Fresh off the holiday season, we were constantly being enticed by retailers to spend money. This presents an opportunity to talk about tax-effecting. While this topic isn’t nearly as fun as buying gifts, they are inextricably linked.
When you are saving money to buy presents, have a great dinner, take a vacation, etc., it is natural to view a savings goal in terms of the amount of time you need to work to earn that money. If someone hypothetically makes $20/hour, it reasons that (after fixed expenses) 5 hours of working can translate to affording $100 worth of purchases.
However, you need to tax-effect your earnings for a true portrayal of how much something costs. Someone making $20/hour may face these marginal tax rates: 25% federal, 5% state & local, 6.2% Social Security, 1.45% Medicare. This totals to 37.65%.
Instead of a $100 gift being financed by 5 hours of work, it actually takes 8 hours. To tax-effect $100 of after-tax income:
Pre-tax = After-tax / (1 – combined marginal tax rate)
Pre-tax = $100 / (1 – 0.3765)
Pre-tax = $100 / 0.6235
Pre-tax = $160
So in actuality, someone making $20/hour would need to work 8 hours to earn $160 pre-tax. Once taxes are applied, that gets effectively reduced to $100 which enables him or her to make the purchase.
Depending on your income, you can calculate your combined marginal tax rate and use that figure to identify the true cost of whatever you’re purchasing.
As a general rule, the higher your tax rate, the more relatively expensive purchases become.
Applying this concept to the discourse on taxes, it stands to reason that progressive proposals to extract even more tax revenue from higher-income families could produce adverse consequences. Millions of households would not only experience an income reduction but it would become more expensive for them to consume goods and services. With 2/3 of the U.S. economy driven by consumption, a pronounced decline in purchases by affected taxpayers would be unsettling for the entire country. This concept is often overlooked in the taxation debate, but it clearly merits attention and should be given proper consideration when evaluating the costs and benefits of different tax proposals.
Kevin, you clearly and effectively make the case here that there is no free lunch. However, given the current deficit and debt, an increase in taxes, combined with a decrease in spending, will probably be necessary to balance the budget and avoid the massive deleterious effects that would be caused by a large debt combined with high interest payments on those Treasury bonds.
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