David Cay Johnston

If you make more than about $33,500 a year, your federal income tax burden is probably lighter than you think.

The portion of your income that you pay in taxes is your “effective tax rate.” But when politicians and pundits talk about effective tax rates, the data they typically use relies on an incomplete measure for income. Use an incomplete measure for income and your tax rate calculation comes out high.

In a new analysis the Tax Policy Center, a nonpartisan Washington research organization, used a wider measure of income to calculate effective tax rates. The rates are much lower using this broader measure of income.

The Tax Policy Center computer model of the tax system, which estimates how changes in the law would affect tax burdens, has repeatedly made projections that subsequent events showed were accurate. The center is a joint project of two Washington research organizations, the Urban Institute and the Brookings Institution. The George W. Bush administration went out of its way to praise the reliability of the center findings even when they were not helpful to administration policy.

The incomplete measure is called “adjusted gross income,” or AGI. This is the number on the last line of the front page of the standard tax return.

To get a fuller picture, the Tax Policy Center used what it called “cash income” to calculate effective tax rates. This included municipal bond interest, government benefits and many of the other items that are excluded from AGI. Use this fuller measure of income and the share of income that goes to taxes falls.

SIGNIFICANT VARIATIONS

In its new analysis, the Tax Policy Center found that the discrepancy between these two ways of measuring tax rates varies significantly between different income groups.

For the middle fifth of taxpayers, those with cash income between $33,542 and $59,486 a year, the average tax burden is 4.1 percent of adjusted gross income but only 3.2 percent of cash income. So these middle-income people are paying almost one percentage point less of their income in federal income taxes than they might imagine based on the popular debate.

One percentage point may seem small, but for people in this income group it means they are actually paying one fifth less in income tax than they might think.

The percentage point discrepancy widens as incomes increase. For the next fifth of taxpayers, those earning between $59,486 and $103,465, the average federal income tax is 8.2 percent of AGI but only 7 percent of cash income, a difference of 1.2 percentage points. For the top fifth, those earning more than $103,465, the average federal income tax is 17.3 percent of AGI but only 14.9 percent of cash income.

For the top tenth of one percent – whose combined income comes close to equaling that of the bottom 50 percent of taxpayers – the disparity is even greater. The tax rate is 23.6 percent of AGI but only 19.8 percent of cash income, a difference of 3.8 percentage points.

UNDERSTATED DISPARITY

As valuable as the Tax Policy Center’s report is, the center acknowledges that it understates the disparity for people at the very top. The reason for this is that the computer model cannot capture certain kinds of income that are only available to the very wealthy. For example, Congress considers the personal use of corporate jets to be income. But, under rules Congress set in 1985, only a small fraction of the real value is included in AGI. Unfortunately, the Tax Policy Center’s model does not capture the remainder as part of cash income.

For the 40 percent of Americans on the bottom of the income ladder, using AGI to measure income also distorts the effective tax rate calculation, but in a different way.

On average, people in the bottom 40 percent receive money from the federal income tax system rather than pay money into it, so their effective tax rates are negative.

This is because the first $19,000 of income for a couple was free of income tax last year. At the same time, they may have received cash payments such as the Earned Income Tax Credit for the working poor or the Child Tax Credit for parents of children. These tax credits are not included in AGI, but the Tax Policy Center counts them as cash income.

The payments the poorest fifth of taxpayers – those who made less than $16,812 last year – get on average from the tax system amount to 12.3 percent of their AGI. But, when calculated against cash income, these payments amount to only 5.8 percent. So, the AGI method overstates the amount this group is getting from the tax system.

For most of us – those in the middle class and above – our effective tax rate is lower than politicians say. So smile a bit today. The cost of civilization is not as high as you’ve been told.

For years, the U.S. Chamber of Commerce has pressed Congress to restrict securities class action lawsuits, saying they put a damper on economic activity.  Securities lawyers argue that such suits act as a crucial protection for investors, who deserve their day in court when deceitful actions by executives cost them money.

Now, some new research sheds light on this question.

Jonathan Rogers, an associate professor of accounting at the University of Chicago’s Booth School of Business, led an investigation into why some companies get sued while others do not.

Rogers, his Booth colleague Sarah Zechman and Andrew Van Buskirk of Ohio State University identified 165 companies that were sued because their share price fell after an earnings statement had pointed to strong future performance.

Booth and his coauthors then did something that I think added real value. They paired each of their 165 companies with a company in the same industry that was not sued, matching them for size and performance. Then they compared the earnings announcements of the two groups.

So why were 165 companies sued, but 165 similar companies were not?

First, the companies that were sued made unusually optimistic remarks about their future earnings, according to the paper, in the current issue of the American Accounting Association’s Accounting Review.

UPBEAT WORDS INVITE SUITS

They used words like “excited,” “strong” and “thrilled,” and these words were frequently quoted in securities fraud complaints, the researchers found. The firms that were not sued used these words less often and made more use of words such as “weak.”

The researchers concluded that optimistic words elevated the chance of litigation slightly. But what really raised the odds was an optimistic announcement followed by a sale of stock by company insiders, they found.

“Optimistic language can get you sued,” Rogers told me, “but what’s significant is optimistic language followed by abnormal insider stock sales.”

Bragging about performance while selling lots of stock seems a fairly obvious formula for getting sued, so why has this lesson not been universally learned in executive suites?

For an answer, I turned to Gregory Roussel, a Silicon Valley corporate lawyer and former editor of the Vanderbilt Law Review, who has coached executives on how to talk up their companies without inviting litigation.

Roussel said executives are reluctant to dial back their remarks.  ”They are enthusiastic about their company and they believe what they are saying,” Roussel said, suggesting that excessive optimism rather than deception is to blame.

PUFFERY DEFENSE

Corporations that are being sued often assert that optimistic statements are not material representations and therefore not subject to the 1934 Securities Exchange Act, which requires disclosure of facts an investor would need to make investment decisions. Call it the corporate puffery defense.

Increasingly, judges think investors can distinguish such puffery from material statements and they have become more hostile to such class action lawsuits, according to David Hoffman, a professor of law at Temple University who has researched this field. As a result, “being a class actions securities litigator is a lot less lucrative than it was not many years ago,” Hoffman said.

So, can investors distinguish puffery from substance?

Stefan Padfield, a professor at the University of Akron School of Law who blogs about corporate governance, thinks not.

In a 2008 research paper on corporate puffery, Padfield found that judges generally embrace the ancient doctrine of caveat emptor. Under that doctrine, a farmer who buys a plow horse based on sales talk — instead of an inspection of its mouth and fetlocks — shouldn’t come crying to the courts if the horse turns out to be old and lame. But, Padfield found, 45 law students and professors who had made investment decisions regarded executive statements as material far more often than the judges believed.

Having bought both horses and stocks, I think Padfield’s conclusion makes sense. A work horse is not as complex or difficult to appraise as a stock.

There is a lesson here for Corporate America: companies should make their insiders put proceeds from stock sales into escrow for some period of time — 90 days ought to do it — after upbeat executive statements. If the price drops during that time, make them take the lower price or wait until the price recovers. After all, the law requires directors and executives to put company interests ahead of their own.

With so much attention placed on Mitt Romney’s verbal blunders, much less has been given to his written plans for the economy and taxes.

The Republican frontrunner’s 160-page “plan for jobs and economic growth,” which he released in September, contains some sound ideas. He would encourage more Americans to save and invest. And one of his proposals would strengthen America’s status as a technological powerhouse. See the plan here.

But there’s a side to the plan that would raise taxes on the poorest 125 million Americans while tilting tax cuts further toward the rich.

President George W. Bush cut taxes for almost everyone who paid income taxes. Romney would make the Bush tax cuts permanent. But that’s only a first step.

He would also raise taxes on poor families with children at home and those going to college. Romney does this by reducing benefits from the child tax credit and the earned income tax credit and by ending the American Opportunity tax credit for college education.

Without these tax breaks, the poorest fifth of taxpayers would pay $157 more in taxes in 2015 than under current policy, the Tax Policy Center says in its analysis of Romney’s plan. The second poorest group would pay $82 more, according to the center, whose past work has been praised by Republicans and Democrats alike.

TAX CUTS

While Romney would make these two groups — the poorest 125 million Americans — pay higher taxes, the top 60 percent all would get tax cuts. The top tenth of one percent would save, on average, $464,000 a year, the Tax Policy Center’s analysis says.

His plan gives one third of his tax cuts to the top tenth of one percent of taxpayers. By comparison, Bush gave this group only one eighth of his cuts.

Romney would also eliminate estate and gift taxes, a policy that I believe would damage the spirit of striving that has served us so well until now, replacing it with a new era of dynastic wealth.

Romney’s campaign did not answer specific questions about his tax proposals, referring me instead to the plan itself.

On the more positive side of the ledger, Romney’s plan would let households earning less than $200,000 a year collect capital gains, dividends and interest tax-free. That would encourage more Americans to build cash nest eggs and to own stocks and bonds above and beyond their retirement plans.

Unlike today, when a shrinking minority of Americans has savings accounts and bonds, in the 1970s a majority earned interest. Back then, a couple could collect $400 of interest and dividends tax-free.

Romney’s plan would give unlimited tax-free interest, dividends and capital gains to about 98 percent of households. (I have recommended the same tax break be given to everybody, but with a $1,000 cap, twice that for married couples, on tax-free capital income.)

NO TAX BREAK

Given the news coverage of the low tax rate Romney paid in 2010, and expects to pay for 2011, people could easily assume he would get a huge tax break under his own plan. That is not the case.

Under his plan, high-income taxpayers would continue to pay 15 percent on their capital income, about the same rate Romney paid in 2010 and expects to pay for 2011.

As a taxpayer, Romney would do much better under rival Newt Gingrich’s tax plan. Gingrich would let everyone collect capital gains, dividends and interest tax-free. Had that been the law in 2010, Romney’s tax bill would have been cut by at least 97 percent, my calculations show.

Another provision in Romney’s plan would be to raise the ceiling on the number of visas issued to holders of advanced degrees in math, science and engineering who have job offers in those fields from U.S. companies.

While this seems like a smart idea, it does have a downside. Software engineers and others already complain that foreign workers on visas are depressing their wages, and Romney’s plan would likely make it worse. But employers will love it.

Romney, whose father was born in Mexico, would also let foreign-born students stay in the United States, provided they earn advanced degrees in engineering, math or science. And he would open the doors to wealthy people because he believes they are “job creators.”

Those last two provisions seem very smart. It is also exactly what happens in Canada, where one in five Canadians is an immigrant.

These are serious issues with potentially far-reaching implications. This is what the media should be examining, instead of verbal trivia from the campaign trail.

PHOTO: Republican presidential candidate Mitt Romney speaks at a campaign event at an RV dealer in Loveland, Colorado February 7, 2012. The Colorado caucuses take place today. REUTERS/Rick Wilking

Newt Gingrich’s 2010 income tax return inspired a quick response from U.S. congressman Pete Stark.

Twelve days after Gingrich, a Republican presidential hopeful, made his return public, Stark proposed the Narrowing Exceptions for Withholding Taxes (NEWT) Act.

This proposal has an uncertain future in Congress, but it would be a good addition to our tax laws, closing a significant loophole that Gingrich took advantage of.

In their 2010 return, Newt and Callista Gingrich declared that most of the money they earned from their multimedia company, Gingrich Productions, was dividends, rather than compensation for their services.

Because the Medicare tax applies only to labor income, this move allowed them to avoid paying $71,152 in Medicare tax — the amount of the dividend times the 2.9 percent tax rate.

Michelle Selesky, Gingrich’s spokeswoman, did not respond to multiple requests over several days for an interview or comment.

This technique is used by many accountants, lawyers, lobbyists and performers who, like Gingrich, set up S corporations, a type of business organization that passes any tax obligations on to its owners.

The same loophole was used by John Edwards, the 2004 Democratic vice presidential nominee, to avoid about $600,000 of Medicare tax on his earnings as a trial lawyer over a period of four years, information he made public showed back then.

THEIR OWN LABOR

Some investors in S corporations have capital at stake but do little or no work. It is reasonable to classify their profits as dividends. But in the case of Gingrich, and Edwards, their income resulted from their own work and it should be taxed as such.

Stark, a California Democrat, told me he introduced the NEWT Act after learning that Newt and Callista Gingrich reported 80 percent of their nearly $3.2 million in income in 2010 as dividends, mostly from Gingrich Productions, which is set up as an S corporation.

Under Stark’s bill, the income from an S corporation with three or fewer principals would be taxed as compensation, thus incurring Medicare taxes.

Passing Stark’s bill and closing this loophole is a matter of fundamental fairness. The principle that government should tax makers of microchips and potato chips alike should also apply to earnings from work, whether it comes from work on the factory floor, or, as in Gingrich’s case, making videos.

Just as you cannot claim a depletion allowance for your aging body, you should not be able to declare that money you earned by working is a dividend.

The official scorekeepers on tax matters, Congress’s Joint Committee on Taxation, estimated in 2009 that closing the loophole would raise $11.2 billion over 10 years.

IRS ATTACKS LOOPHOLE

The IRS has been attacking this loophole in audits, challenging many tax filings that have used the same strategy that Gingrich used. One of those challenges is now before the 8th U.S. Circuit Court of Appeals in St. Louis in a case watched closely by tax professionals.

It involves David Watson, a certified public accountant in West Des Moines since 1982, who paid himself a salary of $24,000 in 2002. He then reported nine times that much in dividends, which reduced his Social Security and Medicare taxes. He followed a similar pattern in 2003. The IRS said the dividends were really labor income and demanded Medicare taxes.

Watson sued. Robert W. Pratt, the chief federal judge in Iowa’s southern judicial district, wrote in a 23-page decision in 2010 that such a small salary was “unreasonable.” A salary of $91,044 would be reasonable for someone with Watson’s skill and experience, he wrote.

The judge then ruled that Watson owed payroll taxes on $67,044 of the money he had labeled dividends, saying this finding “is amply supported by the evidence.” Watson’s case has been argued on appeal and he now awaits a ruling.

Watson told me that he does not think the IRS has the authority to decide what is salary and what is a dividend. Other court cases show that it does. But Congress should remove any ambiguity by passing Stark’s bill now.

Stark’s proposed NEWT Act contrasts with Gingrich’s own tax plan, which he released in December. Under Gingrich’s plan, dividends would not only be free of Medicare tax, they would also be entirely tax-free.

Had Gingrich’s tax proposal been the law when he filed his 2010 return, my calculations show that his income taxes would have fallen more than 90 percent. His is one of the most outrageously self-serving tax proposals I have seen in years of studying our tax system.