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The American tax system is complex. It’s also ineffective: our tax rates are high, yet our budget deficit is even higher. Add to that the failing state of many school systems, infrastructure, and health care accessibility in our country, and the whole question becomes even messier.
Also, how and why has the American tax code grown to 74,608-pages long? Even Certified Public Accountants can’t stay up-to-date with the ever-growing code requirements.
So what gives? What is wrong with the American tax system and how does it disproportionately tax the middle class?
If you want to know more about this topic that impacts us all, read on.
Recent History and Changes
In the United States, we have a progressive tax system. This means that people who earn more should pay a higher tax rate than those who pay less. This is based on a fairness concept called “ability to pay.”
Tax rates have changed over time, sometimes increasing and other times falling. In the early 20th century, tax rates on high earners were around 80%. After the Great Depression, those rates fluctuated and fell as low as 25%.
After World War II the top marginal tax rates reached 90%, with the effective rate at around 70%. The effective rate is what is actually paid, after deductions, credits, and loopholes.
The tax rate remained fairly high until Reagan became president in the 1980s. His administration lowered the tax rate on high earners to 50% in 1982 and then to 25% in 1988.
The marginal (high earners) tax rate has hovered between 25% and 41% since that time.
Today’s top tax rate for a salary of over $501,301 is 37%.Â
That doesn’t mean that all $501,301 is taxed at 37%, though; the progressive system applies here, too. Only anything over $501,301 is charged at 37%; anything below that has a lower rate applied.
In addition, there are tax breaks, deductions, and loopholes that many people—especially those at the high-end of the tax bracket—use to pay even lower tax rates.
Deficit? Debt? Deductions? What’s the Difference?
As I said, the American tax system is complicated. There’s a lot of lingo and vocabulary that can be daunting if you’re just learning about this. Let’s look at a few of these key terms.
Deficit
A budget deficit means that we take in less money than we spend, so we have to borrow money from other sources in order to pay our bills. The government can borrow money from its taxpayers (in the form of bonds) and from other governments.
The last year that America had a surplus—that is, more money than we needed to spend—was in 1993.
(Seriously, imagine telling your parents, “It’s alright mom and dad. I budgeted my finances correctly 27 years ago. There’s nothing to worry about here.”)
Debt
The national debt is how much we owe after these 27 years of running deficits. The budget deficit adds to the overall national debt each year.
Tax Credit
A credit is money you deduct directly from your tax bill. The government provides these credits to individuals and businesses to incentivize certain behavior, like environmentally-friendly machinery or homeownership.
Tax Deduction
Deductions are expenses that you subtract from your income before applying the tax rate. These will also help reduce your tax bill, only in an indirect way.
Problems with the American Tax System
Clearly, we need a way to fund our government and the services it provides. The three biggest categories that our tax dollars pay for are:
- Medicare and Medicaid (Health Programs)
- Social Security
- Defense and National Security
Plus, we all value roads, schools, and of course, fire and police departments, and there’s no perfect way for the government to gain revenue. However, many people will tell you that the tax system is broken—or at least, clunky.
Let’s take a look at a few of the common complaints about the American tax system:
1. It’s Complicated
Just take a look at the 74,608-pages of rules and regulations that make up the tax code. It’s complex, convoluted, and requires a bureaucracy of 80,000 employees that costs over $11 billion to run. It’s just too unwieldy, and if not for political considerations, would be possible to simplify.
2. It’s Unfair
While the current tax system is progressive up to a point, this isn’t true at the highest levels. Meaning, it is not progressive for wealthy individuals. (Remember, progressive means that people who earn more should pay a higher tax rate than those who pay less.)
For example, in 2015 the effective tax rate peaked at 29.3% for taxpayers in the $2-$5 million group, then fell to 28.8% for the $5-$10 million group, and dropped to only 25.9% for those making $10 million or more.
As you can see, among the wealthiest earners, the American tax system is the opposite of progressive. At the highest levels, people who earn more pay less in taxes.
This is because high earners in the US have more access to ways to shield their income to avoid paying taxes. The tax code unfairly burdens the middle-income tax bracket with a huge share of the tax obligation.
Lobbyists for corporations, industries, and other interest groups have also been able to access favorable tax treatment from Congress. The thousands of tax breaks have made these groups even wealthier and more powerful. This process has made an unequal playing field even bumpier.
3. It Slows Down the Economy
On average, the government taxes earned income from work more highly than savings or investments. Placing a high tax burden on active forms of income impedes economic growth and stability.
More importantly, for most middle class earners, earned income typically composes the greatest percentage of their total income.
In contrast, for wealthy individuals, earned income usually represents a fraction of their total income. This is because multiple flows of income are common among the wealthy, who tend to collect the bulk of their income through business profits, capital gains, interest and dividend payments.
For example, a study from the non-partisan Tax Policy Center found:
- Taxpayers who earned $500,000 or less per year had salaries and wages account for 75% of their adjusted gross income
- Taxpayers who earned $10 million or more per year had salaries and wages account for only 15% o their adjusted gross income.
One way to correct this problem is to tax capital gains—money made on the sale of assets—more similarly to active income. This would shift the burden from wages onto passive income, and encourage people to keep their money invested. This type of taxation could help to boost the economy.
4. It’s Ineffective
Despite all those thousands of rules and regulations, the country still doesn’t bring in enough money to pay all of its obligations. Looking ahead, the situation is even more dire as baby boomers retire and our workforce shrinks. The system simply doesn’t work well and undermines the citizens and corporations it should be supporting.
What are Tax Breaks?
Tax breaks are all the ways to reduce paying your taxes, whether its from credits or deductions. All tax breaks must be approved as laws by Congress and signed off on by the President.
Individuals and businesses each receive these breaks, but again, they inconsistently favor wealthy earners, corporations, and lobby groups. Tax breaks given to corporations and the wealthy are rarely felt by middle-income folks that make up most of the tax base.
For example, the recent tax cut of 2017 was inconsistently applied to favor large corporations, few of who opted to distribute it to employees. The additional tax breaks the law provided were supposed to spur wages and economic growth, but instead, have been used overwhelmingly for bonuses and share dividends for investors.
What This Means For the Middle Class
Remember how we mentioned that the American tax system is progressive? Well, it is structured to be that way, but it’s not true in practice—at least among the highest earners.
A study from 2019 showed that billionaires in America will now pay a lower overall tax rate than middle-income earners.
Since most rich Americans’ wealth comes from sources other than income, the income tax can’t reach a large amount of the money in our nation. Things like performance pay, a low capital gains tax, and tax havens undermine the IRS’s ability to collect taxes on a lot of wealth.
While it’s a complicated question—and there is, of course, much debate surrounding it—it is true that the richest members of our nation have a greater ability to control their tax bills.
At the same time, wealthy Americans also contribute to our nation in the form of real estate development, business growth, job creation and charitable contributions.
Meaning, nothing is entirely “good” or “bad” — it is simply practical to consider how to apply current tax law to your individual situation.
How to Protect Your Money in the American Tax System
While it’s true that the middle class is heavily burdened within the American tax system, there are still plenty of deductions and credits available.
Plus, federal tax brackets are near all-time lows, topping out at only 37%, when they spiked to 94% in 1944 and stayed over 70% in the 1950s, 1960s, and 1970s.
Within this context, even the highest tax brackets today sure are reasonable.
Why do the tax rates of higher and lower income earners matter to you? Because tax laws are always changing and you too can take actions in order to maximize your return.
To learn how to “play the tax game” like the wealthy, read this next. It’ll teach you three core tax strategies to protect your hard earned money.