You are right in that my computation doesn't show up on the tax form or even in the instructions! But a small clue here about deductions, the value of any deduction is always subject to the taxpayer’s marginal rate. How would you value it except to multiply it by that rate, then use that product to reduce the cost of the deduction?
It is assumed that the person doing the taxes understands that a tax deduction that adjusts the AGI lower only affects the total income tax paid. This would be the same for something like Federal income tax deductions for State tax, the state tax payment itself doesn't change but if that payment reduces your Federal tax bill then you can say that the State tax payment actually costs you less (or adds less cost) than it appears at first blush.
I did make one mistake, in that to compare the employed person to the self-employed you have to use the gross amount of 95,000 and then add the employer half of FICA payment to factor the FICA effective tax and then back out the tax savings of the employer half not being subject to Federal income tax. This gets the two effective rates roughly equal, that of the self employed and the employed... but not entirely which would be evident if you calculated the after tax pay for both.
Effective tax rate isn't on your 1040 either so don't go looking for it. It is a measure used by economists to measure the actual tax rate and not the computational rate. To get to it you take the tax payment and divide it by the total income. Total income for a wage earner is defined by gross plus the amount of FICA paid by your employer in your behalf. Try to explain that to the ordinary wage earner and get them to agree, that the FICA paid by their employer is actually income.
The wonderful thing about this exercise is that it shows that FICA as well as SE tax has an effective rate on wages of around 12.2%, at least on most wage incomes (those that don't rise above the limit). The effective rate drops substantially for wage incomes above the limit because you get into just Medicare.
BTW I could have predicted you'd have countered with the motel joke, which I'm well familiar with. It does get people spinning when they are trying to put their little minds around the tax code. My husband still really doesn't understand why I've always counted the full value of the deduction for our self employed health insurance but discounted the deduction we used to get for mortgage interest (back when we still had a mortgage). The difference is that the value of deductions on the front of the 1040 aren’t subject to the test of rising above the standard deduction allowances.
I'm also not surprised you balked at my rather simple computations. You expressed some dismay about the adjustments made to household incomes in the CBO data to account for the number of people in the household as well. Most people wouldn't get this. What they do get is that a 4 person household with two income earners making 100k isn't as rich as a one person household making 100k. When I express it this way they understand why it takes a higher income for that 4 person household to make it into the next higher quintile for income, thus the use of the square root of the number in the household to adjust incomes so they fall into the proper quintile.
Of course the macro computations are really only useful when you are trying to factor how much tax policy effects the individual's incentive to produce. You do a little adding, you do a little multiplication and you do a little subtracting but it certainly doesn't get you into that motel room with those three guys.
Where the rubber meets the road for the individual is take home pay, after tax income. To understand the difference a certain tax rate makes in your life you have to factor it down to the last penny for each scenario. In the same vein to understand the real effective rate you have to do this as well. If you had trouble with this you sure don't want to see my "Should I buy or rent" work sheet, which is a much more complicated projection with multiple unpredictable variables (the range of which is being tested as we speak), so much so you can't come up with a single answer.
BTW the real tax that we should be worried about in an investment forum is the effective tax rate on capital investment because that rate actually has a much more serious effect on the long term overall wealth of a nation and its people. |
