Thursday, August 2, 2012

'Americans for Tax Reform' Doesn't Understand Taxes

Well, I've finally been suckered back into the blogosphere. Sadly enough, the impetus for this was an article I read this morning about how Senator Marco Rubio and Rep. Blake Farenthold are introducing bills that would make the cash prizes of Olympic medalists tax-exempt. Yeah, because that's a priority right now. All snarkiness aside, let me preface by saying that there are going to be two main points to this blog post. The first is me deconstructing why this is a pointless bill and the second is to explain in clear terms how federal income taxes work, because it seems that even a group like Americans for Tax Reform, headed by Grover Norquist, doesn't seem to understand how they work anything about them. If I were a paranoid sort, I'd even think that Norquist is deliberately misleading Americans into thinking that they pay much higher tax rates than they actually do. If I were a paranoid sort.

But anyway, these bills aim to make the cash prizes tax-exempt because, according to Senator Rubio, it "punishes success." By that logic, we shouldn't tax anyone who's ever made any money ever, because that would be punishing success, too. But I digress. Let me take this from the top. Americans pay taxes on money they make from working--payroll or income taxes, or both. Olympians presumably make their living by being professional athletes. As part of their jobs, they train to compete in the Olympics once every four years. Winning a cash prize is part of their income, derived from doing their jobs as pro athletes. Thus, it is taxed. Simple as that. The tax code doesn't care if you sweep floors, jump hurdles at lightning speed, or fly a damned rocket ship into space. Income is income is income. Plus, the bill doesn't exempt from taxes the far larger sums of money derived from sponsorships. So there's that.

The impetus for this bill comes from a study done by Americans for Tax Reform (ATR from now on) that says that the tax bill for medalists would be $8,750 for the gold prize, $5,250 for silver, and $3,500 for bronze. They estimated this by saying that medalists would be in the top tax bracket, paying a rate of 35%. And here is where their so-called "study" goes completely off the rails. 

In the United States, income is taxed by bracket with marginal rates. In other words, if you're earning under $249,999 a year today, you're just on the edge of being bumped up into the next tax bracket. Many people think that they stand to lose money if they are bumped into the next bracket, but this is simply not the case. Let's do a quick run-through of how this would work:

Say you're making $249,999, so you're just shy of the top marginal rate of 35%. Should you be afraid of making even 10 more dollars in income, lest your entire fortune be subjected to the higher rate of 35%? No! Not even close. What so many people seem to think is that income taxes work like this:

$249,999 taxed at 33% = $82499.67

If they made ten more dollars, they think that their tax liability would become:

$250,009 taxed at 35% = $87503.15

Sounds like a pretty raw deal, right? Wrong. That isn't how income taxes work. Once you pass that $250,000 threshold, only the money you make above that $250k mark is taxed at the new rate, so really the extra taxes you'd pay would be about $3.50, not $5,003.48. My example was a bit simplified, because realistically, the first $10,000 or so would be taxed at 10%, the next $20,000 at 15%, and so on up until the top rate was reached. So really, the tax burden is even lower than that. In any case, you get the idea, I'm sure.

This is something I've often seen in debates, news articles, and things politicians say. They seem to think that somehow, small business owners who are in the $200-250k income bracket are paying 1/3 of their income in taxes. This is not even close to being true. Unfortunately, people like Grover Norquist like to capitalize on this misconception and reinforce it so that people further misunderstand how federal income taxes work. 

And you always hate what you don't understand. 

P.S. This isn't to say that people should love taxes (I don't), but deliberately spreading misinformation about them won't get us any closer to making our tax code any better.

P.P.S. I find great irony in the fact that one of the biggest obstacles to tax reform in this country is a group called Americans for Tax Reform. (quote semi-lifted from Jon Stewart)