What is an effective tax rate?

Presidential candidate Mitt Romney recently released his tax returns. But what do they mean by effective tax rate?

Adriene Hill: Republican Presidential Candidate Mitt Romney released his tax returns this morning.They show that in 2010, he made about $20 million, and paid $3 million in federal income taxes. Romney's effective tax rate is around 14 percent. But that's a different tax rate calculation than the one you're probably familiar with.

For more we go to Charlie Wheelan. He's a public policy professor at the University of Chicago.  Good morning. 

Charlie Wheelan: Good morning.

Hill: So what’s the tax rate we all think we pay?

Wheelan: Most of us look at the marginal tax rate -- so, over $250,000 if the marginal tax rate is 39 percent, we say, “oh my goodness, I finally make over $251,000,” and we assume that we’re paying 38 perecent or 39 percent on that entire sum. And in fact, the marginal tax rate changes for each level of your income. So you’re probably paying zero income tax on, say, the first $15 or $20,000 of your income and 10 percent on the next chunk of your income, and 28 percent on the next chunk. That high marginal tax rate only kicks in at that last dollop of income.

Hill: So can you tell me what other tax rates are out that that maybe better indicates what I actually pay.

Wheelan: The easiest one is just your average tax. We take how much you payed the government, we take your income and we divide your tax into your income. So if you paid $18,000 on $100,000 of income, your average tax rate is 18 percent.

Hill: And what about the effective tax rate? What are we talking about there?

Wheelan: Well in that case, you start to get a little more complex. If you’re talking about somebody with a very complex life -- like a Mitt Romney -- then you want to look at what is the true tax burden, the effective tax burden, on your overall income. It can get quite complex when you realize that money gets taken from other places that don’t show up on your tax return. In the case of a Mitt Romney, his effective tax rate -- what really goes to the government, as a result of his behavior -- is almost certainly higher than what shows up on his tax return.

Hill: What rate should we be paying attention to? What rate are you most interested in when you look at Romney’s tax returns?

Wheelan: I’m actually not terribly interested in any of his rates. That said, I’m very happy that we’re having this discussion because what we need to be talking about isn’t particular to Romney. It’s, OK, given that we’re taxing these different kinds of incomes at vastly disparate rates, the question is, how does that affect tour behavior? They’re really important questions for the economic future of our country. 

Hill: Professor Charlie Wheelan, thanks.

Wheelan: Thank you.

About the author

Adriene Hill is the senior multimedia reporter for LearningCurve.

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