Senate Republicans this week blocked debate on the Buffett Rule, but the tax-reform measure to ensure that millionaires pay higher tax rates than the middle class is expected to remain an issue throughout the presidential campaign. Sparked by Warren Buffett’s contention that he paid a lower percentage of his income in taxes than his secretary, the Buffett Rule would raise marginal tax rates on the very wealthy. Such proposals have some folks crying “class warfare” and claiming that the top 1 percent of income earners already shoulder 41 percent of the nation’s tax burden, which is plenty high enough, they say. Is that number for real? “They’re cherry picking,” says Philip Reckers, professor of accountancy at the W. P. Carey School of Business. While the top 1 percent does pay some 40 percent of federal income tax, Reckers points out that federal income tax is only part of the picture. Wages below $106,800 annually get dinged with “old-age, survivors and disability income” (OASDI) taxes, which pay for Social Security. Those taxes, he notes, significantly change the percentage of federal tax burden haves and have-nots pay. When debating how much of the national tax liability each income bracket should shoulder, Reckers thinks politicians should look at more comprehensive figures. The price of progressivity At the center of today’s tax-reform debate is “progressivity,” the degree to which tax code is “progressive,” or rises as taxable income rises. “The federal income tax is a progressive tax intentionally, Reckers notes. “There are all kinds of theories as to why progressivity is appropriate ….” or not. One reason to have progressivity in tax structure is basic income redistribution, and Reckers says that’s based, in part, on the concept of diminishing returns, which states that as you get more and more of a thing, each unit of that thing becomes less valuable. So, for example, if you’re running a restaurant, adding an extra chef or two during rush hours might help you get meals out to customers more quickly. But, add too many cooks in the kitchen and, as the saying goes, they’ll spoil the broth. In economic terms, diminishing returns is related to the utility of each additional dollar. “As you get more and more money, each unit of money becomes less important,” Reckers explains. “So, $1,000 has high value to someone who is poor. To someone who is a multi-millionaire, $1,000 does not have the same value.” Vertical equality is another argument behind progressive tax structures. It’s the notion that people who have more money to pay should pay more. Regardless of why a nation chooses to have a progressive tax structure, progressivity in tax structures inevitably redistributes wealth to some degree. According to Reckers, two questions dominate today’s political debates surrounding progressivity and tax-reform measures: At what point is there too much redistribution of income, and will some recent tax-change proposals put us there? Ups and downs To evaluate these questions, Reckers teamed with accountancy professor Govind Iyer of the University of North Texas, formerly at the W. P. Carey School. Their research examined the impact of both federal income tax and social security taxes on taxpayers in different income categories. Most studies focus only on federal income tax, and the Iyer/Reckers research is one of the few studies that combines these two tax sources to provide a more comprehensive view of progressivity and income inequality issues in U.S. tax code today. The team employed non-partisan indices to measure progressivity of the tax system. Specifically, they used the Kakwani progressivity index, which is measured through a computation that compares income distribution against the distribution of tax burden. Likewise, the Kakwani inequality index compares before-tax income and after-tax income. Using these mathematical indices and calculating Kakwani values with tax figures from the Congressional Budget Office (CBO), the researchers confirm that, indeed, the U.S. progressive federal income tax does redistribute wealth. In 2007, the most recent year for which CBO data were available, lower-income segments saw their share of after-tax income rise above their share of pre-tax income. “For instance, the bottom 60 percent of taxpayers accounted for 25.4 percent of pre-tax income but 27.9 percent of the after-tax distribution,” the researchers wrote in a recent paper covering their findings. However, these results change when the researchers add in payroll taxes that fund Social Security, as these taxes are not progressive, they’re regressive. That is, those with lower incomes pay a higher percentage of their earnings into the payroll-tax kitty. According to those 2007 numbers, payroll taxes accounted for 7.28 percent of pre-tax income for the bottom 20 percent of wage earners. For the top 10 percent, payroll taxes equaled only 4.25 percent of pre-tax income, and for the top 1 percent, they ate up only a 1.55 percent share. What’s more, payroll taxes significantly decrease the progressivity of federal income taxes. In fact, looking at the Kakwani Index, progressivity drops by more than 50 percent once you add in payroll taxes. For the 1 percenters — those folks targeted by Occupy Wall Street protesters — the addition of payroll taxes changes their tax-burden story. The top 1 percent of income earners accounted for some 20 percent of total income in 2007, and they paid about 40 percent of federal income taxes. Once you add in Social Security taxes, the top 1 percent only paid in some 26 percent of federal taxes paid that year. Payroll taxes also more than doubled the tax burden for the bottom 80 percent of wage earners. These folks paid 14 percent of total federal income tax, but 32 percent of the combined tax burden that included Social Security taxes. Change we can believe in? President Obama would like to see higher marginal tax rates on the very wealthy, as well as continuation of payroll tax rates. What impact might such changes have on progressivity? Will these changes really hit the wealthy with a significant increase in tax burden? Lower-income earners would benefit from payroll tax cuts, but so would higher-income taxpayers. Currently, the OASDI rate is 4.2 on employees, although it is scheduled to revert to a 6.2% rate for employers and employee alike at the end of 2012. Obama would like to see the tax lowered to 3.1 percent for both employers and employees, which would shave the tax burden on lower-income and higher-income earners alike. In fact, the bottom 20 percent of tax payers would see their effective tax rate drop from 7.28 percent to 4.98 percent. Conversely, lower-income earners would take a bigger hit than the high rollers if Social Security taxes returned to 6.2 percent. The bottom 20 percent would see their effective tax rates rise from 7.28 percent to 8.37 percent — more than a full percentage point — while the top 1 percent of earners would see a one-half percent increase in their effective tax rate as it shifts from 1.55 percent to 1.6 percent. Obama also has envisioned raising tax rates on those earning more than $200,000. This move would predictably increase progressivity, the researchers note, increasing the top 1 percent’s tax share from 40.61 percent of federal income tax paid to 47.15 percent. The effective tax rate for those 1 percenters would rise from the current 19.03 percent to 37.26 percent. This also would drop the top 1 percenters’ share of after-tax income from 17.7 percent to 14.8 percent, thereby reducing income inequality. Reckers says income redistribution may be only part of the reason some want to raise taxes on the rich. “If you want to tax people, you need to tax people who have the money to pay,” he says. He adds, however, that “at some point, you need to decide when you are laying too much burden on one group.” Reckers and Iyer didn’t get into that end of things. “We tried hard to avoid becoming political. The main point of our findings is that people are cherry picking numbers.” To a degree, so are Reckers and Iyer. In their study, they didn’t include state taxes — which vary state-by-state — or sales taxes, which are known to be quite regressive. After all, lower-income earners are more likely to spend every dollar buying rather than saving, so they’re often taxed on every dollar they earn. Still, Reckers asserts, it’s of value to consider both payroll and income taxes in the federal tax-reform debate. “Just looking at income taxes, it looks like the top 1 percent earn 20 percent of income and pay 40 percent of all federal taxes,” he says. “But after adding in payroll tax, you’re looking at that group earning 20 percent of income and paying 26 percent of taxes. That’s a very different story.” Bottom Line Tax payers in the U.S. pay both progressive taxes — those that rise as income rises — as well as regressive taxes, which hit the poor harder than they hit the wealthy. Progressive taxes inevitably redistribute wealth by imposing a larger tax burden on the wealthy. Recent tax-reform proposals that would raise taxes of the wealthy are called “class warfare” by some people. Some claim the top earners already pay too much in taxes. A common argument against raising taxes for the wealthy is that the top 1 percent of earners take in 40 percent of U.S. income and pay 40 percent of federal income tax. This statistic — and most studies — doesn’t include all federal taxes people pay. When you add in Social Security taxes deducted from most people paychecks, the top 1 one percent earn 20 percent of income and pay 26 percent of federal taxes.