Taxes and the value of work
Payroll Tax
Taxes come in many different varieties. There is federal income tax, state income tax, property tax (state), sales tax (county), excise tax, use tax, inheritance tax, and many more. Taxes may be imposed by any legal entity on federal, state, county or city level. In general, tax is a cost of living and doing a specific activity within borders of the taxing authority.
The group of taxes known as payroll taxes hits the working class the most. Employers are required by law to withhold the payroll taxes from employee's paycheck. Payroll tax deductions include the following:
- Federal income tax withholding (based on withholding tables in IRS Publication 15, Employer's Tax Guide).
- Social Security tax withholding (6.2% up to the annual maximum of $102,000)
- Medicare tax withholding (1.45%)
- State income tax withholding
In addition to the above, employers are responsible for paying their portion of payroll taxes. These payroll taxes are an added expense over and above the expense of an employee's gross pay. The employer's portion of payroll taxes include the following:
- Social Security taxes (6.2% up to the annual maximum)
- Medicare taxes (1.45% of wages)
- Federal unemployment taxes (FUTA)
- State unemployment taxes/insurance (SUTA)
Federal Income Tax
Federal Income Tax is a progressive tax imposed by the federal government of the United States on the taxable income of individuals an businesses. It was imposed after Sixteenth Amendment to the Constitution was ratified on February 3, 1913. The Internal Revenue Code is the statutory tax law in the United States.
The tax is levied on adjusted gross income, which is the income from all sources less any exclusions. The basic exclusions are: qualified itemized deductions or standard deduction ($5,450 in 2008) and personal exemption ($3,500 in 2008). Taxpayers may also be eligible for tax credits, such as the Earned Income Tax Credit or the Child Tax Credit. The tax credits are more valuable than deductions, because deductions are applied before the tax rate, while credits are applied after.
For tax purposes income is divided into two types: ordinary income and capital gains.
Ordinary income includes wages and salaries, business profit, dividends and interest. Only qualified dividends are taxed differently (at 15% rate).
Capital gain is the income from the sale of investment property. Long-term capital gains from property held for for one year or more, are taxed at 15% rate. Short-term capital gains are taxed as ordinary income. Capital gains on sale of the primary residence are taxed differently ($250,000 exclusion for single-filer, $500,000 exclusion for joint-filers). Capital losses from sale of stock are limited to $3,000 a year, although the losses can be carried over to the next year indefinitely. As of 2009 there are no deductions or exemptions from capital gain taxes. Thus, saving and investing is practically discouraged.
As of 2008, there are six tax brackets for ordinary income (ranging from 10% to 35%, with 5% increments). Knowing ones top tax bracket rate (marginal tax rate) is very crucial and very helpful in making financial decisions. The effective tax rate (taxes paid divided by income) is much less than the marginal tax rate (tax rate on any extra income).
State Income Tax
Most states (34) have a progressive income tax, with top rate between 3% (Illinois) and 10% (California). The number of tax brackets varies from one (flat rate) up to ten (Missouri). Seven states have no income tax at all: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming. Two states, New Hampshire and Tennessee, limit their state income taxes to dividends and interest income only. For seven states: Alabama, Colorado, Iowa, Louisiana, Montana, Oregon, Utah - the income taxes are deductible for federal income tax purpose. Also, standard deduction and personal exemption varies from state to state.
FICA taxes (Social Security and Medicare)
FICA stands for Federal Insurance Contribution Act. FICA taxes include Social Security and Medicare taxes. Social Security and Medicare are paid half by the employee and half by the employer. However, the worker is bearing the entire burden of the tax anyway, because the employer passes the tax on in the form of lower wages. Workers must pay 12.4% of Social Security tax, including a 6.2% employer contribution, on their wages below the Social Security Wage Base ($102,000 in 2008, $106,800 in 2009), but no tax on income in excess of this amount. Therefore, high earners pay a lower percentage of their total income. The Medicare total cost is 2.90%, including 1.45% employer contribution. People making less than $102,000 a year in total wages effectively pay 15.3% of their wages in FICA taxes alone.
Note: Because wealthier individuals generally have higher life expectancies and thus may expect to receive larger benefits for a longer period than poorer taxpayers. A single individual who dies before age 62, who is more likely to be poor, receives no retirement benefits despite his years of paying Social Security tax. On the other hand, an individual who lives to age 100, who is more likely to be wealthy, is guaranteed payments that are more than he paid into the system.
The Wage Base amount subject to Social Security withholding is adjusted for inflation annually. However, the average annual rate of increase of the Social Security Wage Base is approximately 4.1%, in comparison to the Consumer Price Index (CPI) of 2.8% over the same years.
Unemployment taxes
The federal unemployment tax is 6.0% (6.0% since 2008, and 6.2% before) of first $7,000 earned by employee. After paying state unemployment insurance, the employer receives up to 5.4% federal tax credit. Because state unemployment tax in most states is equal to or higher than 5.4% of wages subject to state unemployment tax (more than $7,000), that makes effective federal unemployment tax rate equal to 0.6%. It's worth to mention here, that employees of the big corporations usually keep their jobs for several years, while workers at small businesses (restaurants, small food stores, etc), usually change their jobs very frequently. In effect, the big corporations pay only 0.6% of the first $7,000 earned by the employee in FUTA, which is only $42. The small businesses with higher churn rate in the same position pay up to 0.6% of the total annual pay. For a job paying $50,000 in annual wages, the small business owner has to pay $300 in federal unemployment tax. The big companies usually pay less than one thousand dollars in state unemployment tax, while small businesses usually pay 2 to 10 times more. Because low-paid workers tend to use unemployment benefits more often, this seems to make sense. On the other hand, this situation forces small business owners to pay workers much less than the value of their work to cover this expense, which creates incentive to use unemployment benefits even more often. On the other hand, people who stay with their low-paid job longer may be rewarded by their employer with quite high bonus, paid from savings on unemployment taxes.
The Value of Work
Tax Impact of federal taxes
All those payroll taxes must be paid from revenue generated by employee's work. Because of the complexity of those taxes it's easier to calculate their impact on an individual basis. Lets review the example of an single-filer employee who works as a web designer for $50,000 salary (close to national median) and stays with the job for the whole year (calculated using 2008 tax tables):
| Salary (gross income) | $50,000.00 |
| standard deduction | $5,450.00 |
| personal exemption | $3,500.00 |
| federal taxable income: | $41,050.00 |
| Social Security | $3,100.00 |
| Medicare | $725.00 |
| Federal Income tax | $6,613.00 |
| taxes paid by employee: | $10,438.00 |
| Social Security (employers match) | $3,100.00 |
| Medicare (employers match) | $725.00 |
| federal unemployment tax | $42.00 |
| Total payroll taxes: | $14,305.00 |
| Real salary: | $53,867.00 |
| Income after payroll taxes: | $39,562.00 |
| tax impact [%]: | 26.56% |
As shown in the table above the tax impact on federal level only is almost 27%. The employee has to pay state tax out of what's left, which lowers the amount he actually receives. The employer has to pay unemployment tax, which adds to the real cost of employment.
Tax impact of state taxes
The state income tax rates, number of tax brackets, standard deduction, personal exemption are quite different in every state.
The state unemployment tax rate and amount of wages subject to this tax also varies from state to state.
Because of so many differences in state tax systems the calculation of the tax impact on this level must be performed for each state individually. The spreadsheet file with calculations shown in the table below is available here: TaxImpactByState.xls.
| State | state income tax | unemployment insurance tax amount | real salary (all taxes included) | tax impact on state level [%] | recalculated tax impact on federal level [%] | overall tax impact [%] |
|---|---|---|---|---|---|---|
| Florida | $0.00 | $378.00 | $54,245.00 | 0.70% | 26.37% | 27.07% |
| New Hampshire | $0.00 | $520.00 | $54,387.00 | 0.96% | 26.30% | 27.26% |
| Texas | $0.00 | $549.00 | $54,416.00 | 1.01% | 26.29% | 27.30% |
| Tennessee | $0.00 | $700.00 | $54,567.00 | 1.28% | 26.22% | 27.50% |
| South Dakota | $0.00 | $765.00 | $54,632.00 | 1.40% | 26.18% | 27.58% |
| Nevada | $0.00 | $1,371.60 | $55,238.60 | 2.48% | 25.90% | 28.38% |
| Alaska | $0.00 | $1,690.20 | $55,557.20 | 3.04% | 25.75% | 28.79% |
| Wyoming | $0.00 | $1,815.03 | $55,682.03 | 3.26% | 25.69% | 28.95% |
| Washington | $0.00 | $2,046.80 | $55,913.80 | 3.66% | 25.58% | 29.24% |
| Arizona | $1,277.32 | $378.00 | $54,245.00 | 3.05% | 26.37% | 29.42% |
| Louisiana | $1,443.00 | $434.00 | $54,301.00 | 3.46% | 26.34% | 29.80% |
| Alabama | $1,506.85 | $483.20 | $54,350.20 | 3.66% | 26.32% | 29.98% |
| Illinois | $1,440.00 | $792.00 | $54,659.00 | 4.08% | 26.17% | 30.25% |
| Indiana | $1,700.00 | $392.00 | $54,259.00 | 3.86% | 26.36% | 30.22% |
| Pennsylvania | $1,535.00 | $736.00 | $54,603.00 | 4.16% | 26.20% | 30.36% |
| Ohio | $1,557.33 | $828.00 | $54,695.00 | 4.36% | 26.15% | 30.52% |
| New Jersey | $1,214.75 | $1,495.80 | $55,362.80 | 4.90% | 25.84% | 30.73% |
| Connecticut | $1,662.50 | $810.00 | $54,677.00 | 4.52% | 26.16% | 30.68% |
| Mississippi | $1,935.00 | $378.00 | $54,245.00 | 4.26% | 26.37% | 30.64% |
| Vermont | $1,823.40 | $616.00 | $54,483.00 | 4.48% | 26.26% | 30.73% |
| Colorado | $1,900.62 | $540.00 | $54,407.00 | 4.49% | 26.29% | 30.78% |
| North Dakota | $1,037.33 | $2,179.06 | $56,046.06 | 5.74% | 25.52% | 31.26% |
| West Virginia | $2,055.00 | $600.00 | $54,467.00 | 4.87% | 26.26% | 31.14% |
| California | $2,221.92 | $378.00 | $54,245.00 | 4.79% | 26.37% | 31.16% |
| Nebraska | $2,188.17 | $486.00 | $54,353.00 | 4.92% | 26.32% | 31.24% |
| Maryland | $2,113.50 | $637.50 | $54,504.50 | 5.05% | 26.25% | 31.29% |
| New Mexico | $1,858.65 | $1,074.60 | $54,941.60 | 5.34% | 26.04% | 31.38% |
| Michigan | $2,031.45 | $927.00 | $54,794.00 | 5.40% | 26.11% | 31.51% |
| Rhode Island | $1,852.38 | $1,370.60 | $55,237.60 | 5.83% | 25.90% | 31.73% |
| Virginia | $2,393.25 | $496.00 | $54,363.00 | 5.31% | 26.31% | 31.63% |
| South Carolina | $2,506.15 | $378.00 | $54,245.00 | 5.32% | 26.37% | 31.69% |
| Kansas | $2,413.88 | $592.00 | $54,459.00 | 5.52% | 26.27% | 31.79% |
| Missouri | $2,340.00 | $720.00 | $54,587.00 | 5.61% | 26.21% | 31.81% |
| Georgia | $2,509.95 | $459.00 | $54,326.00 | 5.47% | 26.33% | 31.80% |
| Montana | $1,953.70 | $1,456.56 | $55,323.56 | 6.16% | 25.86% | 32.02% |
| Oklahoma | $2,410.45 | $748.00 | $54,615.00 | 5.78% | 26.19% | 31.98% |
| New York | $2,514.25 | $722.50 | $54,589.50 | 5.93% | 26.20% | 32.13% |
| Wisconsin | $2,419.18 | $934.50 | $54,801.50 | 6.12% | 26.10% | 32.22% |
| Kentucky | $2,577.10 | $780.00 | $54,647.00 | 6.14% | 26.18% | 32.32% |
| Washington, D.C. | $2,695.13 | $594.00 | $54,461.00 | 6.04% | 26.27% | 32.31% |
| Arkansas | $2,532.83 | $1,000.00 | $54,867.00 | 6.44% | 26.07% | 32.51% |
| Iowa | $2,116.15 | $1,824.00 | $55,691.00 | 7.08% | 25.69% | 32.76% |
| Maine | $2,905.25 | $648.00 | $54,515.00 | 6.52% | 26.24% | 32.76% |
| Massachusetts | $2,431.38 | $1,534.40 | $55,401.40 | 7.16% | 25.82% | 32.98% |
| Hawaii | $3,170.94 | $702.00 | $54,569.00 | 7.10% | 26.21% | 33.31% |
| Utah | $2,157.76 | $2,429.70 | $56,296.70 | 8.15% | 25.41% | 33.56% |
| North Carolina | $3,106.50 | $1,060.20 | $54,927.20 | 7.59% | 26.04% | 33.63% |
| Minnesota | $2,545.86 | $2,325.00 | $56,192.00 | 8.67% | 25.46% | 34.13% |
| Idaho | $2,896.61 | $1,738.80 | $55,605.80 | 8.34% | 25.73% | 34.06% |
| Delaware | $3,485.49 | $861.00 | $54,728.00 | 7.94% | 26.14% | 34.08% |
| Oregon | $3,968.50 | $1,630.80 | $55,497.80 | 10.09% | 25.78% | 35.87% |
In summary, the overall tax impact range is between 27.07% (Florida) to 35.87% (Oregon). It's no strange that the states with the lowest tax impact are the seven states with no income tax.
The conclusion is that the working class people receive only 64%-73% of the value of their work. Lets remember, that out of it they have to pay sales tax and excise tax on most things they buy. They also have to pay property tax, whether directly (homeowners) or indirectly (renters). What's really left is closer to 50%-60%.
If you're planning to start a business that doesn't depend on location, for example a web store or a software company, this example will probably be helpful in choosing the state of incorporation. Remember however, to check the state corporate income tax rates. Also, avoid states taxing dividends, because the most tax efficient way to get the money out of the business is in part in wages and in part in dividends. Two of such states are even in the top-10 on the list: New Hampshire, Tennessee.
A look beyond taxes - the real value of your work and the money you receive for it
There are two types of companies: services and manufacturing. The manufacturing company takes some raw materials, add value created by human labor, and sell the final product. The services company sells human labor. In the first case, the value of employee's work is equal to the revenue generated by this work, less the cost of raw materials. In the second case, the value of employee's work is equal to the revenue generated by it.
Lets get back to the example used before. The revenue generated by rank-and-file employee's work has to cover such business expenses as:
- amortization of: computer, desk, phone, desk lamp, pencils, printer, etc.
- costs: Internet connection, electric energy, office space, printer cartridges and paper, etc.
- insurance: basic health insurance for employees, dental plan, insurance costs for company buildings, cars, etc.
- salary of administrative staff: managers, secretaries, human resources, janitors, etc.
- vacation pay, sickness and short-term disability pay.
- corporate income taxes (state and federal).
- interest expenses (cost of company debt).
- Investor's return: dividends paid to owners of the business (investors) and return reinvested in the company.
To simplify these calculations lets assume that about 50% of total company revenue is paid in salaries to rank-and-file workers and the other 50% goes to all these costs listed above. In such example at least 27% (Florida) out of that 50% goes to payroll taxes. That's 13.5% of total revenue, which is the real value of employee's work. The worker gets only 36.5% of the value of his/her labor. He/she will have to spend most of that on living costs: food, clothes, rent or interest payments on mortgage, property taxes, utilities, etc. Even if such person manages to save 10% of his/her aftertax wages, that is only meager 3.65% of the total value of his/her work.
That the company gets half of even more of the revenue generated by it's workers is not necessary exploitation. If such worker tried to start the business by himself he would have to pay most of the same expenses. The purpose of this part of the example is to show the potential savings. If the company you currently work for is wasteful and inefficient, then start your own business providing pretty much the same service or product, but in a more efficient way. Your business will be more competitive than your former employer's firm, and will be much more profitable.
If you happen to work for a public company (listed on NYSE or NASDAQ), then just look up the most recent 10-K report on the sec.gov website. If your company is in services sector, then divide total revenue (or sales) number by the number of employees. That's the rough estimation of the value of your work. If your company is in a manufacturing sector, then you'll need to substract the raw material costs from revenue, before dividing it by the number of employees. It is a very rough estimate, because your own work may be worth more or less than that. But again, it is a rough estimate. Your salary is included in COGS (Costs of Goods Sold). Although most companies don't disclose that, you may be able to find Direct Labor or Labor Costs. That's the total amount of money paid to regular workers. Compare this number to the amount of total revenue (or sales). While there might be a huge difference between these two numbers, you have to remember, that there are other costs involved in generating that revenue.
Conclusions
It seems that the tax law (especially FICA) was designed the way to hide the truth from the working class. But most probably the tax law evolved over the years to such complexity just because most politicians are not economists. In part unintentionally and in part purposefully they create tax loopholes and incentives. Because of the lobby most politicians and congressmen represent some groups of interest with money, and that's why most of those loopholes are designed to be exploited only by the rich. Sometimes however, there are holes in the tax law that can be exploited by the average individual, if only he knew them. At the very least, the ability to spot those grey areas in the tax law would help many people not to get exploited by politicians and employers. The first and most important thing however is to realize the current situation, that in terms of percentage of income the working class is being taxed the most.
In this world nothing can be said to be certain except death and taxes. - Benjamin Franklin
Taxes are not necessarily evil. Thanks to the taxes we all can enjoy a safe living environment. Taxes are used by the government to support the defense, the police, the judicial system, healthcare, pay Social Security benefits in retirement, etc. The benefits are: no war inside the country borders, relative safety on the streets, ability to resolve legal disputes in court, basic healthcare, money to live in retirement or unemployment, etc. But most of the tax money is simply wasted. According to the invisible hand theory in any free market system, the two sides of the transaction: the citizens and the government, should be able to set the price of the benefits provided by the government, somewhere in the middle between the costs of those benefits and their value. Unfortunately, taxes are not set in a free market system. The government may set the tax as they please, usually well above the value provided, and the citizens who try to refuse to pay, go to jail. Some citizens may be able to give up their citizenship and move to some other country with less or no taxes, but this option is not available for everyone. Until the government can be held accountable for what they do with the tax money, there will be no downward force on tax rates.
...it is the duty of every citizen to avoid paying taxes in any way that the law permits... - Chief Justice Earl Warren
The legal right of the taxpayer to decrease the amount of what otherwise would be his taxes or altogether avoid them by means which the law permits, cannot be doubted. - Gregory v. Helvering, 293 U.S. 465
It is the right and duty of every citizen to structure their financial affairs to pay as little tax as possible, and to avoid paying taxes whenever possible. Tax avoidance is not illegal, tax evasion is. The two are completely different from each other. Every patriotic citizen should avoid paying taxes for two reasons:
- to force the government to be a more savvy spender, make the executioners of the social programs more accountable, and watch the budget closely – if the government won't be able to squeeze too much taxes from the citizens, then it will have spend less and/or decrease it's size.
- to make the tax incentives work – there are many tax incentives created by the government every year for the purpose of spurring economic growth in a select sector, so it is a patriotic duty of every citizen to help it happen.
The final word
The purpose of this article is to show how to calculate the value of your work, so you can compare it with the money you received, and not let to be exploited. Start thinking positively about tax avoidance - it is your right and duty. And whether you believe the current tax rates are unbearable or not, try to exploit every legal way to avoid taxes. As of now, there are still plenty of them.
Useful links to tax related sites:
- TaxPolicyCenter.org
- Bankrate.com - state income tax rates.
- TaxAdmin.org - state income tax tables (individual and corporate).