How Taxes Work

Econ Buff Podcast #7 with Rex Pjesky

Dr. Rex Pjesky talks with me about how taxation works. We discuss what the income tax is, why it is important, and how it works. How the Tax Cuts and Jobs Act of 2017 has impacted filers is examined. We consider the details of the changes to the standard deduction, child tax credits, exemptions, and state and local deductions. We explore examples of taxes work and how Dr. Pjesky views the future of the mechanics of taxation.

Transcript

Stitzel: Hello and welcome to the EconBuff Podcast. I'm your host Lee Stitzel. With me today is Dr. Rex Pjesky, Professor of Economics at West Texas A&M University. Rex, welcome.

Pjesky: Thanks a lot Lee. It's good to be here.

Stitzel: So Rex, our topic today is taxes. But we're gonna do something specific, because taxes is --- it's one of those central topics for economists. We love to talk about it. It works its way into almost all the classes that we teach. Of course, I think you have an extensive history teaching classes that are specifically about taxes like public finance.

Pjesky: Yes.

Stitzel: So we're gonna do something very specific today --- which is talk about the intricacies of how taxes work. So when I think about taxes as an economist, I'm fond of thinking of them on how they change behavior and what kind of incentives they create. But we want to do something very specific today --- which is give the listeners a strong baseline for how do these things actually work. And maybe at another point you and I can spin off and do something a little broader on taxes. So I just want you to kick us off with: what is an income tax? Because I think that's the tax that we'd like to talk about the most today.

Pjesky: Right. Right. Well the, I mean, income tax is probably the tax that is talked about the most. Property taxes might be up there up there as well. But when, you know, there's any changes to income tax, or when people have to pay their income taxes or whatever, it's always a big discussion. And it's, you know, of all of the taxes that at least affect all of us directly. I don't think that there is as much, you know, misinformation and ignorance (if I can use that word) about how income taxes work, and about how changes in laws might affect individual income tax income tax payers. And so, you know, I see this all the time. And I especially saw this, you know, a year or two ago when the new tax law came about. You know, what people were saying about that law was just, you know, absolutely wrong often. And that's really, really unfortunate because, you know, our policies [of] our democracy, I think, really should rely on people being, you know, adequately informed about how these things work.

Stitzel: So in my mind the big three taxes are, sort of, sales tax, property tax, [and] income tax. If we were living in a different world, [then] maybe we [would have] talked about like value-added taxes or something like that. But if you're in an American context, that's what you think about. And there's a lot of talk, sort of, even across states --- like this state does or doesn't have an income tax. And I think that can be a draw. But it's not as if Oklahoma having an income tax --- and Texas doesn't --- means [that] Texas somehow gets less of your money. They just get it through property taxes. So can you lay out, sort of, mechanically what is an income tax? You've done a good job telling us sort of why it's interesting.

Pjesky: Hmm mmm.

Stitzel: Just kind of give us a good footing for…

Pjesky: You know, very, very…

Stitzel:…us.

Pjesky:…simple (at most basic level) --- an income tax is money that you pay for the government. And [it is] based on what you have/you've earned [in the prior year, to be paid] in the following year. And it's usually what you've earned at some, sort of, you know, job or wage salary type situation. Different sources of income are treated differently. But, you know, again, at the most basic level: you make a $100,000 [and then] you pay so much tax on that.

Stitzel: So today we're, you know, we're gonna, kind of, talk about how the different taxes function. And I, sort of, didn't think about this when we were doing the prep, right? But income tax has happened at different levels, and I suspect they happened differently. So what is it that makes, sort of, the income tax system unique, or interesting, or something that is that we would want to talk about? I guess I'll start with a federal case.

Pjesky: Well, I mean, at the federal level (even at the state level) --- income taxes, I think, generate quite a bit of discussion in terms of policy; because there are so many different ways that people can see how it's collected.

Stitzel: Hmm mmm.

Pjesky: And with the income tax, it's the only tax that the ordinary taxpayer has to, you know, basically file every year in a very, very sort of manual way. And many taxpayers actually will help/will get some help filing those taxes. Property taxes are not that way. You know, you get a bill from your, you know, from your county government. Most of the time [it] is from your county government, and it's generally based on the valuation of your house. And there's always, you know, disputes about that. But the mechanism of paying property taxes is very straight forward. Sales taxes, as they are in the United States, are also very straight forward --- you know, [a] straight forward mechanism. You go, you know, you go and you buy something that costs a $100, and [then] you're your final bill ends up being, you know, $108.25…

Stitzel: Hmm mmm. Right.

Pjesky:…or something like that. It's a very, very straight forward thing. There's nothing to calculate. There's really not anything to (not really) anything to think about. But with the income tax, you have a very different situation, O.K.? It's [that] there are all kinds of things that make the income tax complicated. I don't think income taxes are inherently complicated. But the way we end up administering them, I think, makes them inherently complicated, and that creates confusion. And that creates a lot of discussion surrounding the income tax that you don't see around other taxes. So when you go to file your federal income tax --- and most states work this way as well that have an income tax (but, you know, perhaps not all of them [because] you've got 50 states, and so you're going to have 50 different tax systems) --- but the federal income tax works very basically like any income tax would work. At least [it would work] at any level in the United States where you have a certain amount of income that's subject to the tax. And then that income goes through a, you know, a filing process where it's subject to different kinds of means and status tests, all right? So you have exemptions, you have credits, and you have deductions. And after all of that process, after all of your income is categorized, and all the arithmetic is done, [then] you're left finally with a tax liability (which can be a very different process for taxpayers that are otherwise in similar situations, perhaps). And so, again, that leads to a lot of confusion, a lot of misinformation, and a lot of discussion about the income tax [because] it's not present with other taxes.

Stitzel: So you said there's a portion of income that is subject to the income tax.

Pjesky: Right.

Stitzel: And I assume that means above some level of yearly earnings? Is that correct?

Pjesky: Right. So here's the [thing]. We can just go (we can just walk) through this, you know, with, you know, maybe a hypothetical taxpayer that makes say, you know, $100,000 a year. The first thing that goes on with that is: you are subject to a certain amount of deductibility of income off of that. So a deduction from income is: income that you earn that is not subject to tax at all. And in The United States, we have two different kinds of deductions from our income. First we have a standard deduction. So every tax paying unit, which is usually a household, is eligible to take a standard deduction (which is a certain amount based on filing status) which is another complication of the income tax.

Stitzel: And so filing status is like marital status?

Pjesky: Filing status would be like single head of household. I mean, these are terms that are going to be familiar to anybody that's filed taxes before. So you're married filing joint, [or] married filing separately. It could be [that you are] a head of household or you could [just] be a single taxpayer. And all of these different terms have very, very specific meanings. And every taxpayer has to make a decision based on what they're eligible for, and based on what's best for them. They're going to have to make a decision about how they're going to [go] about [and] how they're going to file. And the amount of income that is deducted through the standard deduction depends on the filing status of the taxpayer. So, you know, it might be, you know, [a] married filing joint taxpayer (you know, [a] married couple that's filing their taxes together) --- their standard deduction is in the neighborhood of about $26,000 a year (so and, you know, 25 [or] mid-20s). You know, I'd like to say now that as we go on with this podcast we might be talking a lot of numbers.

Stitzel: Hmm mmm.

Pjesky: And I want to make it clear that when we talk about a number it might not be the exact truth. But, you know, sometimes we might round it to make the arithmetic simple. So, you know, for instance a tax rate might be 39.6%, [but] we might call that 40%...

Stitzel: Right.

Pjesky:…(just so we can conceptualize what's going on a lot better), because I have a very difficult time thinking about 39.4% or 39.6% or whatever. But I can think about 40% percent fairly, you know, fairly easily. So, you know, don't do taxes based on the numbers that we say here, because they might be approximation from here.

Stitzel: This is not professional tax guidance.

Pjesky: Yeah. Not professional tax guidance from here.

Stitzel: So is the standard deduction --- is that [a] percentage, or is it a fixed number?

Pjesky: The standard deduction is going to be a fixed number. It's not a percentage, at least at the federal level. The next thing that the filing process will, what will, do in between your earnings and your final tax liability is that often a tax system will have a certain process that will exempt some portion of income. And this is important because exemptions were changed quite a bit with the new tax law that was passed in 2017.

Stitzel: So let me back you up really quickly. So there were two types of deductions. One is standard. Are you coming to what the other deduction is? Or are we jumping to exemptions?

Pjesky: Well it's --- thanks for catching that.

Stitzel: No problem.

Pjesky: The other kind of deduction that we can take at the federal level are itemized deductions. So in the tax code there are certain expenditures that the government has deemed to be important enough (or special enough) to deserve tax treatment. A lot of these are well known to everybody. State and local taxes that you pay, under certain circumstances, are deductible off of your federal income tax. Health expenditures are, under certain circumstances, deductible. Home mortgage interest that you pay is, again probably the big one, is deductible. Certain benefits that you get from your employer --- you know, things like life insurance are deductible in a very special way also. So if all of these eligible deductions that a taxpayer might have add up to more than the standard deduction, then the taxpayer will allow those deductions instead of standardized deductions. So in other words the taxpayer…

Stitzel: Instead itemize?

Pjesky: Will itemize. So if you have, if you’re a taxpayer…

Stitzel: You can pick?

Pjesky: You can pick or choose.

Stitzel: @12:07 ??

Pjesky: Alright. So if you’re a taxpayer, and you have the $25,000 standard deduction, and the sum of (your mortgage interests, the sum of your eligible medical expenses, you know, and other) things that you might deduct --- if that adds up to more than $25,000, then you'll take the itemized deduction and not the standard deduction. And, you know, that process yields a lot of confusion among taxpayers and in any tax discussion.

Stitzel: Well, very interesting. So before we jump over, let me ask a question. Because this is something that I'm ignorant of. And so I hope I'm not putting you on the spot too much. But so different types of income --- are they all counted under this umbrella, right? So we're gonna sometimes get income from investments, or rental properties, or something. And that might be counted differently than my primary employment at a job?

Pjesky: If it's taxable under the income tax, then it all ends up being taxable income. So when you're filing your taxes, you will account for income from different sources, with different forms, [and] through different processes. So you'll have income from your wage. You might have income from a rental property. You might have income from investment properties that are subject to the current year's taxes. And then there will be a process in which you figure out what your income is from all of those sources. And then once you file your taxes, you will start out with the sum of all of those sources. Then you will go through the process of figuring what your deductions are, what your exemptions are, and what your credits are.

Stitzel: So when I'm looking at itemized deductions, you've mentioned things that I think are, sort of, straightforward for us to think about. Are there other itemized deductions that are, sort of, specific to those other types of income that we've talked about? Or I'm getting into minutia here a little bit.

Pjesky: Hmm mmm.

Stitzel: But the reason I asked it is because, you know, I've had this conversation with people where it's like my version of income tax filing has always been very simple; because I don't have complexity of these other kind of things out there. And then I know people who they go to file their taxes [and] it's a much better chore for them. They got to start thinking about the different places that their income is coming from. And so I was curious if you had any insight for us about that?

Pjesky: Well.

Stitzel: I mean of specific related to deductions.

Pjesky: No.

Stitzel: O.K.

Pjesky: No, there is not at this point. Again, depending on where your income comes from, there may be deductions that are in an entirely different context than what we're talking about here. So if you're a farmer --- in other words or if you own a business...

Stitzel: Hmm mmm.

Pjesky:…you know, you're a sole proprietorship then. And then you're gonna figure your income, and there are going to be lots of expenses that are deductible in a certain way. You know, the complicated nature of that is beyond what most taxpayers…

Stitzel: Yeah.

Pjesky:…face when they file their taxes. The sort of median or the, sort of, typical taxpayer doesn't have those particular complications. They just get, you know, they just have an income from a wage that they've earned at a job, and that is their income that they start with. So other taxpayers have a much more complicated story to tell when they do their taxes. So if you have investments that are generating current income for you in a way that's taxable, [then] that adds complexity. If you do have a business in any way , [then]that adds complexity as well; because you have to, you know, calculate your revenues and costs for, you know, for your business activities and arrive at a taxable income from that. You know, how the tax code treats businesses is an entirely different discussion...

Stitzel: Right.

Pjesky:…I think because that is also is a very, very complicated process.

Stitzel: O.K., so we've set the scene. You got in income tax. Or to have an idea what that is, then the deductions fundamentally remove some of that income from what can be counted as taxable?

Pjesky: Yes.

Stitzel: O.K.

Pjesky: Yeah. So the process of filing taxes is basically this. You start out with your income. And then you go through the filing process that takes away income, and takes away (in other ways) what your tax liability will be. And the end of that process should be a number that ends up being your personal tax liability. And so that process is what's subject, I think, to a lot of…

Stitzel: Right.

Pjesky:…a lot of discussion and a lot of confusion.

Stitzel: So when our listeners hear the word tax liability, that means your income after your deductions? That's your tax liability?

Pjesky: Your tax liability would be how much you owe the government from your previous year's income generating activity.

Stitzel: O.K. so we're still kind of working up to that then.

Pjesky: Yes. Yeah.

Stitzel: So what did you call it then whenever you've got your income, sort of, after your deductions and that’s what’s potentially your taxable income?

Pjesky: Yeah. That’s your/that would be your adjusted gross income.

Stitzel: Perfect O.K.

Pjesky: Yeah.

Stitzel: So got our adjusted gross income. And then now let's turn to exemptions. What are exemptions like sort of?

Pjesky: Exemptions are again, a special way that the government will reduce someone's tax liability. The first thing that happens --- or either the standard of the itemized deductions that reduces the tax payers taxable income based on their filing status all right if they take them if they --- [is they] take the standard deduction; and [also] based on what they have spent on tax favored activities (if they itemize). The next step in filing taxes is exempting any income that's subject to income exemption. And the way that it was before the new tax law came into place was that every member of a household would be eligible for an exemption (and it was about $4,000). And this is interesting, because we don't have exemptions anymore. You know, one might wonder why we talk about them, because we don't have them. But, you know, you take away something from the taxpayers process, and there's gonna have to be an explanation for that. So the exemptions only applied for 2017 and before, you know, before the new tax law came into effect. And what an exemption would do was basically making an adjustment to income based on the size of someone's household. So if you are for example a married couple, you get your standard deduction --- however much that was under the old law, it was about 12 grand give or take. For a married couple filing jointly under the new law, it's, you know, in the neighborhood $25,000 or something. That's about double what it was before. But under the old law, a tax paying unit could exempt a certain amount of income for every person in the unit. So if you're a married couple with no children and you're filing jointly, then you could exempt about $8,000 from your income. The exemption was $4,000 per taxpayer (per person) in the taxpaying unit. Then of course as family size grows, you get more exemptions, all right? So if you've got one kid, that's another $4,000 that you exempt from your income. If you have, you know, five kids then each one of those would be an additional $4,000 that you could exempt from, you know, from your income. So that leads to the adjusted gross income in a very basic sense. So once you arrive at that adjusted gross income, then it's time to, you know, go to the tax tables basically and figure out how much you owe.

Stitzel: So before we do that, we could sort of see that as: well, if you've got the ---you said the exemptions are gone now.

Pjesky: Hmm mmm.

Stitzel: And you had this number of exemptions per person in the household. If you started with $12,000 and then now we're up to -- I think you said -- $25,000-$26,000, [and] so having the number of people in the household [being] your two adults and one child [then] makes those two numbers roughly equal, right?

Pjesky: Yes.

Stitzel: And so didn't you, sort of, get more benefit. Now I think we're gonna undo this here in a second.

Pjesky: Right.

Stitzel: That's sort of the rough gist to though is you get some of these tax reforms and they just kind of shift how those things work, right?

Pjesky: Right.

Stitzel: But you so you could, sort of, see I'm interested from a policy perspective of where you could [get more benefit]. Like well, one way you could get your money is $12,000 as a base, and then plus $4,000 per person. And that average household, you know, is three people or whatever. And then you've got roughly, on average, that $25,000 number. Or we could just give everyone $25,000 and, sort of, on average, you haven't changed anything but the differences in what deductions and exemptions people are getting. How that changes when you get away from being the average household has changed. Now I think here in a minute…

Pjesky: Hmm mmm.

Stitzel:…you're gonna sort of walk that back. But that's roughly how…

Pjesky: Right.

Stitzel:…policy analysis --- in terms of how much revenue versus how much burden are we putting on people --- works, right?

Pjesky: Right. Right. When an individual taxpayer is assessing how a tax change is going to affect them, right, then they have to --- at a very granular level what would be appropriate for them to do is, you know very, very simply --- figure out how much tax they would pay under one policy versus how much tax they would pay under another policy. So, you know, once the tax liability is figured, then, sort of, the final step --- and, you know, in my mind I'm just sort of walking through how tax form is the final step --- is that the credits come into play at the last step. So you figured your tax liability --- where you've got your adjusted gross income. You apply the tax tables to that amount. You come up with a tax liability. And then if you have any activities, that you've done in the past year, that qualify you for a credit --- then you would figure those credits. It takes the credit off of the tax liability. And then finally, that's how much your tax liability is going to be to the government for that year. Now for most taxpayers, they've had income withheld from their paycheck throughout the year. So they'll have to then report how much income they've had withheld, [and then] compare that to their tax liability. And [then] either [they must] pay the difference to the government, or [they should] expect a refund for the difference if they paid in too much at the end of the year. Then their tax filing is done.

Stitzel: Awesome. So I want to get to the credit thing here in a minute, because I --- that's, sort of, what I was hinting at when I --- was saying you would walk some of this back.

Pjesky: Hmm mmm.

Stitzel: But take us through the tax tables a little bit, because --- I think/when we think about as people who are not, sort of, the level of expert that you are when we're thinking about our income tax --- we think about, you know, deductions and exemptions a little bit. And then [we think about] how much we're making in them. But we don't, really [and] probably, have a good grasp about what are the rates that we're paying and how that works --- which is what I'd like to you to lay out for us a little bit.

Pjesky: Right. When I read, you know, things in the popular press, and even things in other media, and even when I, you know, even when I teach the subject to students --- I find that there are certain aspects of how taxes work that people are very commonly ignorant about. And the first thing that I notice very, very often is that people are ignorant about how these tax tables work. So people cannot --- if they're given an income that is subject to tax people cannot --- figure out how much they would owe based on the various rates that that income is subject [to] in the United States. And I think that any income tax is going to be structured this way -- don't have to be, all right. But most income taxes in the United States, [as well as income taxes] around the world are structured in a progressive sense. And what economists mean when they say a tax is progressive is: that as your income goes up, the amount of tax that you pay (as the percentage of that income) also goes up, all right? So, in the United States with the federal level we do have a progressive tax --- which means that we have graduated rates. So as your taxable income goes up, the tax that you pay on the highest dollar that you've earned goes up, all right? So in the United States, our income tax rate starts at 10%, all right? So after you have deducted all of your deductions (either itemized [or] standard), [and] after you've taken any exemptions (which don't exist anymore but used to exist), [then] the first sort of segments of your income is taxed at 10%, O.K.? And again in the United States, it's roughly about the first $20,000 of your income that subject to tax; [whereas that first $20,000 of your income] is taxed at 10%. Any income that is made above that is taxed at a higher rate. And again in the United States, this tops out for a married couple, right? And this is where the tax gets really kind of complicated to talk about, because there are so many different statuses that people can fall under. But for a married couple that's filing jointly, your marginal tax rate tops out at about an income of $600,000. And at that level of income, anything you make above and beyond that is taxed at 37%, all right? So taxes in the United States --- [the] marginal tax rates in the United States range from 10% at the low end, and go up all the way to 37% for higher income tax payers. The confusion that I see in a lot of people is that people think that when they get into a higher tax bracket then their entire income is subject to being taxed at that rate. That's not true at all. So, you know, the first tax bracket is 10% --- [tax rate starting at a dollar range of] about $0, not about [but actually] from $0 to about $20,000 (actually $19,050) --- but from $0 to about $20,000 dollars in income is subject to a $10,000, or I'm sorry, a 10% tax. And that's true no matter what your income is.

Stitzel: So can we do a simple example there? So if I make $35,000, and then I only get the standard deduction, and then I file, and then I pay under this rate…

Pjesky: Hmm mmm.

Stitzel:…then I would have that $10,000 there. That's above the standard deduction.

Pjesky: Yeah. Yeah. Let's make your example even simpler.

Stitzel: So let’s do.

Pjesky: So let's say you make $35,000 of taxable income. So that's after all of you’re your deductions, of after…

Stitzel: [Repeats] Of after.

Pjesky:…any deductions, or under the old regime [of any] exemptions [that] have been applied. And [so then now] you're left with a taxable income of $35,000. The first $20,000 of that is taxed at 10% --- which means that you would pay $2,000.

Stitzel: Right.

Pjesky: All right? Now after that is taken away, you've got $15,000 of income left.

Stitzel: And so then that would face the next rate?

Pjesky: That would face the next rate, which in the United States is 12%.

Stitzel: Right.

Pjesky: All right? So it goes up a little bit. So the next range of income that is subject to tax would be taxed at 12%. And then it goes up from there to 22%, 24%, 32%, 35%, and finally 37% starting at $600,000, all right? So if you're $35,000 is taxed at 12% --- that doesn't mean that you pay 12% on the whole $35,000. You pay 10% on the first $20,000 or so. Then you pay 12% on the next $15,000 O.K.? So that's significantly different than what many people think.

Stitzel: Right.

Pjesky: Many people think that if you are bumped into the next higher tax bracket, then every single dollar that you earn is subject to tax at that higher rate. And it doesn't make any difference whether you are you know someone in the middle class or you're one of the highest income taxpayers in the United States.

Stitzel: Right.

Pjesky: You still have a $20,000 band of income that is subject only to the 10% tax. And that's, again, that's something that a large proportion of my students who are majors in economics don't really quite understand. It's something that we all have to be taught this.

Stitzel: Yeah.

Pjesky: But it's something that has been ingrained in them from their previous exposure to this topic before they've learned it formally. And, you know, in a class like mine it's a prior belief that they come into. And it's a prior belief that almost everyone, evidently almost everyone, has. And so when you have, you know, when you have citizens that misunderstand how taxes work at such a fundamental level, [then] to me it's really kind of difficult to have a discussion about tax policy --- at the federal level or at any level --- when so many of the voters and so many of the decision-makers don't quite understand how it works.

Stitzel: Do you suspect that really there's a lot of policymakers that don't get that either?

Pjesky: I don't know. I hope there's none.

Stitzel: Yeah. Your hope would be that they would all be able to pass your test. I put it there.

Pjesky: I mean, I hope there's none. But that in and of itself is uncertain to me. Alexandria, (how do you [say])…

Stitzel: Ocasio.

Pjesky:...Ocasio-Cortez recently you know hit on this. And of course, she's an econ major. You know, she studied…

Stitzel: From a very good economics school.

Pjesky:…from a very good school. And so we would expect her to understand issues like this. It turns out she does. So, you know, she recently, you know, she recently remarked that a lot of people don't understand how taxes work. Because, you know, her preferred --- or at least at the time that she that she wrote this her preferred --- top marginal tax rate on the wealthiest or on the highest income taxpayers [is[ about 70%. You know, again right now it's 37%. She'd like to see that to be 70%. And she recently sent it --- I don't know it was a tweet, or if she wrote a blog or something --- you know, about how people that would oppose this plan think that if the top marginal tax rate was 70%, then if you're a high income tax payer then all of your income would be subject to a tax of 70%. Which of course [this] is not true. And, you know, AOC knows this and she used this to her advantage. So, you know, it's not that if you earn a salary of like say $500,000, which would put you in the top, you know, 1% or above of taxpayers; and [therefore] that income was subject to a tax as high as 70% on the margin. It doesn't mean that you'd pay $350,000…

Stitzel: Right.

Pjesky:…in taxes, because your income would go through all of these different levels of taxation starting out with 10%. I don't know what AOC would have at the lower end.

Stitzel: Yeah, I was going to say.

Pjesky: But I was going to start out with 10%, and it would go through 12%, to 22%, to 24%, and eventually it would get to 70%. So, you know, if the cutoff was --- you know, just hypothetically of income of a AOC top income tax bracket at 70% would say [be] --- $500,000, and, you know, someone made $501,000, then only that last $1,000 of income would be subject to that 70% marginal tax rate. Not all of it. Not all of it.

Stitzel: So can we do a couple things really quickly? I want to get a sense of how fast the rates go up, because you've said 10% and 12% a couple times. And then you jump up into the 20%’s. You read that off for us once.

Pjesky: Right.

Stitzel: Kind of give us a sense of how quickly those go up, and how broad those brackets are. And just use the married filed jointly or whatever we’d…

Pjesky: O.K.

Stitzel: The others will be, sort of similar…

Pjesky: O.K. You know, again, like I said ---- that it starts at 10% up to $19,050, you know [be aware the $19,000 adds another] $50. And then, you know, again, to keep the arithmetic very, very simple, but yet still answer your question, you know, the ending point we know is 37% at $600,0000. So if…

Stitzel: Above? Is that above $600,000?

Pjesky: Yeah, for income above…

Stitzel: O.K.

Pjesky: $600,000. So for most taxpayers that are considered middle class, [they] are going to be subject to tax rates at the 24% rate, O.K., on the margin. So by the time you you're hitting $100,000-$150,000 in income, your marginal rate (and at that level of income) is going to be in the/that new 24% range. And then, you know, very, very quickly after that, then it hits the 28%. O.K., and then it goes up very, very slowly. So you know under the new rate schemes, the trend in taxes in the United States have been for marginal rates to go lower. And the bands that are subject to those marginal rates to get a little bit broader over time. Under the old tax law that was replaced in 2007, the top rate was 39.6%. And that kicked in at $470,000 of income. So the trend in these rates is for them to become a little bit lower, you know, because that top rate went from 39.6% to 37%, a little bit lower and a little bit broader, alright? So this range of increasing rates started at $0 and went up to $470,000 under the old tax law. And now it doesn't hit the top marginal rate of 37% ‘til $600,000. So I think most, you know, most tax payers end up in that 12%-24% range on the margin.

Stitzel: Are there any in-betweens between that 12%-24% or does it jump straight?

Pjesky: It goes from 12%-22%-24%.

Stitzel: So there is that one kind of big jump there…

Pjesky: Yeah.

Stitzel:…from your second tier.

Pjesky: And that was the same under the old law. Under the old law it went from 10%-15%-25%-28%.

Stitzel: So where I [would like to be is to be] starting from scratch and designing it [better]. Like, I would make this very, sort of, linear progression of the same size jumps over certain kinds of income. Now I presume there are reasons that they've done this kind of thing --- whether they're, sort of, good policy reasons [or] they're sort of less charitable political reasons. I don't know. Do you have any sense of what drives…

Pjesky: Oh. I…

Stitzel:…that kind of let's make it 10% jump here..

Pjesky: I…

Stitzel:...to make that bracket?

Pjesky: You know, all of these tax laws, you know, (that I shouldn't say all the tax laws, we only have one), but the different aspects of tax laws --- they do fit together in a, sort of, and, sort of, weird and surprising ways. So when you look at tax laws --- and they might look extraordinarily convoluted and extraordinarily complicated, [but] there's almost always a reason for that. And the end result of tax law is almost always the end result of a very long years, decades, generations long process of changes to tax law. So there's never really been a case, where in any practical sense, we can think of the taxes that we pay today as being the result of them throwing everything else away --- [or] every single notion that we've had about taxes and completely starting over. The 2017 law was kind of close to that. And the law that we had in the mid 80s under Reagan was the last time that there had been, what we might consider to be a [start[ over [or] an attempt to, sort of, start over with taxes. But when you have, sort of, a path dependent process that gets us to today, that becomes a really hard question to answer. You know, there's always (I hesitate to say good economics) but there's always economics behind these changes, and whatever the existing laws are. And there's also political considerations as well. So often these breakpoints, you know, these brackets are designed in such a way to make sure that the outcome of certain categories of taxpayers are what the current political climate wants. So one of the bigger changes in the new tax laws was the addition of this, you know, 12% income tax bracket down from 15%.

Stitzel: So I really want to turn to specifically this 2017 law that you're talking about. But I actually want to get in three different things really quickly. So the first is: how would you think that if we were to just scrap the whole thing, but we wanted to keep a progressive income tax --- what would just be some general pointers? Cause we could take the rest of the podcast if..

Pjesky: Right.

Stitzel:…you lay the whole thing out. But just what are some principles? And how might it change from what it is that we have?

Pjesky: Well, I mean, again, that is/that's a really, really, really, really, big question. I'll kind of answer it sort of a tangential way. What I would like to see with tax policy, regardless of what it ends up being, I would like to see economists write the policy…

Stitzel: Hmm mmm.

Pjesky:…and politicians fill in the numbers. O.K. So…

Stitzel: That’s really clever.

Pjesky: I would like to see a tax policy where, you know, here's the principles of what our tax policy is going to be. And it's going to be based on really, really good you know really, really good economics. So you're gonna have a standard deduction, [and] you're going to have exemptions (or not). You're going to have a graduated rate structure. And then, you know, once the economists have informed that process, the politicians then (or the political process) need to then go in and fill in the numbers. So I, you know, I would like, you know, taxes to be designed in a way that the maximizes efficiency O.K.? And most economists are going to have that view; where the expertise of economists, kind of, goes by the wayside is exactly, you know, again [and] like I said before, what the numbers are. So it’s the political…

Stitzel: It’s the political basis?

Pjesky: Yeah. So it's the political process that determines, for instance, how much revenue a tax needs to generate. So if you have a need, based on what the government is going to spend, of having a tax code that generates four trillion dollars, then it's the politicians. [And] it's the political process that needs to fill in the numbers in order to achieve that amount of revenue. But what the economist is going to tell the political process is this: look, if you're going to generate four trillion dollars worth of income, [then] there are really good ways and really bad ways to go about doing that, O.K.? So not all tax systems that generate four trillion dollars worth of tax revenue are created the same, all right? So there are certain principles that economists can report on, you know, on to the process that would hopefully inform the process. So, in other words, if you're going to have deductions of certain things --- what things in our society deserve special tax treatment, all right? So, in other words, do we want to be a very, very concrete example? Do we want to be able do we want to allow taxpayers to deduct mortgage interest that they've paid, O.K.? And is that a good thing to have in the tax code? In this particular case, most of you, not all, but most economists are going to say: absolutely not. That's not something that that we want to allow people to deduct. So in the design of the tax code, mortgage interest paid wouldn't be a deductible expense at all. It wouldn't be there. It wouldn't be there at all. So the numbers would have to work out some other way to generate the income without that in it. Some other things might be, you know, might be up for debate. You know, economists might say: you want to differentiate taxpayers based on household size, O.K.? So, you know, so if you have a married couple that have no kids, and another married couple that have at least some kids (or, you know, one kid to five kids or whatever) --- an economist might say: O.K., you want to treat those two taxpaying units differently, all right? And then the political process would determine exactly how they are treated [and] how they are treated differently. So, you know, just a, sort of, you know, sort of, circle back to your question. I'll reiterate so, you know, what the economists position should be on all of these. Economists have the expertise in order to, you know, basically assess whether or not a certain tax is a good way to raise revenue or not. But it's the political process that has to determine the magnitude of those taxes and exactly how they're administered.

Stitzel: So for our listeners --- you mentioned that an economist will want to target an efficient tax. Can you just describe to our listeners what that means to an economist for something to be efficient?

Pjesky: O.K. But we'll ultimately --- I'll use the mortgage interest deduction again. So, the shortest way that this could be described is this: an efficient tax is a tax that generates revenue for the government, but doesn't alter people's decisions. O.K. so when economists, in this context, talk about efficiency, [then] that's what they're talking about. So we want to minimize the changes to people's decisions that are generated by the tax code. So in other words, if you deduct mortgage interest, all right, [reiterates] if you deduct mortgage interest from taxes as a way to, in this case, generate less revenue, [then] actually what you wouldn't want that to do is change people's decisions on how big a house they buy and how they finance that house.

Stitzel: Hmm mmm.

Pjesky: So from an economist’s perspective --- if we found out that having deductible interest for mortgage caused people to buy larger houses (then they otherwise would have), and would basically change people's behavior (in such a way that made them finance more of those houses then they otherwise would), then to the extent that that happens --- an economist would say that that tax provision was inefficient, because it's changing people's behavior. It's causing overproduction. It's causing an over allocation of society's resources into housing built with borrowed money.

Stitzel: So one of the things that is frustrating about the current tax system, from an economist’s point of view, is that we don't disentangle revenue generation from taxes that are used to intentionally to alter behavior, right? Classic example…

Pjesky: Right.

Stitzel:…would be like a cigarette tax or something like this. And so one of the things that you said: well, hopefully our economists would design it, and then the politicians would put plug in the numbers. I think that's an elegant way to think about it, because that would help address some of that. And what I would like to see them is: this notion that we want people to live the lives that they want to live [and] to make the decision that they want to make. And taxes [would then] come in and do the things that it needs to do which is: collect this revenue, and allow for the things that we think government needs to be spending money on, and make that a part of the political process. So I’m really glad you hammered that home on the efficiency.

Pjesky: Yeah, I mean, and that's another thing that makes tax policy complicated, because sometimes the goal of tax policy might be specifically to change people's behavior. And there are some instances when government wants to do that, and it's a good idea. And there's some other instance when it might not be a good idea. You mentioned the smoking. You mentioned that, you know. You mentioned this --- the tax on an activity of smoking. Well, you know, that tax would be specifically designed to prevent people from smoking. So every, you know, every exemption, every deduction, [and] every credit --- that's built into the income tax, might [actually] be put there by politicians specifically to be inefficient from the economists perspective. And so, you know, the complicated nature of the tax code is sometimes because the government wants to encourage certain things [and] wants to subsidize certain things. You know, sometimes there are good reasons for that. And in the smoking example, we might have some, sort of, excise tax on smoking because we want people to stop smoking, because smoking creates what economists call external costs on the rest of us (for whatever reasons). There might be other good reasons why we might want to stop people from, you know, people from smoking. Maybe there's, you know, some reason that we think that, [possibly] because of the addictive nature of cigarettes, [and] that people can't really make good decisions when they decide to start smoking. So I don't --- I mean, that's beyond the scope of what we want here. But on the other side, you might have an activity that the government is either discouraging through taxes, [or] are encouraging through subsidies that don't have any, you know, non-political reason for doing at all. And, you know, sometimes the government might just want to encourage an activity that benefits a certain segment of the economy. You know, you look at the people who, you know, you look at the people who are really strong advocates of having mortgage interest rates. You know, [the people] having the money spent on mortgage interest deductible, and they’re the ones that benefit the most from people buying bigger houses with borrowed money, right? So those kinds of activities run the whole spectrum. And, you know, that's the tension between, you know, voters, special interests, economists, and policymakers that exists. Most economists would throw most of those things out completely. But the political process is always going to have mechanisms which these things can get reintroduced. Most people can, you know, make a pretty good coherent argument about why the government might want to discourage people (particularly young people) from smoking, all right? But it's very, very difficult, I think, for most people to make an honest argument about why we should be encouraging people to borrow money for bigger houses.

Stitzel: And unless you think that's a small issue, that is [actually] pretty well identified as the serious component. It's certainly not the only, or the principle, but the serious component of the financial crisis.

Pjesky: Right. And so there's that as well.

Stitzel: That’s not trivial --- is my point.

Pjesky: It's, yeah. It's absolutely not trivial.

Stitzel: We're not sitting here talking about, you know, sort of theoretical political and policy problems. Like that's concrete stuff. So I mean I said there were three things there. So I started you off on the one that's unnecessarily large question. Let me turn to a somewhat smaller question. Do you see problems with the way that this graduated structure for increasing marginal rates, sort of, has these cut off points? And [also] has these brackets? And in theory, right, I could take that structure and smooth all those edges you do by interpolating between all those points, and just averaging those marginal tax rates out. And you need to have a different marginal tax rate for every dollar that you spend. They make the understanding of the tax problem even worse.

Pjesky: Right.

Stitzel: But it would remove those, sort of, cutoff and the big jumps between our 12% and 22%.

Pjesky: Yeah. I don't, you know, I don't know if these discrete jumps in rates really cause that much problems economically. And, you know, I do think it creates a lot of confusion among taxpayers. But I think, sort of, a continuously variable rate structure might even be more confusing to people; because someone can look at these tax rates, and these income levels, and they can figure their taxes pretty easily (if they know what they're doing). If you make it continuously variable it might be.

Stitzel: Yeah.

Pjesky: I don't really know.

Stitzel: Yeah.

Pjesky: I have to be honest. I don't really know about that.

Stitzel: So the question there also leads us to another which is: do people really look at where the tax brackets are and then change their behavior? Because an economist would write down a model and assume a rational individual. [Whereas, this rational individuals would be someone] who would know exactly what/how the tax system works, and where the tax breaks are, and then how they might make decisions on which job they take, or, you know, how hard they work to pursue a raise. [This most certainly] --it would put them in a different bracket. Now there's a lot of uncertainty, and all those things in real life, and I assume that there are people. I'm not familiar with this literature, but I assume there's a big literature out there that investigates…

Pjesky: I…

Stitzel:…how people behave on the margin.

Pjesky:…I think there's quite a bit of evidence to suggest that people do actually behave.

Stitzel: O.K. that's very interesting.

Pjesky:…in this way. So, you know, in any, you know, in any paper that you'll read that assesses the impact of taxes on people's behavior --- marginal rates are always the desired measure of taxation for that. And so it's a really, really easy thing to think about. And I think most people actually do think about this. You know, you know, take an example that would be applicable --- like, you and I all right? Let's say that we get an opportunity to work extra for a year. Let's say that we get a opportunity to teach an extra class. So how are you gonna decide whether or not you're going to do that, if it's purely a financial decision, all right? If it's purely a financial decision, [then] you're going to look at the pay of that extra job. Again, just to make the numbers easy, let's say it's $5,000, all right? So let's say that you get offered $5,000 to teach, and to teach an extra class. And, you know, is that worth it, right, to you? Because there's certain amount of work involved in that, and in deciding whether or not it's worth it to you to take that extra course. You won't make that decision based on $5K, because, you know, you're gonna have to pay a certain amount of taxes on that $5,000. So, you know, it may be subject to payroll tax, all right? So that that knocks off a certain percentage of that $5K. And then, depending on whether or not you're in the, you know, the 22%, 24%, 32%, 10%, [or] whatever income tax bracket, [then] you'll knock that off too, all right? So if you're in the 10% tax bracket, and you're deciding whether or not --- and we can just ignore payroll taxes and stuff (just make things easy) anything else, [so] when you're deciding whether or not --- to take that extra job that pays $5,000, you know that you're not making $5,000. You know you're making $4,500, all right --- and so in a cost-benefit calculation, all right, that economists think people make (and economists are about the only group that thinks people think this way), but you decide on that. And when we look at people's behavior, there's really quite a bit of evidence to suggest that people do make these kinds of calculations in some kind of way. So when we look at broad trends and how people behave, the people do respond to taxes. And, you know, how much [people respond to taxes] is the subject to massive debate in economics. But no economist is gonna say that they don't respond at all. Right? And, you know, there might be few economists that think that: well, good grief that's the only decision. You know, that's the only factor that plays on people's decisions. It's a huge one. But, you know, there are a lot of people who when they're deciding what job to take, and or whether or not to work overtime, [or to] take on an extra task, [or to] take on a second job, [or] moving from one state to another --- taxes are an incredibly important factor in all of these kinds of calculations. We see in migration patterns people moving from one state to another. It's pretty clear. I don't want to say it's absolutely clear. But a majority of the literature on topics like this suggests that, you know, people's, you know, decisions on where to live is influenced by taxes that they pay.

Stitzel: So I was getting ready to pounce on you. It's a question that says: if/how do you explain that being such a large factor, if you also think people don't understand the tax structure? Which of course, your answer there just beautifully destroyed that question, so I'll dispense with it. But it highlighted something very interesting to me. And tell me if you disagree with this: the notion that people could, sort of, be wrong about it [of] what [their] understanding [is] that the marginal rate is an average rate; and yet understand what tax they're paying on the margin (which is what both does and should determine their behavior). [This] is a very, very fascinating [reiterates] very fascinating point, right? We would be concerned if I described [that] if I ambushed somebody with this setup and I said: the people conflate marginal and average tax rates, right? And so they think the marginal tax rate is the tax rate they pay on all of their income that they have to pay. And then would you expect their behavior to reflect, correctly reflect, the marginal tax rate? Because the story that you described is exactly how it goes, right? That's exactly what happens. I get offered: you can teach you this extra class and you'd make this much, I never in my head go: ah. that's $5,000. I go: O.K., that's $4,000 after-tax. Do I or do I not want to take it --- which is exactly the way that one, sort of, using scare quotes “now ought to behave” in that context. I think some of those people might answer that incorrectly and say: well, if they can't come, [and[ if they don't understand that, [then] they probably [will] make the wrong decision. And I could see avenues through which that would kind of be right. And yet, it's completely fascinating to me that a person in that setting --- whether or not they understood the difference between this being an average tax rate and a marginal tax rate --- is completely irrelevant. Because if that's the tax rate that they know that they face (which they correctly do in this case)…

Pjesky: Hmm mmm.

Stitzel:…[then] that's an excellent way for them to predicate their behavior.

Pjesky: Yeah.

Stitzel: Yeah.

Pjesky: Yeah.

Stitzel: It was very interesting. I never thought of that before. So I'm glad I had you on because, so, I've learned something. Really quickly, before we turn to The Jobs Act here --- because I, sort of, let this one get out of hand with these last two questions --- is do you have [or] do you suspect that there's some kind of [strategy] with a AOC’s plan? That [within her plan] it would just be the top rate? Or do you think that she would change some of those other things?

Pjesky: I know. I'm not really exactly sure.

Stitzel: But I've never seen. @58:16??

Pjesky: It's hard to, I mean, it's hard to know what her complete plan would [or] wouldn't would be.

Stitzel: Right.

Pjesky: I mean, it would, you know. My guess is that most of her rhetoric that I say [and] that I see is that, you know, everybody's gonna, you know, politicians gonna look at someone and say: I'm gonna cut your taxes, and raise everybody else’s, or raise somebody else's. So I wouldn't want to elaborate on what a complete plan would…

Stitzel: Because it isn’t completely laid out?

Pjesky:…would be. It's not been laid out as far as I know.

Stitzel: Sorry.

Pjesky: As far as I know.

Stitzel: So, what I want to do now to, sort of, wrap this bad boy up is to turn to the Tax Cuts and Jobs Act of 2017. Give us an overview of what the impact…

Pjesky: Yeah.

Stitzel:…is on what filers.

Pjesky: You know, what the, you know, The Tax Cuts and Jobs Act was, I mean, it, you know, (not to be too mean [and trying] not to be too dramatic) is/[was a] massive change in the tax structure in the United States. It covered, you know, personal taxes. It did a lot more than just change rates --- which is what most of the time a tax reform bill will do. It has vast implications for corporate taxation. And just, you know, it was a pretty major overhaul of most aspects of a federal tax law. And so I don't want to minimize that. Well, what I do think is important is to think about how did that new law (or how does that new law) affect (or how did it affect just, sort of,) your typical tax filer? And when I think about The Tax Cuts and Jobs Act of 2017, I see just a very small number of major changes that I think an ordinary taxpayer needs to know about. The first thing that it did (which I think was huge) is that it eliminated the concept of exemptions and vastly increased the standard deduction in taxes. So in other words: for at least for most taxpayers, their tax unit started to matter, and the actual size of the tax unit mattered less. So in this narrow context, the size of your household matters quite a bit less, all right? Because before, you were getting an extra exemption for each member that was added to your household. So if you had, if you were married and had no kids, [then] you got two exemptions. If you were married and had five kids, well then you'd get seven exemptions. And so when you do away exemptions, [then] you do away with that. On the flip side, the standard deduction was increased a lot, all right? So it was basically doubled, all right, from, you know, $12,000ish to this, you know, $25,000. You know, think about how that impacts the household with kids. You know, let's say that you have three kids in your household, O.K.? And just from this one change, you're losing all of your exemptions, right? So you're losing $20,000 worth of exemptions, because before you had five exemptions, and now you don't have any, all right? But you're gaining $12,000 in standard deduction. So, you know, taken as a whole, these two things taken together means that the increase in the standard deduction basically dilutes the impact of losing the exemptions.

Stitzel: But it doesn't wipe it out in this case.

Pjesky: Doesn’t wipe it out in this case. You know, they're winners and losers, all right? So if you focus only on this aspect of the tax loss, you know, you can say very, very confidently that, you know, smaller families were relative winners, and larger families were relative losers. But that's just focused on this one tax change. There are other things. The other major thing that The Tax Cuts and Job Act of 2017 did, that I think impacts a lot of typical householders/households, is the credit for kids. The credit per child doubled from $1000 to $2000. You know, so before, you know, before --- for every kid under that you had you got a $1,000 tax credit, all right? So when you're done filing your taxes and all of it, you know, (like well, what we talked about at the beginning of this) you've got your income figured, and you have your exemptions, and [you have] your deductions taken off. And [now] you're looking at your tax liability for every child that you have, all right, [and] you get to take $1,000 off the top of that final tax liability. That was doubled from $1,000-$2,000, all right? That was doubled from $1,000-$2,000. So when you contrast that with the elimination of exemptions, [then] what does this do? Well this tends to favor larger families, all right? So if you've got no kids, [then] you didn't get any tax credits before, and you don't get any now. If you've got five kids, you were eligible for a maximum of $5,000 in tax credits before. Now you're eligible for $10,000 in tax credits. And, sort of, the interaction between those two changes and policies is really, really interesting. You know, on the margin, when are these two things equivalent, O.K.? On the margin, these things are equivalent to someone that was in the old 25% tax bracket.

Stitzel: Right.

Pjesky: Which is something I don't think really people understood, all right? So think about it --- if you were given a choice as a tax payer, which would you rather have? Would you rather have a $4,000 exemption for your kid? Or would you rather have a $1,000 tax credit for your kid? Well, it would matter what your marginal rate was. If your marginal rate is 25%, [then] those two things are the same for you, right? Because if you get to exempt $4,000 worth of your income, and your tax bracket is 25%, then you pay an extra, you know, that's $1,000, right? So that exemption basically takes off a $1,000 from your tax liability, all right? That's exactly the same as getting a $1,000 credit off your tax liability. So for someone in the 25% tax bracket (which is, you know, basically people who have, you know, upper-middle incomes, O.K.), [then] you are basically made whole. It doesn't make any difference to you, on the margin, whether or not you have the exemption or the credit. For people who have incomes less than that --- if your marginal tax rate is less than 25%, then you are much better off giving up the exemption and gaining the credit, all right, in this sense. So you lose $4,000 --- for that, you lose the ability to exempt $4,000 worth of your income. Let's say you're in the 10% tax bracket. If you lose that exemption, [then] your tax liability goes up by $400 (10% of $4,000). But if at the same time you’re gaining a $1,000 tax credit, well then you’re gaining $1,000, all right? So lower income taxpayers who are in the 10% tax bracket, their earnings a net gain of $600 from that combination of changes. The reason that I think that that's so important is because so many people we're talking about how losing the exemptions were going to be really, really difficult for taxpayers that had kids (and especially low-income taxpayers that have kids). And yeah, you know, regardless of any of the other merits or drawbacks to the law, that statement just simply wasn't factual at all. So, you know, given this particular isolated set of changes that the new Tax Cuts and Job Act, you know, [what] the new tax law gave us [was] basically a win for lower income tax taxpayers, all right? So that is that. The change in exemption statuses and credits are kind of the first two big things that impacted normal taxpayers. The next thing that I think was really, really important for, you know, for many taxpayers is the fact that the deduction for state and local income, and property [taxes], and sales taxes, all right, that people were able to claim was capped at $10,000, O.K.? So, you know, think about what impact this has on people. And this was actually was a big deal [and was] very, very talked about, you know, very much talked about. So before, if you paid say $20,000 in state income and property taxes, or $20,000 in state sales and property taxes, it's a situation where there are three broad kinds of taxes you get [to] pick two, right? So there are state income taxes, there are state sales taxes, and there are state property taxes. You could deduct any two of those, all right? And of course, you'd pick which were the highest for you. So in Texas, everybody deducts their property taxes and sales tax, haven’t got a [state] income tax, all right? So other states that have all three taxes, you pick the top two that you pay, and that’s subject to deduction, right? So if you pay $20,000 in income tax and property tax yield in California as, you know, so [then] for instance, then you get to deduct $20,000 off your federal income tax. The new law taxed that amount $10,000, O.K.? So if you had that $20,000 in tax payments to your state and local governments, you could only deduct $10,000 of that off of your income tax. And this was a big deal, because I think it made it really, really unclear to me what final impact this would have on taxpayers that were higher earning taxpayers. Say, you know, tax payers that earn between like maybe $200,000-$400,000 or $500,000. Because on one end, those people got massive cuts in the rates that they paid, all right? So before they were paying you know like 33%, 35%, and 40% marginal tax rates. And now, they're paying 32%, 35% and 37% marginal tax rates. But, you know, so their tax liability would go down because of that. But if they are no longer able to deduct their state and local tax payments, then that means that their tax liability actually will go up, right? Because before, they were able to deduct that extra $10,000 or $20,000 or $30,000 that they were paying to their state and local and county governments in the form of income and property taxes. And now they can't do that anymore. So the first response to this law, that most people had, was that: well, this is massive income tax cuts for, you know, for the rich. And that was sort of how the story went for, you know, for quite a while. And then it was a, you know, economist Greg Mankiw that came out on his blog and said: wait a minute, not so fast, right? Because, you know, it's true that if you're, you know, one of these higher income earners, [then] your tax rates are going down. And they're going down in many instances [and] is, you know, quite a bit. But at the same time, you're gonna be paying more because you're not going to be able to deduct your state and local income taxes fully like you were before. So to him, it was unclear what the impact of this law was gonna be for higher income taxpayers. And it's probably true that under this law almost everyone, you know --- as we transition from, you know, the 2016-2017-2018 losses [and] we transitioned into this new law (my guess is that if you only consider people that didn't have major changes in tax filing status and major changes in income) my guess is that everyone ---- or almost everyone paid less, all right? But it’s --- poor people paid less. Middle income people paid less. Rich people [and] everybody paid less. But the tax cut that the higher income people got as a result of this law wasn't anywhere near as large as what a lot of people were thinking first. Because this this cap on the deductibility of state and local income taxes, and sales taxes and [state] property taxes, in fact, is really a big deal to high income/higher income taxpayers.

Stitzel: Well, it's sort of interesting. Because you have that child tax credit versus eliminating the exemptions as you said would be harder on higher income people.

Pjesky: Hmm mmm.

Stitzel: That's one thing that would cut against that.

Pjesky: That's something else as well.

Stitzel: But it's, sort of, fundamentally interesting to me that just --- because those are not percentages, those are not rate effects --- just it's $4,000 off the front or a $1,000 or $2,000 off the back kind of set up. Those become more and more irrelevant the higher your income gets…

Pjesky: Right.

Stitzel:…any ways that there might be a lot of money to somebody who's making $35,000-$50,000 a year, and gonna view quite a bit less to somebody's making $500,000.

Pjesky: Right. Right.

Stitzel: I mean, those are, kind of, already structured [in] that.

Pjesky: And so you have that. You have that going. And you've got something else that's going on here, that I would feel remised if I didn't mention. And this is something that makes the tax code much more complicated. I hope I haven't used the word complex, because those are two different [definitions], but then maybe we'll talk about that in a few minutes. But the tax code gets incredibly complicated. And everyone knows that taxes are complicated. But one of the things that makes the tax code really, really complicated in evaluating these kinds of situations, is that the ability to have these exemptions --- the ability to take various credits and various deductions. As your income gets really, really high, those things go away all right? So someone making a million dollars a year that/they didn't get exemptions for anybody, all right? Because those, you know, again, depending on tax filing status, once you hit about $200,000-$300,000 in income, the ability of you to exempt income based on the size of your household --- that fades out, all right? That, you know, that fades out. So, you know, for people making extremely high incomes $600,000-$700,000-$800,000 a year, then the conventional [and] initial story that people were saying was: we're right. I mean, this is just a 3% cut in their rate, all right? And it gave them a pretty big tax cut. But for a larger number of taxpayers that are just (how should we say this is) intermediately rich --- I don't even know what words to…

Stitzel: Right.

Pjesky:…describe.

Stitzel: ?? @1:13:33

Pjesky: So not even that, right, you know, it would be --- [or] like sort of middle upper class. I don't know what you would call them, but, you know, people making $200,000-$500,000 a year. You know, they probably didn't see their taxes go down as much as people may have expected, because the phase-out wasn't complete on these exemptions and all these other things. But, you know, they still had the ability to deduct their state and local income taxes. But this new law took away their ability to deduct state and local income and property taxes above $10,000. So the, you know, these, you know, figuring these tax is a very, very complicated thing. And looking at a new tax law and saying: wow, you know, this is gonna raise taxes on these people and cut taxes on these other people. That's generally a really, really hard thing to do in a very, very simple way. So, you know, the, you know, the bottom line with The Tax Cuts and Jobs Act was that, you know, after all of these changes were made almost everyone [benefited] --- again, unless they had a change in income or status, right? So, you know, if you had, you know, if you happen to have triplets or whatever that all turned 18 during the tax year, and you didn't get those $2,000 per kid credit, [then] your taxes would have went way up under those circumstances. But, you know, you too lost those credits too anyway, all right? So that's what I mean by a change in status. And, you know, if your income went from, you know, $50,000 the last year of the old law, all the way up to $300,000 --- through some, you know, whatever, you know, maybe you made the pros or something like that and your income went from you know $50,000 to $300,000 --- at the same time we were transitioning into the new law, [then] of course your taxes are going to go way up. But ignoring those kinds of situations for almost everyone --- all right, almost everyone that filed under similar incomes and statuses under the new and old law --- almost everyone saw some kind of tax cut, all right? You know, poorer individuals, lower income individuals, saw big tax cuts. Middle-income individuals saw tax cuts, and so did the richer individuals. So did higher income individuals. In other words, the reason I mentioned this is because there was so much rhetoric around this tax law; [wherein the rhetoric was framed in such a way and] that talked about [featured] people that were actually paying more under the new tax laws. And that just absolutely wasn't true. You know, I saw this on all kinds of, like, otherwise reputable magazines [like] Atlantic. And there are other places that had features. And, you know, not to single anybody out, but there, you know, there were all kinds of outlets that had these features that were explaining that people were paying more taxes. And that's just not true. A lot of the confusion may have been --- you know, [actually let me backtrack]. The source of a lot of confusion is, sort of, you know, maybe the last thing that I would want people to understand about taxes. And this tax law change really is a nice context to learn this: is that there's a big difference between what you pay in April and what your actual tax liability is. And that difference can be confusing to people. The reality is that your tax liability and what you pay at filing time --- it’s probably independent of one another completely, all right? So just because your neighbor gets a bigger refund than you, doesn't mean that your neighbor’s paying for your taxes than you are. Because you don't know how much your neighbor had withheld throughout the year. Your taxes are withheld from every paycheck, all right, based on a formula that the IRS basically would give your employer, right? So if, you know, if the taxpayer (if the worker) has identified themselves (him or herself) as this status, and this is their income, then this is how much you withhold. And you send to the IRS every two weeks, every month, or whatever. And that's based on a very, very well known process. And at the end of the tax filing process, for every individual taxpayer, they look at their tax liability and they see how much they paid into the system. And then the difference is how much they get in refund, or how much how much they owe. As part of The Tax Cuts and Job Act, the government really tried to refine that process, so that people's taxes would be withheld more accurately. So there were a lot of people at the end of the filing process, under the first year of The Tax Cuts and Job Act, that got a much smaller refund (than they were expecting based on previous years); [whereas due to this difference in the amount of refund, made taxpayers to believe] that [and] they thought that their taxes went up, all right? But in almost every case, it was because they're withholding was simply more accurate, and their checks throughout the year had been larger. I don’t know why they didn't notice that. But their checks throughout the year had been larger.

Stitzel: They didn't notice that. And they didn't notice that because of direct deposit, probably.

Pjesky: Yeah, probably.

Stitzel: ?? @1:18:38

Pjesky: I don't, I don't know. I…

Stitzel: How often do you see your actual check?

Pjesky: Well, you know, you look at it. And I know how much I've got in the bank.

Stitzel: Right.

Pjesky: And, you know, it doesn't take ---you know, people might say: well, this is just more evidence that people don't understand this financial [process]. And, you know, there's no way they can be making decisions on this kind of information. They don't have it. Well it doesn't take very many people to clamor about something for it to be a big deal.

Stitzel: Right.

Pjesky: And so you had, you know, an overwhelming majority of people, I think, actually understood this. But there are a few people that didn't. And they caught on to these horror stories of people that were expecting a refund of this amount, and they got much less. And so it put them in financial calamity.

Stitzel: So but…

Pjesky: And they thought that their taxes went up, when actually their taxes did not go up.

Stitzel: So what's going on with your news outlets, that they don't catch on to that?

Pjesky: I don't know.

Stitzel: They just want to sell newspapers?

Pjesky: Why I mean, yeah, well. So that’s another conversation as well.

Stitzel: Yeah, so that’s sort of out of the bounds.

Pjesky: So with, you know, the, you know, to, sort of, sum up maybe --- the things that the people need to know about taxes is: they need to understand the graduated rate structure that they're subject to. So as your income goes up, the average taxes that you pay will go up, O.K.? And your marginal dollar (to use the econ lingo) will be subject to ever increasing rates. But if you get into one of these higher rates, [then] all of your income will not become subject to that higher rate --- just the income that's within that band, all right? The second thing [that] I think people really need to understand is the differences between deductions, and exemptions, and credits, all right? Now they need to just understand the difference between deductions and credits, because exemptions don't exist any anymore, all right? But a credit is a device that the government uses to basically reduce somebody's tax liability, by some fixed amount, based on some status that they have. So if you have a child, you get a $1,000 or $2,000 now off of your taxes, because the government wants to --- for whatever reason, all right, the government wants to --- figure your taxes differently because you have a kid (or more than one kid or whatever). And then finally, people need to understand the differences between their tax liability and the refund that they get at the end of the year, all right? So two people that are identical from a tax perspective, all right, are gonna have identical tax liabilities, all right? But those two people might get different refunds in April (or whenever they file their taxes) depending on how much was withheld, all right, throughout the year. But the amount of your refund does not have any reflection (much at all) with how much your tax liability actually was. All your tax liability is based on your income and your status, all right? The various statuses that you have --- that might affect how your income is taxed, and nothing else, all right? Nothing else.

Stitzel: My guest today has been Rex Pjesky. Rex, thanks for joining us on the EconBuff.

Pjesky: Thank you very much.