Statutory vs. Effective Tax Rate

December 31, 2011 Tagged with: politics

I’m learning the difference between the statutory tax rate and the effective tax rate. it’s an important distinction.

The statutory tax rate is the tax imposed by law (by “statute,” hence the name). This is expressed as some percentage. The effective tax rate is what percentage of our income we actually pay in taxes.

The effective tax rate will always be lower than the statutory rate. Why? All sorts of reasons, but suffice it to say that there a number of ways – most of them perfectly legal – to reduce your income so that the statutory tax rate is applied to a lower number than what you actually earned. At the end of the day, the statutory tax rate is just a starting point; a baseline; a pipe dream, even.

So, an example –

If the statutory tax rate is 25% and I made $100,000, then you’d expect me to pay $25,000 in taxes. However, due to various deductions and credits, I only paid $15,000 in taxes. This means my effective tax rate is just 15%.

Out of curiosity, I looked up my 2010 tax return and found that Turbo Tax has a nice summary on the cover page. My effective federal income tax rate in 2010? 17.74%

So, does the statutory tax rate really matter? It depends who you ask, but I don’t think so. I think the only number that matters is the actual percentage of your income you pay in taxes – this is the only number that you can honestly claim is your tax burden.

The problem is, a lot of people point to the statutory number to claim that federal income taxes in the U.S. are high, when they’re not, historically speaking. Read this article in the New York Times, and you’ll see the actual numbers:

The broadest measure of the tax rate is total federal revenues divided by the gross domestic product.

By this measure, federal taxes are at their lowest level in more than 60 years. The Congressional Budget Office estimated that federal taxes would consume just 14.8 percent of G.D.P. this year. The last year in which revenues were lower was 1950, according to the Office of Management and Budget.

The postwar annual average is about 18.5 percent of G.D.P. Revenues averaged 18.2 percent of G.D.P. during Ronald Reagan’s administration; the lowest percentage during that administration was 17.3 percent of G.D.P. in 1984.

In short, by the broadest measure of the tax rate, the current level is unusually low and has been for some time. Revenues were 14.9 percent of G.D.P. in both 2009 and 2010.

So, that’s the effective tax rate for the country in aggregate for the last two years: 14.9% (note too that the rate averaged 18.2% during the Reagan administration).

The problem is, no one talks about this number:

[...] one almost never hears that total revenues are at their lowest level in two or three generations as a share of G.D.P. or that corporate tax revenues as a share of G.D.P. are the lowest among all major countries. One hears only that the statutory corporate tax rate in the United States is high compared with other countries, which is true but not necessarily relevant.

“True but not necessarily relevant” – that’s the key phrase. If you’re going to complain about taxes in this country, do us all a favor and don’t complain about the statutory rate – talk only in terms of the effective rate, the true tax burden. If everyone did that, I think we’d have a much more accurate picture of where we stand historically and in comparison with other countries.

(Of course, this is just federal taxes. It doesn’t include state taxes, municipals fees, sales taxes, etc. Two researchers tried to calculate the effective tax rate when everything was included, and came up at about 40%. Do you think that’s a lot? Okay, fine – but talk about this number, not some hypothetical percentage that only exists on paper.)


cmadler says:

I know of one place where the statutory (aka marginal) tax rate does matter: the Laffer curve.

The Laffer curve posits that, at very high levels of marginal taxation, there is little to no incentive to increase earnings/income. Consider a very simple (and unrealistic) example:

Suppose that marginal rates are 0% up to $25,000, 10% from $25,000.01 to $250,000, and 90% over $250,000. Someone earning $250,000 will have a 9% effective rate, but 90% of any further income will be paid in taxes. Such a person will probably not expend much effort to increase their income by $10,000, since they’ll only see $1,000 of the increase.

That said, I think the US is currently on the left side of the Laffer curve.

Deane says:

I don’t think that Laffer really says anything about the statutory rate, though. It just talks about the effect of tax rates in general on output. In that case, it would be effective tax rate, since that’s the only tax rate that people really feel.

cmadler says:

No, it is the marginal/statutory rate, because the Laffer curve is about motivation for additional investment (including time/labor). So what matters is not the overall (effective) tax rate, but what the taxes would be on that potential additional investment.

In my above hypothetical with an exaggerated graduation of the income tax, you would end up with a lot of people making exactly $250,000. It would not be worth their while to expend much effort or invest much money to earn more. Or, if they did, it would likely move to untaxed black market or non-monetary (barter) activities.

Deane says:

I’m confused about your usage of “marginal/statutory.” Trying to figure out how those two are related. “Marginal” taxes have both a statutory rate (what the law says you should pay), and an effective rate (what you actually pay).

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