We need a better system for delivery of commuter tax benefits

Most people are familiar with the concept of purchasing their health insurance through their employer with pre-tax income, but fewer are aware that the same option is available for the costs of commuting (transit or parking). Part of the reason for this is that it's up to employers whether they want to offer the benefit, and not all of them do, and it's a newer program than the one for health care premiums. But given that pre-tax benefits of this type lower taxes for both employee and employer, why don't all employers offer it? If there are legitimate reasons to be hesitant to participate, we in Seattle and we as a nation should be doing everything in our power to address those concerns and encourage maximum use of the commuter benefit for transit users.

First some background: the commuter tax benefit, found in section 132(f) of the  Internal Revenue Code, began in 1993 and offered deductions of up to $60 a month for transit use and $155 a month for parking costs. In recent times the value of the transit/vanpool benefit has been approximately half the value of the parking benefit (a policy failure worthy of its own post), but during 2010 and 2011 they came to parity when they were both set at $230. Unfortunately, in 2012 the value of the transit benefit was allowed to fall back to $125 whereas the parking benefit was increased to $240. Even so, someone making $35k a year using their full $125 transit benefit every month ends up saving almost $30 a month in taxes, and more than $300 a year. Those earning more than $35k a year save even more. And on the employer side there's a little over $110 per year tax savings.

Commuter tax benefits since 2007. From Wikipedia.

Just for reference, I calculated the employee number by summing the 15% for federal income tax (at that income level), 6.2% for Social Security tax, and 1.45% for Medicare, then multiplying that percentage by the $125/month. For employers, the savings are just the payroll taxes, since they don't pay federal income tax.

Employees--both those who already use transit and those who would like to--can't participate in this program if their employer doesn't offer it. But what employer wouldn't want to save up to $110 a year per employee? I think the "per employee" part is the answer: like any other program, government-operated or otherwise, there will be paperwork and accounting to accompany it, and it's possible that for small employers the costs would outweigh the potential savings. This is an unfortunate loss for the employees, but it's understandable why the employer wouldn't want to lose their own money for the greater good of his or her employees.

This is also why participation in this program is much more common among large employers, like mine at the University of Washington, for example. (This pdf is an impact survey that has tons of information on the program in various cities, including that fact.) If you have to administer the same program whether you've got ten employees or ten thousand, economies of scale make it much more efficient--you could have an employee whose sole job was to administer this program, and even if only 1,000 workers took advantage of the program you'd be saving over $100,000 a year, far more than you'd need to pay your new administrator, and all of those participating employees would be saving even more for themselves.

Small businesses can't take advantage of these economies of scale, so I think we should build that economy for them by outsourcing the administration and accounting to government or a non-profit organization. State and local governments would benefit tremendously from the savings, leaving their citizens with more spending money to contribute to the local economy, so the costs of creating such a system would be far outweighed by the benefits. And the benefits aren't just financial: by increasing participation in the commuter benefit program we'd be adding ridership to our transit system at no cost, decreasing pollution and congestion, and ultimately encouraging more people to live in denser, more efficient transit-oriented developments.

I've never owned a business, so I don't know the details of how employee payrolls are managed and how the various pre-tax deductions available are tracked and accounted for by employers. That said, we needn't look any further than health care for a similar example of what I'm suggesting, and how it might work. As a result of Obamacare we'll soon have health care exchanges, run by state governments (or the federal government for states that choose not to participate), which will allow people to purchase health care independent of their employers. There are various merits to this system, but since this isn't a health care blog I'll only mention the one that I think is relevant to this discussion; namely, the shift away from employers being responsible for their employees' health care plans. In the long term there's no rational reason to have an employer-based system because it takes choice away from the employee, and as we see with the commuter benefit it can also lead to some arbitrarily missing out on savings--a worker shouldn't be punished for working at a small business whose owner doesn't feel up to the task of setting up and overseeing a commuter benefit plan, and frankly there's no particular reason that the employer should bear this responsibility in the first place.

Perhaps states could set up a similar exchange in which all of a state's transit agencies are represented, and residents can purchase their passes through it according to their location. The state can track the purchases and award the tax savings in real time, then go to the federal government to get reimbursed. Or, at the very least, those who aren't offered the benefit at work can claim a separate deduction (on top of their standard or itemized deductions) on their tax returns every year. This isn't ideal because it forces individuals to save the records of all their transit spending and once-a-year tax refund windfalls don't lend themselves well to responsible financial planning, but it'd be an improvement over the status quo.

This post was originally inspired by a post at Mobilizing the Region about a law that was recently passed in California requiring businesses with at least 50 employees to take part in this program (or offer their own transit benefits), and this is certainly an option too, but not an ideal one. For one, it's not easily replicable. But besides that, many, many people work at businesses with less than 50 people. Ignoring them just because it might take a little more effort isn't fair to them, and it fails to take full advantage of the opportunity to get more people out of their cars. 

What we have right now is a system that favors large employers and their employees over small businesses and their workers, and just as with health care, an exchange or similar institution might be a solution to the problem. Certainly, what we're doing now just isn't working.

How federal taxes work, and sometimes don't

I'm aware that this has nothing to do with transportation whatsoever, but I'd like to talk about taxes in the United States. I could make a point about how we fund our government plays a major role in how we pay for infrastructure, which is true; in reality I just think this is very important and I only have one blog, so this is where it's going.

Let me just start with an anecdote. About seven years ago I was an employee at Comcast as a cable technician and, during my first few weeks, I was trained by a few different people who'd worked there quite a while. One of them was telling me about how much money you could make as a contractor, relating to me that he'd made just under $75,000 in a prior year, which led to a brief discussion about how he was worried about hitting that $75k threshold and being taxed at a higher rate. Knowing what I did about taxes at that time (i.e., nothing), I took it at face value that if you earned more you would be taxed at a higher rate, and assumed that applied to every cent you earned. So if you paid a higher tax rate above $75k than you did below it, you would actually keep more of your money if you earned $74,999 than if you earned $75,001.  It seems kind of unfair, but in a simplistic way it makes perfect sense.

It's also perfectly wrong. Even professional writers have been shown to be ignorant of this fact. In fact, we have something called a marginal tax rate for federal income tax in this country, and it's structured such that you only pay a higher tax rate on money earned after a given threshold has been reached. For example, if we had only two tax rates, 10% for earnings under $50k, and 25% for everything above that, it would look like this:

$35k earnings: full amount taxed at 10% = $3,500

$50k earnings: full amount taxed at 10% = $5,000

$51k earnings: $50k taxed at 10% ($5,000) + $1k taxed at 25% ($250) = $5,250

$100k earnings: $50k taxed at 10% ($5,000) + $50k taxed at 25% ($12,500) = $17,500

Play around with the numbers all you like, the takeaway point is that the more you earn in this system, the more money you take home. Always. There are diminishing returns on the amount of money you keep as you earn more, but it's impossible to be taxed more than someone with higher earnings than your own. The corollary here is that, ignoring the many exemptions that exist, as well as non-wage income, your average tax rate is always lower than someone who earns more than you. So the people making $35k and $50k pay a tax rate of 10%, the person making $51k pays a tax rate of 10.3% (5,250 divided by 51,000), and the person making $100k pays an averaged rate of 17.5%. This is exactly how our system works, with a greater number of brackets (2012 rates pictured below) so that the tax rate increase from one threshold to the next isn't quite so dramatic.

Federal income tax brackets. From Wikipedia.

One thing I think it's important to keep in mind when someone says they're paying a certain tax rate is that they're often referring to the highest marginal tax bracket that they pay. So if I earn $150k per year I might say that I'm paying a tax rate of 28%, but that's not actually the case. Instead, my tax rate is calculated as follows:

10% of $8,700 = $870

15% of $26,650 (35,350 minus 8,700) = $3,997.50

25% of $50,300 (85,650 minus 35,350) = $12,575

28% of $64,350 (150,000 minus 85,650) = $18,018

Total tax paid = $35,460.50

Actual tax rate = 23.6%

A 28% tax rate on $150k would come out to $42,000, so while it's not a massive discrepancy between the highest marginal tax rate and actual tax rate, that difference equates to more than $6,500 that they get to hold onto. To get just a little bit political here, this is why I don't find the "it'll hurt small business owners" argument against increasing the rates of the upper brackets convincing: for one, about 2% of business owners who file their taxes as individuals earn over $250k a year; that point aside, only the income beyond that $250k threshold (or other arbitrary amount) would be subject to the increased rates. And since high earners still get the benefit of all those sub-$250k tax cuts, they still get a bigger tax cut than anyone else. Passing up hundreds of billions of dollars in revenue just for the sake of this tiny group of business owners--people who are just as free to use that extra money on a fancy rug as on expanding their business or hiring new employees--seems very foolish to me when we're supposedly so concerned about our nation's debt and the insolvency of our entitlement programs.

Moving on: federal income taxes aren't the only taxes we pay, of course. There are property taxes which everyone pays (including renters, since this cost is generally passed on by the owner), as well as sales taxes, capital gains taxes, gas taxes, and income taxes for many states (on top of federal income taxes). And we have payroll taxes, the other tax that shows up on your actual paycheck. On the employee side, we pay 6.2% of our income for Social Security, and another 1.45% for Medicare. Social Security taxes are only collected on the first $110,000 of taxable income as of 2012, so earnings beyond that are only subject to federal income tax and the 1.45% Medicare tax.

Keeping the Social Security tax exemption for income over $110,000 in mind, let's calculate the total tax rate for three different incomes. I'll just give you the total amount of taxes paid (summing income tax, SS tax, and Medicare tax) and the actual total tax rate:

$110k income = $32,675.50 taxes = 29.71% tax rate

$150k income = $44,455.5 taxes = 29.64% tax rate

$300k income = $94,698 taxes = 31.57% tax rate

Uh oh, we broke it. Why is $150k-person paying a lower rate than $110k person? The answer is that the person earning $200k is paying exactly the same dollar amount in Social Security taxes, but since their income is higher their effective payroll tax rate is much lower than the rate of the person earning $110k. Once we get up to $300k we see that we're back in "higher earnings = higher tax rate" territory, although it might be reasonable to ask why the person earning almost three times as much as the $110k guy is paying a rate that isn't even 2% higher. For comparison, the jump from roughly $35k to $85k in earnings is commensurate with an effective tax rate increase of almost 7 percentage points:

$35,350 income = $7,571.78 taxes = 21.42% tax rate

$85,650 income = $23,994.73 taxes = 28.01% tax rate

Someone increasing their income from $35k to $85k is experiencing a much more significant and positive change in their quality of life and financial circumstances, and yet it seems that we're penalizing them more for this improvement than we are for someone jumping from $110k to $300k. Of course the point of taxes is not to punish people for earning money, and rather to fund government services of various kinds, but we should also be honest about the fact that taxes discourage the activity that they're tied to. This is more obvious with things like cigarette and gas taxes, but it also has some small impact on how much time people devote to work versus leisure. Why we are applying that discouraging tax rate increase more forcefully on those raising themselves from middle-class to upper-middle-class than we are from people moving from upper-middle-class to upper-class is something of a mystery to me. Weren't we supposed to be champions of the middle class?

You've probably figured out by now that I don't have any particular point I'm trying to make here. Hopefully you learned a little something about how the United States tax system works, and maybe have a slightly different perspective than you did before (or maybe a radically different one!). It's important that we do more than complain about the things we don't particularly like (i.e., taxes) and instead make an effort to better understand them and make educated decisions about how they should be changed. Maybe lower taxes are a good idea, but "lower taxes" doesn't tell us anything about who's paying less, how much less they're paying, or whether some people might be paying more to afford it. Additionally, how our institutions are organized is important. People will always argue about appropriate tax rates, but few would disagree that things aren't working properly when someone earning $150k a year pays a lower tax rate than another person earning $110k without even taking advantage of any of the numerous loopholes found in our tax system (which would take much more than this one post to discuss). Conversely, the advantages of a marginal tax rate system are self-evident: in actual dollars, people shouldn't pay more taxes than someone earning more than them.

If this post left any questions unanswered for you please let me know in the comment section. Chances are that I won't know the answer off-hand, but in the spirit of Better Institutions I'll be happy to learn the answer for myself and pass it along.