A taxing exercise

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As people work on their tax returns, they would do well to spend a couple of minutes before calculating their final tax rates. This important information may surprise many and affect routine decisions about investments and lifestyles.

The first calculation is simply the mean or average tax rate. This is the tax you owe on line 62 of the 1040 form divided by the income figure on line 22. (To be more accurate, you should also add income for tax-exempt bonds on line 8b.)

This is important because many people delude themselves into thinking they aren't actually paying any taxes if they end up with a refund. But a refund just means too much money was withheld from the taxpayer's paycheck. You need to be aware of what you really paid: Withholding less any refund or plus the check youhad to write to the Internal Revenue Service.

A more important tax number takes a little effort to calculate. It's called the marginal tax rate, which is the tax you paid on the last taxable dollar earned. This will probably be well higher than your average tax rate. To find the marginal rate, take your taxable income from line 42 and see where you fall in Table 1, showing marginal tax rates for married couples filing jointly.

The marginal tax rate is critical for knowing the after-tax rate of return on different types of investments. For example, lately the spread between taxable bonds and tax-exempt bonds has been about 19 percent. Thus, if you are in the 10 percent or 15 percent marginal tax bracket, you should not buy municipal bonds. You would be better off buying taxable bonds. Those in higher brackets should do the reverse.

According to the Tax Policy Center, the vast bulk of taxpayers either pay no federal income taxes or are in the 10 percent or 15 percent marginal tax brackets. But taxpayers increasingly find the Alternative Minimum Tax raises their marginal rate.

The AMT is a completely separate tax system with two brackets, 26 percent and 28 percent, which apply to a broader definition of taxable income than calculated on the regular tax form. In particular, taxpayers lose several deductions, such as that for state and local taxes. This tends to force people in high-tax states, like New York and California, to pay higher taxes under the AMT. Taxpayers must pay the AMT if it is higher than their regular income tax. Table 2 shows the distribution of marginal tax brackets among tax filers in 2004, including the AMT.

Various types of business investments are also taxed differently because of provisions in the tax code. Those that are debt-financed bear a lower tax burden than those that are equity-financed due to the deductibility of interest, even with the current lower tax rates on dividends and capital gains.

For this same reason, when taxpayers invest in housing the return is taxed much more lightly than if they invested in stocks or a business.

According to new calculations by the Treasury Department, the marginal effective tax rate on equity-financed investments is close to 40 percent, but there is actually a negative tax rate on debt-financed investment. Tax rates also vary considerably depending on whether an investment is in land, buildings, inventories or equipment, and on whether the business is a "C" corporation, "S" corporation, partnership or sole proprietorship.

The Treasury Department has also calculated the 2001-2003 tax cuts sharply lowered the effective marginal tax rate on all new investments. The tax rate in the corporate sector has fallen from 33 percent to 27.9 percent, and from 20.6 percent to 17.5 percent among noncorporate businesses. Overall, the tax rate on new investment has fallen from 17.2 percent to 14.2 percent. In time, this will raise investment in the economy, which will increase productivity, economic growth and, ultimately, wages and living standards.

We may not like thinking about the taxes we pay or our tax rates. But they are important economically. And at least once a year we should take the time to become aware of them. It's important information that can help us make both financial and political decisions.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.