Welcome back gang!
In the 100 level we discussed how what is classified as “individual income taxes” and we showed that they make up 54% of all federal income.
Within individual income taxes, you have several categories of income. Salaries and Wages, taxable interest and dividends, capital gains or losses, net business income (which is different than C corps like Google, Amazon, Safeway etc.) Within individual income taxes, Salaries and Wages make up 66% of available money to tax income.
These charts do not show that they collect $10 trillion in taxes. This means that there are $10,021 trillion of wages that can be taxed at essentially whatever rate congress wants. In 2022, congress was projected to tax Americans at an effective rate of 19.2%. Meaning on average, a wage earner paid 19.2% in taxes. This translates to congress collecting $1,924 trillion in salaries and wages, essentially W2 income. If you get a 1099, own a business, sell stock, none of that money counts here. This is just what they call labor wages. In my former job, I earned commission and some of that was paid via W2.
Many people are unaware of how their accountants calculate their owed tax. At its core, it is really simple.
Most often your employer reports how much money they paid you to the IRS and how much money they withheld for you. Withholding just means your employer took money from your paycheck and sent it to the IRS on your behalf. This info is on your W2 form that you should be receiving around the time this post is published on January 18th. From there, everyone has two options: you can take what’s called the standard deduction, or you can itemize your return.
In 2022 roughly 158 million people will file a tax return. 18 million of those returns will be itemized. What does itemized mean?
Itemized means that you pay large enough amounts of mortgage interest, charity donations, medical expenses, and other expenses. What congress says, is that these expenses you can “write off”. You’ve all heard of a write off, what it means is if you earned $100,000 in W2 wages, and you donate $5,000 to charity, congress will say that you only earned $95,000 when they look to tax you. They will ignore that $5,000.
Why does congress do this? Taxes are the main tool congress has to encourage or discourage you from doing anything (outside of punishment like jail which is reserved for things they really discourage like murder). Congress wants society to be charitable, so they allow you to write it off. Congress wants to encourage you to purchase a home with a mortgage, so they allow you to deduct interest expenses on your mortgage, but congress has rules around write offs such as you cannot deduct your interest if your loan is above $750,000. Presumably this is to exclusively help the middle class, or at least not offer it to the very wealthy. Have no fear those of you wealthy enough to purchase $1,000,000+ homes, there’s plenty of help for you later.
(These numbers change so please consult your accountant for personal tax advice, I am not a CPA or tax expert, just a value investor curious in how our government works and taking my readers along for the ride)
Itemizing means you have a list of expenses that add up to a meaningful amount of money that will reduce your AGI. Why do only 11% of returns itemize? Because you have to either itemize or take the standard deduction. The standard deduction is $12,950 per individual or $25,900 if you are married. If you earn $100,000 as a single individual, congress will say, we will pretend you only earned $87,050 and only tax you on that amount.
One of the major things President Trump changed in the Tax Cuts and Jobs Act (TCJA) was that he eliminated what are referred to as SALT deductions, or state and local tax deductions. Before the TCJA, households could take the tax they pay to their individual states, counties/cities and deduct that from their federal taxes. Democrats didn’t like that for two reasons, #1) Trump did it and in general both parties tend to oppose anything the other party does, and #2) Democrats tend to come from high income and high tax states, so it hurt them more. Higher income and higher taxes mean higher SALT deductions. Eliminating SALT deductions means raising taxable income. It hurt higher income earners.
Another major change Trump signed into law was doubling the standard deduction. This doubling, along with eliminating SALT deductions, is the reason why almost all returns, 89%, take the standard deduction. Before the TCJA the standard deduction would likely have been $6,475 for individuals and $12,950 for married couples. Trump doubled those numbers. I’m not a fan of the former president, but I actually really liked this decision. It was progressive and good for the middle and working class. By progressive I don’t mean climate friendly or anything like that, I mean it raised taxable income for higher income earners and lowered it for lower income earners. But again, there are plenty of benefits for high income earners in our system. But we’ll save that for capital gains taxes.
Alright, so intuitively you should understand that when you get your W2, congress say’s “hey, we will pretend like the first $12,950 of your income isn’t there, or if you can show that you have the following expenses (charity donations, medical bills etc.) in excess of $12,950, we will take off that number, whichever number is greater we’ll let you “write off””. This number is referred to as your Adjusted Gross Income (AGI).
AGI is your income minus deductions. Congress then takes your AGI and puts it into the appropriate tax bracket. For single individuals, these are the 2022 tax brackets.
Presume you earned $100,000 and took the standard deduction. Your owed income tax would be $14,767.50.
(Wages) $100,000 - (Standard Deduction) $12,950 = $87,050 AGI
That puts you in the third row.
$87,050 - $41,775 = $45,275 * .22 (top marginal rate) = $9,960.50 + $4,807.5 = $14,767.50 (total tax)
The $4,807.5 is for the money you owed on all income below the $41,775 that we subtracted off. As you can see, your top bracket is 22%. However, you didn’t pay 22% on all of your income. If you did, you would have paid $19,151 in taxes off of your AGI. And without the standard deduction you would have paid $22,000 if that was your tax rate. But it’s not.
We have a progressive system. The first $10,275 of AGI that everyone makes: you, the McDonalds fry cook, Patrick Mahomes, that first $10,275 gets taxed at 10%. The next $31,499 gets taxed at 12%. Progressive taxes means that you are never disincentivized to work or make money. Again, when I say progressive, I am not referring to any ideology or leanings, it’s just that the rates get progressively higher. Some people argue for a flat tax, and perhaps we should, but that would likely raise taxes on almost everyone, minus the very very wealthy, who would save money. A person making $100,000, due to the standard deduction and progressive tax rates, pays an effective rate of 14.7%. Often people tell you they pay 22% because that’s the highest bracket they are in. Examine the following:
Technically nobody pays 37%, but with rounding, by the time you start earning $9,000,000 you can round up to 37%. This is if you’re single. If you’re married… here are the brackets.
This is what we mean by progressive rates. Maybe you believe in flat rates for all taxpayers. Or maybe you believe in progressive rates, which implies that $5,844,966 to a person making $16,000,000 a year is less impactful than $41,455 is to a person making $250,000. Or maybe you believe that it doesn’t matter the personal impact we should all pay the same rate. It’s up to you to decide. But when you hear congressmen talking about our 37% rate, or our complicated tax system, you can see what they had in mind when they made it. The idea is that the higher income earners can pay a higher rate and have that impact their lives very little whereas a person making $100,000 would be more burdened by the same rate.
I think the interesting discussion is around the rates, and the number of brackets. I think people get very upset at the idea of adding another tax bracket, but I believe the person making over $5,000,000 a year might be able to afford more than a person making over $647,851 a year, I’m not sure why there’s panic around that discussion.
Here’s a borrowed chart showing the history of the highest rates:
I think we can all agree 94% is way too high. When each additional dollar you earn only brings you 6 cents, you’re disincentivizing work. But when you’re earning over $200,000 a month ($2.4 mil/year), I think you can afford to pay a higher rate than a person making $60,000 a month ($720k/year). And for those who say ‘yes but high-income earners build businesses and create jobs’. That might be true, however, we could easily include, and do include, write offs for that type of activity. If you choose to create jobs we can tax you at a lower rate, if you choose to just let the money pile up and buy houses, jewelry and cars, maybe we can tax you some amount more.
On the contrary, and now I will begin to appease my great friends on the right, raising the top bracket wouldn’t really move the needle too much. In 2022 we are projecting that roughly $380 billion of income tax will come from that top marginal tax rate. Meaning if all of them were married and earned $16,000,000 per year (something that’s almost certainly a high estimate) we would collect roughly $120 billion in additional income tax if we raised the top rate to 49%. That’s not that much more money considering how politically challenging that might be. Not to mention there is some merit to the job creator argument.
I do think there’s room for adding a bracket and raising rates, however, it’s unlikely to solve our deficit problems by doing so… see you next week. '
Hey gang!
If you know anyone who would enjoy this series, please share the post with them. All of my old posts are available on my substack and I will put a glossary of the entire series below.
Have any comments you’d like to share? Did I make any statements that you are dying to correct? Subscribe to my page and reply to the next email and I’ll see it.
Thanks for reading Ed's Newsletter! Subscribe for free to receive new posts and support my work.
Table of contents:
Salaries and Wages 201
An early episode of The Twilight Zone addresses the 94% tax rate when a $1M lottery jackpot dwindles to $60K after the tax man shows up. In reality, much like the 50% excise tax on missed RMDs, few people pay those high rates because the incentive is so strong to avoid them. Even the IRS understands this.
What would be interesting to evaluate is how much government revenue comes from Corporate America (mid-to-large cap corps) both through taxation of corporate earnings and on employee earnings. If we counted both sources, I speculate/estimate corporations provide about half of federal revenue.
That’s important because you got to follow the buck to know who anyone is working for.