A professional shell game

Let me apologize up front for writing a somewhat technical article. However I’ve been watching journalists and commentators for most of 2012 reporting on the battle over tax policy between Republicans and Democrats. Now with the “fiscal cliff” upon us, the intensity of the debate has increased. Many, if not most of these journalists don’t understand what they are talking about.

That’s understandable. The U.S. Internal Revenue Code is a complex and difficult subject.

A couple weeks ago I was watching Squawk Box on CNBC. The show’s hosts were discussing the tax rates in terms of marginal rates and a taxpayer’s effective rate. Joe had no understanding of what an effective tax rate is. Becky was able to explain it but not in a way a novice might understand. But as business journalists, I was surprised of their lack of understanding of these terms. These terms are not difficult to grasp. They just aren’t used in typical everyday conversation.

So what is the difference between a marginal (or incremental) tax rate and an effective tax rate? If you are concerned about the debate on income tax policy and the path over the upcoming fiscal cliff, a clear understanding of these terms might be important for you to understand the debate.

The marginal tax rate is the percentage at which your next dollar of income is taxed. This is what our politicians are referring to in their speaking points. The more important rate, in my opinion, is your effective tax rate. Your effective tax rate equals your total tax paid as a percentage of your total income.

Pre-election there was a lot of talk about arithmetic. Here’s the basic arithmetic in determining your marginal tax rate. When you look at your 2011 Federal Form 1040, you’ll see that it’s divided into sections. The sections you want to focus on to determine your marginal tax rate are labeled Income, Adjusted Gross Income, and Tax and Credits. The magic number needed determine your marginal tax rate is line 43, Taxable Income in the Tax and Credits section.

The simple math to arrive at taxable income is total income (line 22) minus the total above the line deductions from total income (line 36) equals your adjusted gross income (line 37). Next subtract the higher of your itemized deductions or your standard deduction (line 40) and the total of your exemptions (line 42) and you arrive at line 43, taxable income. It’s your taxable income that determines your “tax bracket.” You then take the amount on line 43 and compare it to a table (see IRS publication 2012 Form 1040ES, page 6) to determine the amount to place on line 44, Tax.

Since there are six different tax rates (10%, 15%, 25%, 28%, 33% and 35%), the “bracket” with the last dollar of “taxable” income you report determines your marginal income tax rate. For example, a married couple filing a joint income tax return with taxable income of $50,000 would have a marginal tax rate of 15% while a person filing with the status of single would have a marginal rate of 25%.

Of course the above illustration is an oversimplification. There are variations to the calculation such as for individuals with qualified dividends and long-term capital gains. These taxpayers have to use a worksheet in the instructions of form schedule D to determine their actual income tax. And there are other exceptions we don’t need to cover in this discussion.

As for the computation of the effective tax rate, this is much simpler. The effective tax rate is the percentage of income tax paid as a percentage of your total income. For most people calculating the effective tax rate is simply taking the amount on line 61, “This is your total tax” by line 22, “this is your total income.” If you have some form of nontaxable income such as municipal interest income, you would add your nontaxable income to your total taxable income to get a true picture of your effective tax rate.

So which tax rate do you think would be the most important to you? Your marginal tax rate or your effective tax rate? For me the effective tax rate is the most important rate. It is the amount of my total income I had to pay in income taxes.

As you follow the debate on income tax policy over the next couple of months listen for keywords. Tax rates are only part of the math. Pay attention when the discussion is about deductions and credits, limitations and changes in accounting methods. There is a lot more to the story than their talking about.

When politicians say they won’t agree to an income tax rate increase, don’t confuse this with they won’t raise taxes. They will. The will increase the effective tax rate, the amount you actually pay in taxes to the U.S. Treasury. This increase will be achieved by limiting or eliminating certain deductions and credits which effectively increases your income taxes.

And spending? They will continue to spend freely. They have wealthy donors and wealthy donors don’t give out of the kindness of their hearts. They want their entitlements too.

The bottom line: Our government leaders are professional politicians. They are playing a shell game, coached by professional consultants and lobbyists and you’re the mark. They don’t want you to know the truth, at least the whole truth.

I’m not concerned with which side you take in the debate. Just don’t be duped. The income tax rate, the marginal or incremental tax rate, the tax rate most commonly referenced in the tax policy debate, is just a small piece of the equation.