Some of the confusion surrounding Warren Buffet’s secretary and her taxes comes from the failure to distinguish between average and marginal tax rates. There’s also the fact that Social Security and Medicare payroll taxes are paid on only the first $106,800 of income.
But considering income taxes alone and not payroll taxes, there’s often confusion between average tax rates (the total amount of tax paid divided by the amount earned) and marginal tax rates (the amount of tax paid on the next dollar earned).
As an illustration, consider a single person earning $60,000. Plugging the numbers into the tax calculator at efile.com, and not taking any deductions other than standard and personal, produces a tax liability of $8,444. On income of $60,000, this is an average tax rate of 14.07 percent.
But consider if the person earns another $100. (The calculator doesn’t work with fractional dollars, so we’ll use $100 instead of $1.)
Now, the tax liability is $8,469. That’s an increase of $25 in taxes for an increase of $100 in income. In other words, this person is in the 25 percent tax bracket, meaning that each additional dollar earned results in an additional $0.25 in tax.
Not all earnings are taxed at this 25 percent rate. Some is taxed at a much lower rate, and some not at all. By the way, the average tax rate has now increased to 14.09 percent.
If the $60,000 wage earner is married with two children, the tax bill falls to $3,463, producing an average tax rate of 5.77 percent, and the marginal rate on the next dollar earned is 15 percent. This again assumes no deductions beyond the standard and personal.
So what tax rate does Warren Buffet’s secretary pay? There can be many answers.
One thing we can be certain of, however, is that wealthy people like Buffet have options in structuring their income that ordinary wage earners don’t. Buffet, for example, says he receives most of his income in the form of capital gains or dividends, which are taxed at 15 percent.
This is an illustration of Hauser’s Law at work. Try as we might, raising tax rates won’t generate higher revenues (as a percentage of gross domestic product), due to Hauser’s law. W. Kurt Hauser explains in The Wall Street Journal: “Even amoebas learn by trial and error, but some economists and politicians do not. The Obama administration’s budget projections claim that raising taxes on the top 2% of taxpayers, those individuals earning more than $200,000 and couples earning $250,000 or more, will increase revenues to the U.S. Treasury. The empirical evidence suggests otherwise. None of the personal income tax or capital gains tax increases enacted in the post-World War II period has raised the projected tax revenues. Over the past six decades, tax revenues as a percentage of GDP have averaged just under 19% regardless of the top marginal personal income tax rate. The top marginal rate has been as high as 92% (1952-53) and as low as 28% (1988-90). This observation was first reported in an op-ed I wrote for this newspaper in March 1993. A wit later dubbed this ‘Hauser’s Law.’”
People react to changes in tax law. As tax rates rise, people seek to reduce their taxable income and make investments in unproductive tax shelters. There is less incentive to work and invest. These are some of the reasons why tax hikes usually don’t generate the promised revenue.
Any plan to generate substantially more revenue by raising tax rates will have to overcome this tax-avoiding behavior. Hauser’s law says this is not likely to happen.
Hauser’s Law illustrated. No matter what the top marginal tax rate, taxes collected remain an almost constant percentage of GDP.