The American Tax System, Explained

The American tax system is complex.

It's also ineffective: our tax rates are high, yet our budget deficit is also high. 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.

So what gives? What is wrong with the American tax system?

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%. 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 we had a surplus—that is, more money than we needed to spend—was in 1993.

Debt

The national debt is how much we owe after these 26 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 home-ownership.

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. And there's no perfect way for the government to gain revenue. However, many people will tell you that the tax system is broken.

Let's take a look at a few of the common complaints about the American tax system:

It's Complicated

Just take a look at the 67,500 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 fairly easy to simplify.

It's Unfair

Currently, 80% of tax revenue is paid by the middle class. The higher earners in the US have more access to ways to hide their income to avoid paying their fair share of 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 been able to basically buy favorable tax treatment from Congress. The thousands of tax breaks have made these groups even richer and more powerful. This process has made an unequal playing field even bumpier.

It Slows Down the Economy

The government taxes income from work, savings, and investments, three things which are supposed to spur the economy. Placing a tax burden on these things actually places impediments on economic growth and stability.

One way to correct this problem is to tax capital gains—money made on the sale of stock—at the same rate as regular income. This would shift the burden from wages onto passive income, and encourage people to keep their money invested. This type of taxation could actually help boost the economy.

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, favoring large corporations that have hoarded the extra money rather than sharing it with their 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 unfortunately, it's not true in practice. A few facts show that wealthy Americans are not paying their fair share of taxes.

A study from 2019 showed that billionaires in America will now pay a lower overall tax rate than middle-income earners.

While taxation should reduce income inequality, the way the American tax system functions is actually increasing inequality. 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.

The upshot is that the middle class now appears to carry a larger share of the tax burden than wealthier Americans, which is not just or fair. 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 dodge their tax bills.

Learn the Facts and How to Protect Your Money

While it's true that the middle class lost out in the 2017 tax cut law, there are still plenty of deductions and credits available within the American tax system. Make sure to educate yourself now before tax time rolls around in order to maximize your tax return.

And check the blog for plenty more personal finance tips as well.

Let's make 2020 a prosperous year for us all!