In the continuing public discussion about reducing Oklahoma’s personal income-tax rate, tax-cut opponents often argue that these tax cuts disproportionately benefit “the rich.”

The assumption seems to be that the so-called rich are just sitting on their money, and having the state government take it from them in order to spend it is a wiser course of action.

But the caricature of the so-called rich is misleading. We analyzed the latest data from the Internal Revenue Service for 2011 that show the dramatic differences in the composition of income by various income groups. Simply looking at total income can be misleading if one does not understand the underlying income dynamics, because today’s tax code includes a mish-mash of personal and business income.

Chart 1 shows the various characteristics of Oklahoma’s taxpayers by income group as a percent of tax filers within each income group. The first item to note is how marriage affects the perception of “rich” versus “poor.” For those earning between $25,000 and $50,000, the percent of married filers is 37.9 percent, but for those earning between $200,000 and $500,000 the percent of married filers is 86.3 percent.

This makes perfect sense since in today’s economy, where oftentimes both husband and wife are in the workforce, marriage can result in a doubling of household income. A single person earning $40,000 would fall in the “under $50,000” category, whereas a couple earning a combined $80,000 would show up in the “$75,000 to $100,000” category. By this metric, the married couple looks (sometimes misleadingly) better off economically than the single person.

The second item to note is that the percentage of taxpayers that have some kind of business income soars at the income levels over $1,000,000—97.6 percent of taxpayers have interest income, 81 percent of taxpayers have dividend income, and 85.7 percent of taxpayers have capital gains income.

More importantly, the percentage of taxpayers that have partnership/S-corporation income is dramatically higher for those earning more than $1,000,000 (79.7 percent). This is nearly five times as high as those earning between $100,000 and $200,000 (16 percent) and nearly 14 times as high as those earning between $50,000 and $75,000 (5.7 percent). The income from S-corps is particularly problematic because, unlike C-corp income, S-corp income is taxed at the personal level. As we will demonstrate in a moment, this pass-through income is not necessarily indicative of the taxpayer’s actual financial condition.

The Tax Foundation has published a booklet, “Putting a Face on America’s Tax Returns,” which shows that “the vast majority of taxpayers who face the highest marginal tax rates [meaning high-income people] tend to be married couples. But aside from being married, they also tend to be dual-income, residents of high-cost urban areas, older, college educated, and engaged in business activities.”

For tax year 2013, Oklahoma has seven tax rates: 0.5 percent, 1 percent, 2 percent, 3 percent, 4 percent, 5 percent, and 5.25 percent. These increasing tax rates indicate a “graduated” or “progressive” income tax rate system and can lead to all kinds of economic distortions.

To see how, let’s compare two hypothetical taxpayers—a single taxpayer with wages of $50,000 and a married couple (with two children) with combined wages of $100,000, S-corp income of $50,000, capital gains income of $20,000, and interest/dividend income of $5,000.

As shown in Table 1, taxes for the single taxpayer are straightforward and amount to a tax bill of $2,050. As a percent of total and actual income (there is no difference for this taxpayer), this amounts to a tax burden of 4.1 percent.

The married couple’s tax bill is not so simple. The problem stems from the S-corp income that is derived from a family-owned business that is in financial trouble. The business needs to make some necessary investments to stay competitive, so, for the next few years, all profits will be retained to fund them. However, the profits still must be distributed to shareholders for taxation. So, this family’s share of profits comes to $50,000, even though they won’t actually receive $50,000—this is often referred to as “phantom income.”

As a result of having to pay taxes on the S-corp income, the family will have to sell some stocks, resulting in $20,000 worth of capital gains. They also receive $5,000 in interest and dividends from personal savings for college/retirement. The end result is that they will owe $7,960 in Oklahoma personal income taxes.

While on paper it looks like this family is better off than the single taxpayer, the single taxpayer is getting a much better tax deal with a tax burden on actual income of 4.1 percent. The family’s income may be 3.5 times higher, but their tax bill is 3.9 times higher thanks to Oklahoma’s increasing marginal tax rates and marriage penalty (due to the married tax brackets not being double the size for singles).

Adding insult to injury, their overall tax burden is significantly higher at 6.4 percent of actual income—keep in mind that they never received the $50,000 from the S-corp, which was kept by the business as retained earnings.

This simple illustration shows that the interplay between personal and business income within the tax code can lead to misleading conclusions about the actual financial condition of taxpayers. A “high-income” family with children and a business could be one step away from financial disaster, while a “low-income” single taxpayer may be better off in terms of after-tax income.

As a result, comparing a taxpayer in the “$25,000 to $50,000” income category with a taxpayer in the “over $1,000,000” income category is not an apples-to-apples comparison. Only 3.1 percent of taxpayers earning between $25,000 and $50,000 have any partnership/S-corp income, while 79.7 percent of all taxpayers earning more than $1,000,000 have partnership/S-corp income. It is absurd to compare the income of an individual with that of a doctor’s office, yet that is exactly what is happening when using income tax data to make such comparison between aggregate income groups.

While it would take a major tax reform proposal to permanently fix the underlying double-taxation of business income, for now policy makers could help the situation by continuing to reduce Oklahoma’s personal income-tax rate.

History of the S-Corporation

In 1958, subchapter S of the tax code was enacted, which created the modern S-corporation as we now know it. The primary reason for its creation was to eliminate the double-taxation of income that exists under traditional C-corporations.

For instance, dividends paid by a C-corp can only be paid out of after-tax income, which is one layer of taxation. Individuals must then declare the dividends as income, which results in two layers of taxation for the same stream of income. S-corps avoided this double-taxation by taxing business income only at the personal level.

However, S-corps remained a small part of the corporate landscape until two major events that dramatically increased their desirability.

First, individual income tax rates were higher than corporate income tax rates until the Tax Reform Act of 1986, which dramatically lowered the individual tax rate to 28 percent. As a result, the popularity of S-corps increased significantly.

Second, the payroll tax rate for Social Security and Medicare topped 14 percent (combined employee and employer rate) for the first time in the mid-1980s. Unlike wages and salaries, S-corp dividends are not subject to a payroll tax, which also boosts the popularity of S-corps over C-corps.

However, S-corps do have important limitations, such as a restricted number of stockholders and types of stocks that can be issued. Nonetheless, as of 2009, S-corps represent 70 percent of all corporations in America.

OCPA research fellow J. Scott Moody (M.A., George Mason University) has worked as a public policy economist for more than 13 years. Formerly a senior economist at the Tax Foundation and a senior economist at the Heritage Foundation, he has twice testified before the Ways and Means Committee of the U.S. House of Representatives. His work has appeared in Forbes, CNN Money, State Tax Notes, The Oklahoman, and several other publications.

OCPA research fellow Wendy P. Warcholik (Ph.D., George Mason University) formerly served as an economist at the U.S. Department of Commerce’s Bureau of Economic Analysis, and was the chief forecasting economist for the Commonwealth of Virginia’s Department of Medical Assistance Services. She is a co-creator (with J. Scott Moody) of the Tax Foundation’s popular “State Business Tax Climate Index.”