When politicians speak about the economy, they almost always talk about how they are going to cut taxes to stimulate “growth.”
In this year’s Presidential election, the Republican nominee Mitt Romney has promised not only to cut Federal income taxes, but to also cut a whole host of other investment taxes.
On the other side of the aisle, President Obama promises to keep taxes low for most Americans and to raise them only for the well off.
Current Tax Rates
Before we start dissecting the two tax plans, let’s first establish the context for which both men are making their tax promises.
First, Federal taxes are generally very low. I know, you don’t want to hear that, but it is true.
The nonpartisan Congressional Budget Office calculated that the average effective tax rate Americans paid to the Federal government in 2009 was 17%, making it the lowest rate paid in 30 years.
Since taxes have not gone up significantly since 2009, we can assume that the rate is still very low.
That takes into account all the money that a person pays to the Federal government, including income tax, investment tax and a whole myriad of other taxes from the alternative minimum tax to the estate tax.
Here are the current US Federal income tax rates:
Married Filing Jointly
|10% Bracket||$0 – $17,400||$0 – $8,700|
|15% Bracket||$17,400 – $70,700||$8,700 – $35,350|
|25% Bracket||$70,700 – $142,700||$35,350 – $85,650|
|28% Bracket||$142,700 – $217,450||$85,650 – $178,650|
|33% Bracket||$217,450 – $388,350||$178,650 – $388,350|
|35% Bracket||Over $388,350||Over $388,350|
The second thing that you should keep in mind is that the US government isn’t raising enough taxes to cover its bills.
Washington is, on average, spending a trillion – with a T –more dollars than it is taking in every year. All this overspending in the last decade has added up, contributing to a national debt of more than $16 trillion.
President Obama’s Tax Plan
Ok, now let’s take a look at President Obama’s tax plan. He wants to keep the Federal income tax rate for the four lowest tax brackets the same, but raise taxes on the fifth and sixth brackets by 3% and 4.6%, respectively.
So that means if you are single and earn between $178,650 and $388,350 a year or if you are married and filing jointly and earn between $217,450 and $388,350 a year, your tax rate next year will be 36%.
If you earn more than $388,350, married or single, then your effective tax rate goes to 39.6%.
Now, those numbers will be adjusted up for inflation next year, but they shouldn’t change dramatically.
President Obama’s plan would also leave the Alternative Minimum Tax (AMT) in place as well as the estate (death) tax.
The AMT is a Federal tax levied on a person’s adjusted gross income, which is the income you are taxed on after making all your deductions.
The AMT is designed to make sure that high-income taxpayers pay a minimum amount of tax after accounting for deductions.
A little background here: Usually, taxpayers can deduct a large percentage of their income, pushing them down into a lower tax bracket. Some people can deduct so much that they don’t have to pay anything at all.
That is partly why the average tax rate in 2009 was so low at 17% and why it has been said that 47% of Americans don’t pay any Federal income tax at all.
The AMT forces taxpayers into paying a minimum amount of tax after adjusting for their deductions. That way, millionaires can’t deduct their tax rate down to zero.
Some deductions don’t apply, though, like those for state income taxes and those for dependents.
Since the income level in the tax bracket doesn’t adjust annually to inflation, the AMT, which was established in 1969 to only affect a select group of the very wealthy, now affects millions of Americans.
It is complicated to figure out if you qualify, but you need to start worrying about the AMT if you make more than $112,000 a year or $150,000 a year if married and filing jointly.
If you are hit with the AMT, you will end up paying either the AMT rate, which ranges from 26% to 28%, or the normal income tax rate, but not both.
President Obama has floated the idea of a new AMT, known as the Buffett Rule, after billionaire investor, Warren Buffett. While not officially a part of his 2013 budget, The Buffett Rule is still on the table.
The Buffett Rule would replace the current AMT and would only hit taxpayers who earn more than $1 million.
The rates would be 32% for those making between $1 million and $10 million; 33% for those making between $10 million and $100 million; and then back down to 32% for those making over $100 million.
The estate tax, thankfully, is a much simpler concept. It is basically a Federal tax (currently 35%) levied on the value of a person’s estate (starting at $5.12 million) when they die.
President Obama wants to raise the tax rate to 45% and lower the value at when the tax kicks in to $3.5 million.
President Obama’s plan also calls for extending the payroll tax cut, which currently reduces the amount of Social Security tax people pay.
Mitt Romney’s Tax Plan
The President submitted his tax plan to Congress in his 2013 budget proposal, and when compared to the information Mr. Romney has presented, the two plans appear to have some significant differences.
On Federal income taxes, Mr. Romney has said he would like to cut taxes for all six tax brackets by 20%.
From bottom to top, the tax brackets would fall to 8%, 12%, 20%, 24.4%, 26.4 and 28%.
So if you fall within the top two brackets, President Obama would tax you at 36% and 39.6%, while Mr. Romney would tax you at 26.6% and 28%.
Let’s examine how this could impact a single person (we’ll call him Mike), who is in the second highest tax bracket.
The median gross income for a single person in this bracket is $283,500. Let’s chop $50,000 off for deductions (mortgage interest, personal deduction, children, education, etc.) making Mike’s adjustable gross income $233,500.
That would still put Mike in the second-highest tax bracket. So in 2011, assuming Mike had zero tax credits, he would have been taxed at 33% and would have paid around $79,000 in taxes, based on his adjusted gross income of $233,500.
If President Obama’s plan had been in effect, then Mike’s tax rate would have been 36%, raising his tax bill by $6,200 to around $84,000.
But if Mr. Romney’s plan had been in effect, Mike’s tax rate would have been just 26.4%, lowering his tax bill by $15,700.
This means that under Romney’s plan, Mike would have kept around $21,800 when compared to President Obama’s plan.
Romney’s plan also includes a very investor-friendly tax environment. He said he would totally eliminate the Federal income tax on capital gains and dividends for people making less than $200,000 and would impose a flat 15% tax on those making more than $200,000.
Mr. Romney would also eliminate the current 3.8% surcharge that the government currently tacks on to investment income earned after making $200,000 a year.
Here’s another very simple example:
Say that Mike’s adjusted gross investment income was $500,000.
Under President Obama’s plan, Mike would be taxed at the elevated full income tax rate of 39.4% and would have $300,000 of his investment income taxed at 3.8%, for a total tax bill of as much as $210,000.
Under Romney’s plan, Mike would have been taxed at a flat 15% for a total tax bill of $75,000, a $135,000 difference.
Romney has also said he plans on totally eliminating the AMT, as well as the estate tax.
How realistic are these plans?
Remember how we mentioned that the government currently spends $1 trillion more each year than it brings in? The tax cuts Romney is proposing could potentially add up to billions of dollars in lost revenue, putting the country deeper in the hole.
The President’s budget, on the other hand, still hardly moves the needle when it comes to raising revenue. In fact, it’s possible that proposals like the Buffett Rule would cost billions in lost tax revenue if it ends up replacing the current AMT.
Whichever plan you support, both of these tax changes hinge on a strong growing economy and a huge reduction in government spending.
So how much does Mr. Romney need to cut in order to justify his tax cuts? And how much does President Obama need to raise to pay for his plan to overhaul healthcare?
We’ll look at those two questions next week.