges.
A 91% Marginal Tax Rate?
Krugman’s reference to a 91% marginal tax rate and a 70% effective tax rate left out a few of the finer details.
First, in 1960 the 91% rate applied to the portion of income exceeding $400,000. In today’s dollars, that would be equivalent to a married couple making more than $3 million (the Bureau of Labor Statistics has a handy inflation calculator). In other words, the top bracket in 1960 is in no way comparable to the top bracket today, which kicks in for a married couple with taxable income of just $388,350. And by the way, the tax rate of folks making $4,000 or less in 1960 was a whopping 20%. So if Krugman is right that high marginal tax rates are benign, why not raise everybody’s rates?
Second, his reference to a 70% effective tax rate for the wealthy is very misleading. That rate is not limited to income tax. In a study by Thomas Piketty and Emmanual Saez, How Progressive is the U.S. Federal Tax System? A Historical and International Perspective, they show that much of the 70% effective tax rate in the 1960s was due to payroll, estate, and corporate tax, not individual income tax.
But when you compare effective tax rates calculated using just ordinary income, the effective rate is much lower. The Congressional Budget Office studied effective tax rates from 1979 to 2002. The results do show that effective rates declined during that period for everybody.
In 1979, the average effective rate for all taxpayers was 22.2%. For the top 1%, the rate was 37%, and for the bottom 5th of all taxpayers, the effective rate was 8%. In 2002, the average rate for all taxpayers was 20.7%. For the top 1%, the rate declined to 32.7%, and for the bottom 5th, the effective rate was nearly cut in half to 4.6%.
At the end of the day, what matters is the effective tax rate, not the marginal rate. And any comparison of historical marginal rates is of little value, given the ever changing mix of tax deductions, credits, and tax shelters.