04/19/2011 04:48 pm ET | Updated Jun 19, 2011

The Rich Can Finally Put Their Money Where Their Mouths Are

This year, tax week coincides with the Federal Budget battle, so perhaps it's no surprise when comedian Dennis Miller tells Fox News host Bill O'Reilly that Democrats want state and federal governments to take 51% of his income and he'd like a 1% refund so it's not more than half.

Guess what Dennis: even if the president does reinstate Clinton level tax rates, you still would not be paying the U.S. and California close to 50% in income taxes. (If you do, get a new accountant.)

Miller is just the latest to reflect America's monomaniacal focus on "marginal" tax rates while completely ignoring "effective" tax rates. It has led individuals to believe that they are paying taxes at that marginal rate when they are not.

This is not to say that marginal rates are irrelevant. But effective tax rates, the percentage of one's income actually paid in taxes, are at least as important.

Americans just don't realize how much lower the effective tax rate is for high income -- and I mean very high income -- families. The Tax Foundation has published the percentages of income (or the effective tax rate) paid at different levels of income in 2007.

  • Those making up to about15,000 aren't, for the most part, paying income taxes thanks to the Earned Income Tax Credit (EITC), although they are paying payroll taxes.
  • Those in the next quintile (up to about30,000) pay little in income tax, with their payroll taxes taking them to about 7% effectively.
  • Above60,000, the effective rates for all U.S. households are fairly close, with those making around100,000 paying effective rates of over 16% while those making above10 million coming in at 20%, including payroll taxes for each group.

Now comes the IRS reporting that the effective tax rate of the richest 400 tax payers in 2007 was 16.62%. That's right: the richest among us -- most likely billionaires -- pay the same as those earning $100,000. Throw in payroll taxes and the effective rate of the super-rich is lower than that of the middle class.

No quintile is actually paying a third of its income in federal income taxes, much less half. Throw in effective state taxes and again -- virtually no one is paying half their income in federal and state taxes.

But should they? Shouldn't multi-millionaires, the truly rich (as opposed to those who have been labeled rich, but aren't, at an income of $250,000) truly pay more?

Commentators like Joe Klein, Chris Matthews and Sam Donaldson say that there has to be a middle-class tax increase because "that's where the money is." Sorry, guys, but there was as much Adjusted Gross Income (AGI) reported by the nearly 400,000 households earning over $1 million in 2007 as the 4.1 million making $200,000-$1 million.

Don't think so? How many households do you think reported Adjusted Gross Incomes of $10 million or more annually? 100 entertainers, athletes, and Fortune 100 CEOs? 1,000?

In 2007, nearly 20,000 households filed tax returns declaring over $10 million in Adjusted Gross Income. And those earners averaged over $30 million each.

But AGI shouldn't be our only focus. The key to progressive taxation is not just relative Adjusted Gross Incomes, but the huge disparity in discretionary income -- income after expenditures on necessities and taxes. While this figure can only be estimated, the Conference Board says that over 1/3 of taxpayers have zero discretionary income. That's how much they should pay in additional income tax: zero.

The "real" money, that is the real discretionary income, is with those who make over $1 million. And, while the rich may have substantially more gross income than the rest of us -- they have vastly more discretionary income. Their marginal tax rate may be about the same as those making $250,000 (35% vs 33%), but their discretionary income is what: 100 times higher? Perhaps more. Those earning even $250,000 with more than one kid in college often have to borrow to cover tuition expenses.

So, there is clearly room to increase the taxes on higher income earners. But instead of attempting to increase top marginal rates to extremely high levels (which is almost certainly futile), let's utilize the Alternative Minimum Tax (AMT) to move the effective and marginal rates closer together.

The AMT needs to be fixed in any case (a short-term fix was part of the Obama/Republican compromise in December). Let's permanently fix the AMT: by graduating it.

Here's how:

  • Include all income, including capital gains and dividends.
  • The AMT rate of 28% would be capped at1 million. No AMT rate increases for those earning under1,000,000.
  • A new AMT of 29% at1 million+ of income should be established. The AMT would then increase by 1% for each additional million dollars earned.2-3,000,000 would be 30%.3-4,000,000 would be 31%. And so on.
  • Cap the rate at the maximum income tax rate -- 35% -- at7 million of income.
  • Index all of this to inflation. (Unlike the current AMT, which risks dragging lower income taxpayers into its net.) Say, by increasing the brackets by250,000 every 10 years (i.e. the 29% rate goes to1.25 million after a decade.)
  • Eliminate the AMT on couples who face a phase-in of the AMT today at415,000. Heck, make it500,000. It would cost only a fraction of the amount raised here. And it would represent a permanent tax cut for over 20 million taxpayers now caught up in the AMT.

That's it. The nearly 400,000 tax filers earning over $1 million are already affected by the AMT, so this wouldn't require them to do anything new (as if they didn't have accountants already preparing their returns.)

Guess what: this plan raises more than twice the $70 million raised by increasing marginal rates up to the Clinton era 39.6%. And it affects relatively few earning less than $1 million (only those who have significant capital gains/dividends but less than a million).

How would this affect marginal rates? This schedule affects the marginal rates of the rich, but only at very high incomes. Under this plan, we don't go back to the "bad old days" of 91% marginal tax rates (at over $2 million in today's dollars), which were prevalent prior to the Kennedy tax cut of 1964. We don't even go back to Kennedy's 70% rate. The top marginal rate does exceed 35% -- for those earning $5 million or more -- but it maxes out at 41% and then settles back down to the 35% figure.

Wait... want more compromise? Let the AMT exclude capital gains income for investments in "early stage" businesses and real estate improvements. It's one thing to reward start-up investments. Publicly traded stock trading and existing real estate investments don't have the same entrepreneurial impact. And hedge fund managers would have to start paying appropriate taxes.

Meanwhile, Arthur Laffer might argue that the rich will manipulate their income and deductions to reduce their tax burden, their only ability to manipulate is the timing that they receive income.

Those making big money can only adjust the timing so much, however -- it's not easy to manipulate $10 million down below $500,000 that would maintain the current effective rate around 20%. While the super-rich can always stretch out their compensation or dividends... there's a risk. As the current economic crisis has demonstrated, few institutions are too big to fail -- or to have to restructure their debt.

So, here's a real compromise -- no increases in marginal tax rates. An Alternative Minimum Tax fix that reduces rates below $500,000/couple while limiting increases to those making millions. And the rich finally paying the amount that they say they're paying anyway.

Then let's apply the same principles of graduation and minimums to the Estate Tax and the Corporate Tax. Again, this could be part of a compromise while reducing corporate tax rates. (Exxon sets a record for corporate profit and doesn't pay taxes? Come on.)

Finally, Mr. Miller: if this program is enacted, then you can complain that those making over $7 million shouldn't have to pay 40% or so of their income in federal and state income taxes. It won't reach 50%, but at least you'll have your numbers right.