Middle Class Taxpayers Still Lose

Written by Andrew Pavelyev on Thursday December 29, 2011

The recent fight over the extension of the payroll tax holiday has once again shown that the Republican Party does not particularly care about the middle class tax burden. The party is quite interested though in cutting taxes on the highest earners. What gets completely ignored is the fact that most billionaires already have lower effective tax rates than some segments of the middle class.

Warren Buffet reports paying about 17% of income in taxes. And according to the IRS, 400 U.S. taxpayers with the highest adjusted gross income are subject to the effective tax rate about 18%. How do these numbers compare to those of the middle class?

Let us consider a hypothetical not-so-average Joe. Not Joe the Plumber, but Joe the Scientist. Suppose Joe earned his PhD in a STEM field a couple years ago and last year was earning a salary of $9,000 a month. Furthermore, let's suppose that Joe is single, lives in a rented apartment and has a sizable student loan, just a few thousand dollars in savings and no other assets to speak of except for a nice (but not too fancy) new car (which, alas, comes attached to a car loan with the principal currently exceeding the realistic resale price). In other words, Joe has a negative net worth. Joe is certainly in the middle class and not rich by any stretch of the imagination (in fact, if he lives in a place with very high cost of living like New York City or San Francisco, I'm not even sure he qualifies for the upper middle class).

Finally, let's suppose that Joe was not yet making any 401(k) contributions last year and that his health insurance cost $500 a month of which $400 was paid by his employer and the other $100 was deducted from his pay (so Joe's 2010 W-2 showed $108,000 Medicare wages and $106,800 taxable wages). So, what was Joe's effective tax rate last year?

In order to determine it, we need to calculate both the total taxes and total compensation. The latter needs to include not only all money paid to Joe by his employer but also all money paid on Joe's behalf by his employer. The employer paid $4,800 for health insurance, $108,000 x 1.45% = $1,566 for the employer's share of Medicare taxes and $106,800 x 6.2% = $6,621.60 for the employer's share of Social Security taxes. That brings the total compensation to $120,987.60. Let's just ignore negligible additions like unemployment insurance and workers comp premiums, interest on Joe's savings account etc.

Now, the taxes. The employer's share of FICA taxes was $1,566 + $6,621.60 = $8,187.60. Joe paid the same amount (remember, we are talking about last year, when there was not payroll tax holiday). So the total FICA taxes were $16,375.20.

And then there's income tax. Joe was considered too rich to be allowed to take any student loan interested deduction, so his adjusted gross income was $106,800. Since Joe is neither old nor blind and has no dependents, he can take only one personal exemption, $3,650. Joe does not have any mortgage interest to deduct, and let's suppose that he paid $5,000 in state income taxes and $200 in personal property taxes (on his car) and also had documented charitable donations totaling $500. His potential itemized deductions amounted to a total of $5,700, which also happened to be the standard deduction, so itemizing did not actually make any sense.

Subtracting the personal exemption and standard deduction from the adjusted gross income, we arrive at the taxable income of $97,450. The income tax table shows us the amount of tax due: $21,002.

The addition of the FICA taxes and the federal income tax gives us the total federal taxes paid by Joe in 2010: $37,377.20.

Finally, dividing this amount by total compensation of $120,987.60, we obtain Joe's effective tax rate - 30.9%. Wow! The federal government took over 30% of Joe's earnings! Just as a reminder, typical Joe the Billionaire pays 18%.

We constantly hear lamentations over the low number of Americans pursuing doctorate degrees in STEM fields. Perhaps this hypothetical example of Joe the Scientist might suggest one of the reasons?

When people invest in their education, our human capital increases. But do taxes discourage such investments? Let's not forget that getting a doctorate degree does not only require a big investment of time and effort - it can also be a very substantial financial investment. When people think of really expensive graduate education, they think along the lines of the Harvard Law School. But a doctorate degree in science, math or engineering at a modest public university can cost a fortune too - because of opportunity costs. A bright young person with a BS in, say, chemical or computer engineering can earn a pretty good salary straight out of school and still higher salary after gaining a couple years of experience. Spending several long years in grad school instead can mean foregoing hundreds of thousands of dollars in gross earnings. Sure, an advanced degree means higher income after graduation, but the reward is not all that high (especially when we compare workers with PhD with workers with BS and several more years of experience).

And how is that return on investment in human capital taxed? Well, the top portion (last $15,000) of Joe's earnings is taxed at 28% plus there's a total of 15.3% in FICA taxes. So the federal government alone takes 43.3%, and there are quite a few states with income tax rates over 7%. So depending on which state Joe lives in, the government may well receive higher reward for Joe's educational investment than Joe himself!

If any investment in financial markets received such tax treatment, supply-siders would scream bloody murder. But they seem to be curiously uninterested in other, equally important, kinds of investment.

And while the case of somebody in the middle class with an effective tax rate over 30% is rather rare (although far from impossible, as I have shown), there are millions of people in the middle class with effective tax rates above 20%. The GOP needs either to give them some really good arguments for further cutting taxes on the wealthiest taxpayers who already pay less than 20% - or come up with a different party platform.