How do you define "Effective Tax Rate" ?

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1210sda
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How do you define "Effective Tax Rate" ?

Post by 1210sda »

There was an article in the newspaper today that describes the Effective Tax Rate as follows: "the Internal Revenue Service, when it talks about effective tax rates, typically divides total federal income taxes paid by adjusted gross income for the year".

I had always viewed the effective tax rate as tax paid divided by taxable income. On the 1040, it would be line 61divided by line 43.
Not line 61 divided by line 37.

What do you think ??

1210
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Re: How do you define "Effective Tax Rate" ?

Post by Midpack »

I consider it line 61 divided by line 37 (AGI), so I guess I agree with the article. Where the super rich are concerned (most of the discussion), it's all about cap gains rates more than deductions/exemptions anyway no? My 2 cents...
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Re: How do you define "Effective Tax Rate" ?

Post by porcupine »

1210sda wrote:There was an article in the newspaper today that describes the Effective Tax Rate as follows: "the Internal Revenue Service, when it talks about effective tax rates, typically divides total federal income taxes paid by adjusted gross income for the year".

I had always viewed the effective tax rate as tax paid divided by taxable income. On the 1040, it would be line 61divided by line 43.
Not line 61 divided by line 37.

What do you think ??

1210
Personally, I would just take the taxes I/we paid in the year and divide it by all the money we earned that year (including interest, dividends, pay checks, rent, etc) without subtracting anything from either the numerator or the denominator (i.e., depreciation, charity, etc). And I have not calculated ours ...

But that is just me, and I bet if you dig deep enough, each person would have his own answer of what is included and what is excluded. Disclaimer: I am not trying to look for the 'official' definition of this either (which is probably what you are going for), because I know I will not like it.

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Re: How do you define "Effective Tax Rate" ?

Post by LadyGeek »

The wiki has some background, Marginal Tax Rate , which links to a video: Average vs. Marginal Tax Rates - YouTube and a related forum thread: Important to know Marginal Tax Rate? Effective Tax Rate?
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Re: How do you define "Effective Tax Rate" ?

Post by earlyout »

Turbotax uses AGI. Investopedia uses taxable income. Personally I think it should be a modified AGI that includes the entire amount of non taxable income received (tax free interest, 100% of social security, ...). effective rate = taxes / all income received before any deductions

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Re: How do you define "Effective Tax Rate" ?

Post by azanon »

In layman's terms, effective tax rate is the percent of tax you pay on both earned income AND investment income. Warren B. and critics of Mitt Romney are drawing attention to their low effective tax rate, and equating that with others EARNED income tax rate. Truth is, Warren B. and Mitt are subject to the exact same tax brackets as everyone else on EARNED income. And the more you make in EARNED income, the higher the percentage of tax you pay on it as you move into higher paying tax brackets.
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Re: How do you define "Effective Tax Rate" ?

Post by porcupine »

azanon wrote:[...]And the more you make in EARNED income, the higher the percentage of tax you pay on it as you move into higher paying tax brackets.
That is not strictly correct. Then you get to the MAGIs and the AMTs and the deductions etc. The correct term that you should have used is "EARNED income MINUS all deductions that you can get through the tax code." Folks with higher EARNED income could have 20 kids (or other sundry deductions with the same net effect), and therefore move to a lower tax bracket!

That is why I specifically said what I said in my previous response.

LadyGeek:

You are right (and I probably said something on that thread too). But this is just one of my pet topics, just like mortgage refi is too (which also has a bunch of threads hanging around)! :)

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Re: How do you define "Effective Tax Rate" ?

Post by OhioGozaimas »

For my personal use, I'm with "earlyout" re an MAGI approach. At least 15% of SS is always tax-free, but it's all still income. (The tax-free segment of SS often covers all health insurance premiums, making them, in effect, paid with "pre-tax" money...)
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Re: How do you define "Effective Tax Rate" ?

Post by livesoft »

I define "effective tax rate" in percent as:
Federal_income_tax_I_actually_had_to_pay / ALL MY INCOME * 100.

ALL_MY_INCOME includes the highest number found on my W2 (so definitely NOT Box 1) plus ALL the DIVIDENDS, INTEREST, and CAPITAL GAINS that I get in TAXABLE accounts (not in IRAs, not in 401(k)s, plus my CONSULTING and TEACHING income. It also includes ALL my pre-tax deductions for 401(k), health care, FSA, and ALL my other deductions for FICA, Medicare, etc. It is basically my GROSS SALARY plus my self-employment and my investments, but subtract my capital loss of $3000.

The Federal_income_tax_actually_had_to_pay includes the offset from tax credits.

Therefore, I cannot calculate my effective tax rate from numbers purely on my tax return.
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Re: How do you define "Effective Tax Rate" ?

Post by sscritic »

livesoft wrote: It is basically my GROSS SALARY plus my self-employment and my investments, but subtract my capital loss of $3000.
I wouldn't subtract the $3000. That came from tax loss harvesting in 2001 or 2008. It has nothing to do with my actual income that I have to spend or save this year.

Or maybe that's what you meant: when you subtract a loss, are you subtracting the negative number and thus adding it back in? But I wouldn't add $3000 to my income either. Just ignore the $3000 unless you had new losses this year of $3000 in excess of your cap gains for the year. In other words, look at this year and offset this year's losses against this year's cap gains up to a net loss of $3000, but without any carry over from previous years.

[I could add a comment that livesoft is so efficient at TLH that he always has a new $3000 in net losses every year. :) ]
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Re: How do you define "Effective Tax Rate" ?

Post by MarkNYC »

1210sda wrote:There was an article in the newspaper today that describes the Effective Tax Rate as follows: "the Internal Revenue Service, when it talks about effective tax rates, typically divides total federal income taxes paid by adjusted gross income for the year".

What do you think ??
I'm not sure on what occasions or why the IRS would talk about effective tax rates, but if they actually use Adjusted Gross Income (which I doubt) they may be misleading people into thinking their tax rates are lower than they actually are. Individuals are free to use whatever definiton they like or find useful for themselves, but Barron's Dictionary of Accounting Terms has the following definitions:

TAX RATE is the amount of tax to be paid based on taxable income (and filing status if individual income tax), and

EFFECTIVE TAX RATE equals the tax divided by taxable income.

Since tax rates are applied against taxable income, rather than adjusted gross income, in calculating the tax, it would make sense that taxable income should also be used in computing the effective tax rate.

I would agree that one's marginal rate is usually a more useful thing to know.
Last edited by MarkNYC on Fri Jan 20, 2012 6:44 pm, edited 1 time in total.
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Re: How do you define "Effective Tax Rate" ?

Post by LadyGeek »

Where do state taxes fit into all this? Everyone is focused on federal, but there are state and local taxes to consider. Local taxes include income, real estate, or school.
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Re: How do you define "Effective Tax Rate" ?

Post by livesoft »

For the NYTimes article by Leonhardt about Romney's tax rate, there are quite a lot of readers' comments that they are paying humongous tax rates. Of course, they want to show that all their income goes to taxes and they have nothing leftover to spend, so the readers include every possible tax that they can think of including Federal, State, City, Local income taxes, FICA, medicare, mortgage recording taxes, car taxes, sales taxes, gasoline taxes, cigarette taxes, property taxes, cosmetic surgery taxes, and on and on and on.

And of course, the Romney spokesperson really muffed it when a number was mentioned. They should have picked the highest possible rate and of course given it the right label. Instead, they picked the lowest possible rate, gave it the right label, but no one cares about that label.
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Re: How do you define "Effective Tax Rate" ?

Post by bottlecap »

I take total taxes paid/gross income.

For me:

Total taxes paid includes payroll, state, federal. Although I mentally include payroll taxes paid on my behalf by my employer (as opposed to just what I see coming out of my paycheck), I don't include that tax in the effective tax rate calculation on my spreadsheet. I probably should.

Gross income includes all earned income, plus cap gains and dividend income. I don't have passive activity income, but I'd include that as well it I did.

Arguably, your effective tax rate is much higher because of sales taxes and a myriad of other taxes paid every year, but I usually don't include those because I typically think in terms of effective income tax rate.

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Re: How do you define "Effective Tax Rate" ?

Post by bdpb »

livesoft wrote: ALL_MY_INCOME includes the highest number found on my W2 (so definitely NOT Box 1) plus ALL the DIVIDENDS, INTEREST, and CAPITAL GAINS that I get in TAXABLE accounts (not in IRAs, not in 401(k)s, plus my CONSULTING and TEACHING income. It also includes ALL my pre-tax deductions for 401(k), health care, FSA, and ALL my other deductions for FICA, Medicare, etc. It is basically my GROSS SALARY plus my self-employment and my investments, but subtract my capital loss of $3000.
It should be defined as ALL_MY_COMPENSATION.

It should include things like employer provided health premiums, 401k matches, life insurance premiums, etc.

It wouldn't be very fair to say you pay the same effective rate as the guy who earns the same and pays these
on his own.
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Re: How do you define "Effective Tax Rate" ?

Post by LH »

1210sda wrote:There was an article in the newspaper today that describes the Effective Tax Rate as follows: "the Internal Revenue Service, when it talks about effective tax rates, typically divides total federal income taxes paid by adjusted gross income for the year".

I had always viewed the effective tax rate as tax paid divided by taxable income. On the 1040, it would be line 61divided by line 43.
Not line 61 divided by line 37.

What do you think ??

1210
What is the difference between the AGI and the "taxable income", is there an equation relating the two?

AH forget it, RTFM : )


taxable income = AGI -(standard deduction or itemized deductions) - (3700 times number of exemptions)

where exemptions = yourself + spouse + # kids

http://www.irs.gov/pub/irs-pdf/f1040.pdf

(I have never done my own taxes if its not obvious :))
Last edited by LH on Fri Jan 20, 2012 7:38 pm, edited 3 times in total.
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Re: How do you define "Effective Tax Rate" ?

Post by dbr »

You compute what you want to know, then call it anything you like. If you are trying to compare to someone else or to a published number you find out what that computation is and do the same one.
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Re: How do you define "Effective Tax Rate" ?

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[political comment removed by Mod]
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Re: How do you define "Effective Tax Rate" ?

Post by scrabbler1 »

Lots and lots of grey area here, as pointed out by others. I can add two of my own.

I, like many homeowners in New York, receive a rebate (STAR) from the state to offset a portion of the school (property) taxes I pay each year. While I consider the rebate to be merely an offset of those school taxes, the taxes and the STAR rebate are handled quite differently on my federal income tax forms. Because I itemize my deductions, the rebate is considered income and is part of my AGI and taxable income (TI). However, the original property taxes I paid are only part of my TI and do not lower my AGI. This to me would distort an effective tax rate using AGI.

I have tax-free interest from some muni bond funds I own. That interest is not included in the AGI or TI. I also have some qualified dividends and LTCG which are not taxable because I am in the 0% bracket for those types of income. However, the muni bond fund interest is not part of either the AGI or TI while the QD and LTCG are part of both. Again, a distortion IMHO.
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Re: How do you define "Effective Tax Rate" ?

Post by mickeyd »

Keep it simple.

An effective rate means the taxes you pay as a percentage of your income.
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Re: How do you define "Effective Tax Rate" ?

Post by grabiner »

sscritic wrote:
livesoft wrote: It is basically my GROSS SALARY plus my self-employment and my investments, but subtract my capital loss of $3000.
I wouldn't subtract the $3000. That came from tax loss harvesting in 2001 or 2008. It has nothing to do with my actual income that I have to spend or save this year.
If you don't subtract the $3000 in 2011 because it is a carryover from 2008, then you should subtract the $60,000 that you realized as a loss in 2008 all in that year, resulting in a huge effective tax rate in 2008.

I prefer to subtract the $3000 every year, recognizing this as part of my income which was just taxed in a different year. Similarly, I wouldn't count my 2010 IRA conversion as income for 2010, because the tax was postponed to 2011 and 2012, and I will count it for 2011 and 2012.
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

LadyGeek wrote:Where do state taxes fit into all this? Everyone is focused on federal, but there are state and local taxes to consider. Local taxes include income, real estate, or school.
We pay WAY too little attention to state taxes here. My state tax effective rate is half my federal effective rate. That's alarming. My state doesn't even have an Air Force.

A single person who has no taxable investment income and makes no charitable contributions but is covered by an employer retirement plan has to make at least $150,000 to have a 17% effective federal tax rate. A two-earner family would typically have to be above $250,000, but there are a lot of variables.

I believe marginal rates are the problem. I've had many years in which my first $200,000 is taxed at an average rate of under 15%, but my next $10,000 is taxed at over 50%, sometimes 80%. That creates a huge disincentive to make more money.
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Re: How do you define "Effective Tax Rate" ?

Post by sscritic »

grabiner wrote:
sscritic wrote:
livesoft wrote: It is basically my GROSS SALARY plus my self-employment and my investments, but subtract my capital loss of $3000.
I wouldn't subtract the $3000. That came from tax loss harvesting in 2001 or 2008. It has nothing to do with my actual income that I have to spend or save this year.
If you don't subtract the $3000 in 2011 because it is a carryover from 2008, then you should subtract the $60,000 that you realized as a loss in 2008 all in that year, resulting in a huge effective tax rate in 2008.

I prefer to subtract the $3000 every year, recognizing this as part of my income which was just taxed in a different year. Similarly, I wouldn't count my 2010 IRA conversion as income for 2010, because the tax was postponed to 2011 and 2012, and I will count it for 2011 and 2012.
I think we are answering different problems for ourselves and thus get different answers. If a company knows something has gone wrong, they will often take a huge write-off in a single quarter to get its recognition over with, rather than writing it off slowly over many quarters. One reason is that doing it otherwise distorts the reporting of current profits. I am trying to figure out what happened to me each year, so including things that happened years ago gives a distorted picture of what happened this year. So for me, I guess, recognizing that $60,000 loss in 2008 may mess up the figure for 2008, but is preferable to distorting all the other years. Of course, just like the company, I will deceive myself and talk about "current operations," ignoring the $60,000 loss I just reported to myself. :)
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Re: How do you define "Effective Tax Rate" ?

Post by Fletch »

Just my two cents worth on trying to state my opinion about a tax question without devolving into a political discussion:

I view our household effective % tax rate as all the money we pay to any government (federal, state, local, taxes on phone bills, gasoline tax, etc.) divided my all our income (wages, pensions, social security, rent, realized capital gain, dividends, etc.) times 100. The only thing that ultimately matters to us is someone or organization (government) has under threat of force taken a very substantial portion of our money to redistribute in a manner they believe is "better" than what we might do if left to our own intelligence. Another way to define effective tax rate might be to define what portion of tax receipts is actually "effective" (i.e. not going to pay overhead or services not needed - picture number of highway department workers actual vs. required to fill a pot hole). :shock: :shock:
Last edited by Fletch on Fri Jan 27, 2012 12:14 pm, edited 1 time in total.
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Re: How do you define "Effective Tax Rate" ?

Post by scrabbler1 »

Bob's not my name wrote:
LadyGeek wrote:Where do state taxes fit into all this? Everyone is focused on federal, but there are state and local taxes to consider. Local taxes include income, real estate, or school.
We pay WAY too little attention to state taxes here. My state tax effective rate is half my federal effective rate. That's alarming. My state doesn't even have an Air Force.

A single person who has no taxable investment income and makes no charitable contributions but is covered by an employer retirement plan has to make at least $150,000 to have a 17% effective federal tax rate. A two-earner family would typically have to be above $250,000, but there are a lot of variables.

I believe marginal rates are the problem. I've had many years in which my first $200,000 is taxed at an average rate of under 15%, but my next $10,000 is taxed at over 50%, sometimes 80%. That creates a huge disincentive to make more money.
My federal AGI and state AGI are very nearly the same, so simply comparing my federal and state income taxes due in 2011 is a decent comparison. For 2011, my federal income tax bill is only $130 more than my state income tax bill. This is mainly because I have 1/3 of my income in LT cap gains and qualified dividends, all of which is taxed at 0% at the federal level but taxed as ordinary income at the state level. That and having a somewhat smaller TI at the state level due to a greater combination of itemized deductions and personal exemption at the federal level versus a fairly large standard deduction at the state level also contribute.

My local real estate taxes, net of a state property tax rebate, are in that small layer between my federal and state income taxes due. Each of these 3 taxes are just under 5% of my AGI. BTW I am an early retiree, so all of my income is investment income.
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Re: How do you define "Effective Tax Rate" ?

Post by sscritic »

scrabbler1 wrote: My federal AGI and state AGI are very nearly the same, so simply comparing my federal and state income taxes due in 2011 is a decent comparison. For 2011, my federal income tax bill is only $130 more than my state income tax bill.
Here's the deal that makes this a strange comparison. If you itemize, the larger your state bill is, the smaller your federal bill is. Now suppose it was the other way around: state taxes are not deductible on your federal return, but federal taxes are deductible on your state return. In other words, the state can only tax you on the income that you didn't already give the feds. The total tax might be almost the same, but the distribution between state and federal would be different.

I guess I am trying to say you don't really have two separate taxes; you have one combined tax.
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

Itemizing has almost zero effect on my federal taxes, because I don't have mortgage debt or any of the other things the government has chosen to subsidize. So my itemized deductions are almost the same as the standard deduction. If I paid less in state taxes my federal taxes would be about the same.
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Re: How do you define "Effective Tax Rate" ?

Post by sscritic »

Bob's not my name wrote:Itemizing has almost zero effect on my federal taxes, because I don't have mortgage debt or any of the other things the government has chosen to subsidize. So my itemized deductions are almost the same as the standard deduction. If I paid less in state taxes my federal taxes would be about the same.
I don't have a mortgage, but I have state taxes. NotBob, you need to move to a state with higher state taxes so you can get the deduction (you know, like the people who take out mortgages just to get the deduction). That's why we love CA, for the deductions it provides us! :)
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Re: How do you define "Effective Tax Rate" ?

Post by sscritic »

sscritic wrote: I don't have a mortgage, but I have state taxes. NotBob, you need to move to a state with higher state taxes so you can get the deduction (you know, like the people who take out mortgages just to get the deduction). That's why we love CA, for the deductions it provides us! :)
I lied. I can't itemize this year because I got the old folks boost in my standard deduction. If I were a few years younger, I would be itemizing this year. Ah, to be 20 again and able to itemize!
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

If effective tax rate is to be used as a measure of "fairness", it ought to take into account defined benefit pensions. Many public servants still have pension plans, under which they work for 30 years but get paid for 60 years. It is difficult to compare this deferred compensation advantage to the taxation of a worker who makes twice as much as the public servant but stops earning money when he stops working. Throughout his working life his marginal rate on the top half of his earnings is probably 35% (federal + state), vs. the, say, 15% average rate he pays on the bottom half of his earnings.

Separate issue: I don't agree that entitlements should be included in gross income. They are a negative tax. As I have posted before, I manage the finances of an elderly multimillionaire with six figure income, who pays an effective federal tax rate of about -20%, at least 37 points less than Warren Buffet's secretary. A "millionaire tax" wouldn't change that.
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

sscritic wrote:NotBob, you need to move to a state with higher state taxes so you can get the deduction
Make room in your garage.
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Re: How do you define "Effective Tax Rate" ?

Post by scrabbler1 »

sscritic wrote:
scrabbler1 wrote: My federal AGI and state AGI are very nearly the same, so simply comparing my federal and state income taxes due in 2011 is a decent comparison. For 2011, my federal income tax bill is only $130 more than my state income tax bill.
Here's the deal that makes this a strange comparison. If you itemize, the larger your state bill is, the smaller your federal bill is. Now suppose it was the other way around: state taxes are not deductible on your federal return, but federal taxes are deductible on your state return. In other words, the state can only tax you on the income that you didn't already give the feds. The total tax might be almost the same, but the distribution between state and federal would be different.

I guess I am trying to say you don't really have two separate taxes; you have one combined tax.
That might be true for many people, but it would not be true for me. If I were allowed to deduct my federal income taxes on my state return, my state income taxes would be unchanged because I would still (barely) be taking the state's standard deduction. If my state income taxes were not deductible on my federal return, I would (barely) switch to the federal standard deduction. Therefore, my federal income tax bill would rise by about $200 while my state income tax bill would be unchanged, putting me in nearly the same class as Bob's-not-my-name. [And for 2012, I will be right near the border of the federal standard deduction even with state income taxes being deductible.]

P.S. When I wrote "decent comparison," I was referring to the fact that the AGI in the denominator was about the same between state and federal, as others mentioned that their federal and state AGIs were quite different, mucking up the "effective rate" percentages.
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Re: How do you define "Effective Tax Rate" ?

Post by jeffyscott »

bdpb wrote: It should be defined as ALL_MY_COMPENSATION.

It should include things like employer provided health premiums, 401k matches, life insurance premiums, etc.

It wouldn't be very fair to say you pay the same effective rate as the guy who earns the same and pays these
on his own.
It should also include taxes that your employer pays that are directly related to the compensation paid to you...the employer portion of the payroll tax, for example.

The real issue is we tax unearned income at much lower rates than earned income. Marginal rate for middle income people is 25%, then there is about 15% in payroll taxes...so nominally about 40%. Now let's suppose benefits are worth 30% (just taking a guess at the average :?: ) and the cost of these is all deductible for the employer. Then gross compensation is about 1.3765 (30% fringe plus the employer payroll tax). In the 25% tax bracket the total marginal taxes would be $40.30 (ignoring the temporary payroll tax cut) on an additional $137.65 in effective income. Looked at this way, that is an effective tax rate of 29%. (and no, I did not fiddle with the figures to get it to come out to be almost exactly equal to the proposed 30% tax rate)
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Re: How do you define "Effective Tax Rate" ?

Post by jeffyscott »

sscritic wrote:Now suppose it was the other way around: state taxes are not deductible on your federal return, but federal taxes are deductible on your state return. In other words, the state can only tax you on the income that you didn't already give the feds. The total tax might be almost the same, but the distribution between state and federal would be different.

I guess I am trying to say you don't really have two separate taxes; you have one combined tax.
For a few states there is a question as to what the real tax rate is, because they allow deduction for federal taxes. So federal taxes are deducted from state income and state taxes are deducted from federal income, for those who itemize both.

http://www.ctj.org/html/stdedfaq.htm (this link is old, don't know if these states have changed their rules)
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

jeffyscott wrote:Marginal rate for middle income people is 25%, then there is about 15% in payroll taxes...so nominally about 40%.
May be true for some two-income families, but for single income families it's hard to be in the 25% bracket while still paying payroll taxes at the margin.
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Re: How do you define "Effective Tax Rate" ?

Post by jeffyscott »

How so?

Full payroll tax is due on income up to $106K, the 25% bracket goes up to $83,600. Seems to be the opposite, that a single person in the 25% bracket will always be subject to the payroll tax on all of their income, in addition a portion of income in the 28% bracket would also be subject to payroll taxes.
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Bob's not my name
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

A family has to have gross income over about $110,000 to be in the 25% bracket. So a single-income family is unlikely to be paying both a 25% marginal rate and payroll tax at the margin. I think you misunderstood single-income family to mean single with no family.
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Re: How do you define "Effective Tax Rate" ?

Post by jeffyscott »

I did misunderstand, but it doesn't take $110K to get into the 25% bracket. For joint return, it starts at $69,000 taxable, standard deduction is $11K and personal exemptions are $3700.

You must be assuming $17K in 401K contributions to get to 110K?
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

25% bracket starts at $70,700. Standard deduction is $11,900, four exemptions make $15,200, so AGI is $97,800 without itemizing deductions. Pre-tax health and dental and FSA should be at least $2,200, so that makes $100,000 gross with no 401k or TIRA contributions, which could be $0 to $28,000, so I picked $110,000 as a ballpark median. Number of children might be 1 or 4 instead of 2, itemized deductions might exceed standard, FSA/health/dental might be $6,000 vs. $2,200.

To get below $106,000 with 2.3 children you would have to be a non-itemizer with less than about $5,000 of 401k/TIRA contributions.

Edit: wait, I forgot the 2.3 child tax credits, which would reduce your effective tax rate but not really your marginal rate.
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Re: How do you define "Effective Tax Rate" ?

Post by dyangu »

Bob's not my name wrote: Separate issue: I don't agree that entitlements should be included in gross income. They are a negative tax. As I have posted before, I manage the finances of an elderly multimillionaire with six figure income, who pays an effective federal tax rate of about -20%, at least 37 points less than Warren Buffet's secretary. A "millionaire tax" wouldn't change that.
How did you get -20%? Did you count medicare benefits or something?
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Re: How do you define "Effective Tax Rate" ?

Post by john94549 »

This question is really much harder to answer than it seems, at first blush. My wife read in some newspaper it was tax paid divided by AGI. I then asked her how she would factor in tax-free disposable income (such as from munis) or partially-taxed disposable income (such as from Social Security) or free cash flow from tax-sheltered investments (such as rental property). What about folks who receive untaxed government payments such as state disability insurance?

Perhaps a better definition would focus on disposable income rather than AGI.
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

dyangu wrote:
Bob's not my name wrote:entitlements
Did you count medicare benefits or something?
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Re: How do you define "Effective Tax Rate" ?

Post by rkhusky »

I think it should be line 61 (total tax) divided by line 22 (total income). If the government got rid of all tax loopholes, this is probably what your tax rate would be (except you might have to add in line 8b if the gov't decided to tax muni interest). It would be interesting to see a chart of line 61 versus line 22 for all taxpayers. My ratio is about 8%.
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This is why I asked the question

Post by 1210sda »

1210sda wrote:There was an article in the newspaper today that describes the Effective Tax Rate as follows: "the Internal Revenue Service, when it talks about effective tax rates, typically divides total federal income taxes paid by adjusted gross income for the year".

I had always viewed the effective tax rate as tax paid divided by taxable income. On the 1040, it would be line 61divided by line 43.
Not line 61 divided by line 37.

What do you think ??

1210
Thanks for all the wonderful and varied responses. All of the responses (well, most) are valid.

For the future, whenever I read in the newspaper that someone paid X percent in taxes, or that someone pays at a higher or lower tax rate than someone else, I will think back on this thread. This applies to TV commentators also.

Unfortunately, without a detailed explanation of how the rate was determined, we won't know if the statements are accurate.

1210
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Re: How do you define "Effective Tax Rate" ?

Post by jeffyscott »

While the details may be fuzzy and manipulated for political purposes, what we do know is that income from capital gains and dividends is taxed at a lower rate than income from labor and that most of the capital gains and dividends are collected by those with the very highest incomes. It can be debated whether that is good/bad, right/wrong, fair/unfair, but those are the facts.
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Re: How do you define "Effective Tax Rate" ?

Post by rkhusky »

jeffyscott wrote:While the details may be fuzzy and manipulated for political purposes, what we do know is that income from capital gains and dividends is taxed at a lower rate than income from labor and that most of the capital gains and dividends are collected by those with the very highest incomes. It can be debated whether that is good/bad, right/wrong, fair/unfair, but those are the facts.
I'm not sure that these are "facts".

Only qualified dividends are taxed at a lower rate.

There is a significant amount of labor that is taxed at 0%, 10% and 15%, probably more in total than that taxed at higher marginal rates.

And there are an awful lot of us at lower incomes compared to those at the very highest, so we may collect more capital gains in total, especially if one considers pension funds.
Last edited by rkhusky on Sat Jan 28, 2012 11:19 am, edited 2 times in total.
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Re: How do you define "Effective Tax Rate" ?

Post by rkhusky »

As others have noted, one should probably include as income things that don't show up on the tax forms, such as employer contributions to Social Security, health care premiums, pensions, and 401K match.
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Re: How do you define "Effective Tax Rate" ?

Post by LadyGeek »

Are you sure about employer contributions? I'm not an accountant, but it seems that if we were to include it as income, we'd be taxed on it. For example: imputed income.

My employer's W-2 tax summary shows:

Taxable wages = Salary - Pretax deductions + Imputed income

The formula is the same for federal, FICA and state except that the item details are different. For example, the imputed income is not included in PA (life insurance).
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Re: How do you define "Effective Tax Rate" ?

Post by Bob's not my name »

LTCG and QD are not taxed at a lower rate than income from labor. As this thread has made clear, labor income is typically taxed at a very low rate, typically well under 15%, and in many cases under 0%. LTCG and QD are taxed at a lower rate than income from the same person's labor, e.g., 36% vs. 50% at the margin for a taxpayer with around $300,000 of income in a high tax state, starting in 2013 under current law. But that person's 36% rate on LTCG and QD is much higher than the rate most taxpayers pay on LTCG, which may be 0% (especially on personal residence gain).

I do agree that the people with the very highest incomes have the very highest incomes.
Last edited by Bob's not my name on Sat Jan 28, 2012 12:40 pm, edited 1 time in total.
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Re: How do you define "Effective Tax Rate" ?

Post by sscritic »

How I define it depends on why I want to define it. If I am trying to "prove" that I pay less than someone else, I will include in income every type of income that I receive, directly or indirectly, and exclude any other type of income that the other person receives. This makes my denominator as large as possible and my opponent's as small as possible. I may then adjust to exclude from income something that I have very little of but my opponent has a lot of. This decreases my denominator, but decreases my opponent's even more.

Now do the same on the tax side, but I make my taxes as high as possible and my opponent's as low as possible.

Then I compute my effective tax rate using these definitions. Then I go back and tweak a little, because, for example, using a smaller denominator boosts my effective rate, but it might boost my opponent's rate more than mine.

Or, as it appears that politicians do, I will just use two totally different definitions, one for myself and another for my opponent.
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