Bob Fahnestock


The recent release of Romney’s 2011 tax return has sparked the reporting of what has been termed the “effective tax rate” for both Romney and Obama. It has been reported that Romney’s effective tax rate was right at 14% while Obama’s effective tax rate was 20%. The problem with the reported information is twofold: (1) the effective rates being reported for both are not measured in the same way for both candidates; and, (2) the computation of the “effective tax rate” is incorrect. Because the U.S. tax system uses progressive or graduated income tax rates, the rates increase as the taxable income increases. The rate in each bracket is referred to as the “marginal tax rate.” The overall tax paid will be a combination of these multiple tax rates making the effective rate less than the marginal rate. In fact, one can never have an effective tax rate equal to the tax rate in the highest bracket. The tax rates are applied to “taxable income” which is after deductions and exemptions and before tax credits. In order to correctly compute the effective tax rate the total income tax paid should be divided by the taxable income. Based on the reported information the “effective rate” was not reported correctly for either candidate. Plus, the so-called effective rates are being computed differently for each candidate. The rate that is being reported for Romney is the total tax paid divided by the gross income before any adjustments, deductions, and exemptions. The rate being reported for Obama is the taxes paid divided by the adjusted gross income (after some adjustments to gross income but before deductions and exemptions). When the so-called effective tax rate is computed on gross income it will be lower than if computed on adjusted gross income or taxable income. When computed on adjusted gross income it will be somewhere in-between the lowest and highest possible rate. Because Romney donates such a large chunk of income to charity, this erroneous computation makes the so-called “effective rate” on his tax return look lower than the rate on Obama’s return when, in-fact, they should close to the same effective tax rate. Based on the reported information about Romney’s deductions, we can estimate his taxable income. Using this number to correctly compute Romney’s effective tax rate, the rate is right at 25%. This number cannot be computed for Obama as my research has yet to uncover the amount of his deductions. But it will be higher than 20% and close to 25%. This whole story is much ado about nothing as the media continues to “make” news. Based upon my experience, the “effective tax rates” for the upper middle income and high income earners tend to range from 20% to 25%. Based on my experience, both candidates (as well as Warren Buffet) are paying a typical “effective tax rate” for taxpayers in their respective income tax bracket.

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