The Long Sordid Tale of the American Income Tax
The high cost of the 16th Amendment
It's the time of year again when most Americans will be filing their income taxes. As if that's not painful enough all by itself, here's a little more salt for your wounds.
First, some history: In 1913 the U.S. federal individual income tax was enacted following the passage of the 16th Amendment, which granted Washington the authority to take a piece of citizens' paychecks. According to the Tax Foundation, the top tax rate that year (adjusted for inflation) was 7 percent on income above $11.5 million; the lowest rate was 1 percent on income under $463,826.
Oh, how things have changed. The tax code today is a 76,000-page monstrosity, and the current top marginal rate of 39.6 percent will hit all married filers with taxable income of $466,950 and higher.
According to the Congressional Budget Office, the federal government collected $3.249 trillion in taxes in 2015. Almost half of that amount came from the income tax, meaning that the average income tax per return was $10,300. Most of it is withheld from our paychecks during the year—thanks, Milton Friedman!—and the rest is owed come April. If you've over-withheld (i.e., if you extended an interest-free loan to the federal government), you will get a refund.
But don't go thinking you can refuse the withholding, invest that money, let it grow in the market, and then pay your entire tax bill at the end of the year. The Internal Revenue Service (IRS) is eager to get its hands on your cash right away, so it penalizes anyone who owes more than $1,000 (after subtracting their withholding and estimated tax payments) or who's paid less than 90 percent of their tax burden for the current year or 100 percent of their tax burden for the prior one—whichever is smaller. With the IRS, each time you play, you lose.
Not everyone owes $10,000 per year, of course. The federal income tax is progressive, which means the top earners pay a much larger share of the tab. According to IRS statistics, in 2013 the top 1 percent of households paid about 37 percent of federal income tax revenues collected, while the top 10 percent paid roughly 70 cents of every dollar collected through the federal income tax.
For all the talk of the rich not contributing their fair share, the United States has a more progressive tax system than the social democracies of Europe, even if our top tax bracket is technically lower than theirs. This is in part because lower-income Americans benefit from refundable tax credits like the Earned Income Tax Credit and the Child Tax Credit, which offset their federal income taxes and, for some, their payroll taxes too.
The United States also starts applying its top rate at a higher level of income. In France the top rate is 45 percent, but it's applied to all income above $170,396. In the U.S., on the other hand, a couple has to pull in nearly half a million dollars in a year before the 39.6 percent rate kicks in. So while the French have a higher marginal rate, it applies to a lower level of income, making that country's tax system more regressive than ours.
The flip side of America's progressivity is that the bottom 50 percent of households in the U.S. only shoulder 2.8 percent of the total tax burden. Though it was politically fatal to say so out loud, then-presidential candidate Mitt Romney was right in 2012 when he remarked that 47 percent of Americans don't pay any federal income tax. In 2015, that number dropped to 45.3 percent, or a total of 77.5 million tax "units" (that is, individuals and married couples), according to the Urban-Brookings Tax Policy Center.
But not even those who owe no federal income taxes get off scot-free. The incredible complexity of our income tax scheme makes it costly for everyone to comply with. According to the IRS, filing an income tax return will take each taxpayer an average of 8 hours and cost $120 per non-business return. As Joshua Caherty at the Tax Foundation explained, the cumulative compliance cost of filing all those individual tax returns in 2012 was over $20 billion. "The time consumption is further burdensome," he said. "Considering 8 hours each…Americans spent over 1.35 billion hours filing individual taxes." And that cost gets much higher if you add in the distortions created by the income tax, like when people decide to buy a home rather than rent solely to get a tax break.
There's also considerable anxiety associated with filing taxes. Google "income tax filing" and "stress" and you'll find millions of websites offering advice meant to help people reduce the mental anguish of tax season. One of the reasons stress levels are so affected is that the IRS is incredibly powerful—and unlike other crimes, when someone has a conflict with the IRS, the constitutional presumption of innocence doesn't exist: You're guilty until proven otherwise. And while you're being investigated, the IRS can seize your assets and otherwise make your life a living hell in ways you may never fully recover from.
Don't count on the IRS to help you figure out how to comply with the tricky and convoluted tax code, either. For that, you'll need to hire a professional, since several years ago the agency stopped answering questions during tax seasons. The reason? A lack of resources to assist taxpayers, it said.
In the rush to file their returns, many Americans will not look closely enough at their W-2s to realize they probably paid more in federal payroll taxes than in federal income taxes last year. In fact, only high-income earners or those who get most of their income in non-wage form typically see their income tax burdens exceed their payroll taxes.
In 2015, the feds took $1.065 trillion from our collective paychecks for Social Security and a small part of Medicare. The current tax rate for the former program is 6.2 percent paid by employees and 6.2 percent paid by employers; for the latter program it's 1.45 percent paid by employees and 1.45 percent paid by employers. These rates apply to income up to $118,000.
But don't be fooled: As most economists will tell you, the person who officially pays the tax isn't necessarily the one who actually shoulders its burden. While an employee many only see her income shrink by 7.65 percent due to the two federal payroll taxes, she's also coughing up the employer's share in the form of lower wages.
Eight out of every 10 dollars collected by the federal government comes from payroll and income taxes. Unfortunately, we don't have the comfort of knowing that this revenue is put to good use. Much of it goes to pay for programs that should be privatized or handled at the state level, such as education and transportation; programs in desperate need of fundamental reform, such as Medicare, Medicaid, and Social Security; and programs that could be seriously constrained, such as military spending.
But let's end on a happier note. On April 15, when your taxes are due, you can find a little peace in knowing that Tax Freedom Day is just around the corner. That's the point in the calendar year when the nation has collectively earned enough money to pay off its total tax bill for the year. In 2014 the Tax Foundation estimated that we spent about 30 percent of our national income on taxes at all levels. Thus, we achieved tax freedom three-tenths of the way through the year, on April 21. Only after that do Americans start earning money for things other than running their government—whether they agree with its priorities or not.