Middle-Income Tax Rates: Trends and Prospects
Davig, Troy A., Garner, C. Alan, Economic Review (Kansas City, MO)
Benjamin Franklin observed that nothing in life is certain except death and taxes. But he was referring to the existence of taxes, not the amount. The federal tax liabilities of different income groups change constantly in response to new tax laws and shifting economic circumstances. For example, in recent years, Congress has lowered individual income tax rates, increased child and dependent care credits, and reduced taxes on dividends and capital gains. Much of the economic analysis and political debate about these federal tax changes concerns the impact on upper- or lower-income groups, while the impact on middle-income taxpayers sometimes gets forgotten.
The trends in tax rates can be difficult for middle-income taxpayers, themselves, to discern. Modest revisions to the federal tax code may hardly be noticed in any given year; yet these revisions could build over time into a large change in the middle-income tax rate. Some taxpayers may also find it difficult to determine whether changes in their tax liability are due to legislated changes in the federal tax code or shifts in their own circumstances. For example, shifts in the composition of a household's income between labor income and capital gains could alter the household's tax liability, as could the birth of a new child or unusually large medical bills.
This article shows that, while federal tax rates paid by middle-income households have generally declined in recent years, they are likely to rise in the future. The first section defines the effective federal tax rate for middle-income households and discusses the problems in computing this measure. The second section finds that the effective federal tax rate facing middle-income households has trended downward over the last 25 years and is currently low by historical standards. Moreover, the composition of middle-income tax liabilities over this period has shifted away from individual income taxes toward payroll taxes. Finally; the third section shows that under current tax law middle-income taxes are projected to rise in the future.
I. MEASURING MIDDLE-INCOME TAX RATES
People often talk about the tax rate on middle-income Americans, but both "tax rate" and "middle-income" are harder to define than might appear. The tax rate is hard to define partly because households pay a variety of taxes, both directly and indirectly. Likewise, a middle-income group can be defined in various ways, and the tax rates facing two households in the same income category may still turn out to be different. This section summarizes the simplest computation of a household's federal income tax liability. It then defines effective federal tax rate and middle-income household. Finally, it discusses some of the limitations of these concepts.
Calculating tax liability
To understand the effects that changes in tax laws have on middle-income households, it is useful to briefly describe how the federal government determines a household's tax liability using the 1040-EZ form (Table 1). This "simple" tax form has 36 pages of instructions, so the discussion omits many details.
Taxable income is calculated as
Taxable Income = Gross Income - Adjustments - Deductions - Personal Exemptions,
where gross income includes all income from wages, interest, and pensions. Adjustments include contributions to retirement plans, moving expenses, and interest paid on educational loans. A household takes the greater of either the "standard" deduction or their "itemized" deductions. In 2005, the standard deduction for a household with a married couple filing jointly was $10,000. Itemized deductions equal the sum of expenses, such as medical expenses, mortgage interest, charitable contributions, and state and local taxes. Personal exemptions work exactly like adjustments and deductions, in that they reduce a household's taxable income. For the majority of middle-income households, the personal exemption is equal to $3,200 multiplied by the number of individuals in the household. …