I previously wrote about about the marginal tax rate graph which showed that those on the borderline of middle class and upper middle class had higher marginal tax rates than the wealthy.
It turns out that I was incorrect in thinking that this had something to do with FICA taxes. There’s a followup post at Marginal Revolution with a link to the assumptions used. It seems that the bump in the marginal tax rate has to do with deductions for things like IRAs (as if anyone with a 401k plan would contribute that) and student loan interest being phased out.
It is a big mistake to ignore FICA taxes when considering tax reform. For people earning less than $90,000/year, the employee must pay a 7.65% FICA tax which he sees deducted from his paycheck, plus there’s a hidden 7.65% tax which the employer pays and the employee never even sees. Of course it’s merely a fiction that the employer pays this tax, because it represents money which otherwise would have been paid to the employee. FICA taxes are really like a 15.3% tax.
After $90,000, the FICA tax drops to 1.45% for both employer and employee (so it’s like a 2.9% tax).
So we see, once you reach $90,000 in income your marginal tax rate plummets by 12.4%.
A flat tax that ignores FICA taxes would screw the middle class because they would be burdened with higher tax rates than the rich. Unfortunately, almost all the flat tax proposals I hear about do ignore FICA taxes.
On the other hand, if FICA taxes and regular income taxes are merged into a single rate flat tax which kicks in once someone earns a threshold amount of income, the final result would be a tax system that’s fairer (assuming all the unfair deductions are removed) and more progressive than what we have now because lower income people would be paying no taxes at all. Under the current system, even the poorest workers still have to pay FICA taxes.
TaxProf has the exact opposite take of this post. I'm complaining about how ignoring FICA taxes makes our tax system seem more progressive than it really is. But TaxProf complains that the NY Times modified the chart to make it seem more regressive.