How our tax system really works

This is a subtle, easy-to-miss point — I remember I went into late high school or early college before realizing this, and I still run into people who are confused. So a quick primer on the wonder that is our marginal tax rate system may be in order as Congress debates tax reform. (This is vastly oversimplified, but should suffice to get the point across.)

Right now the U.S. income tax code has six tax brackets. According to this article, for a single filer, those rates and income thresholds are as follows:

  • 10%: $0-$8,700
  • 15%: $8,700-$35,350
  • 25%: $35,350-$85,650
  • 28%: $85,650-$178,650
  • 33%: $178,650-$388,350
  • 35%: $388,350+

So what does that mean? If your taxable income is $8,500, you’re going to pay 10 percent of that to the government. That’s simple.

What if your taxable income is $10,000? Do you pay 15 percent of that to the government?

No, no, no, no.

The new tax rate only applies to income in the particular bracket. Income in lower brackets is taxed at the lower rate. Let’s explore.

Our tax system is built around the concept of the marginal rate. In economics and math, “marginal” implies that you’re concerned with the change, not the whole — what impact does adding one extra unit have?

So if you have $10,000 in taxable income, you pay 10 percent of the first $8,700. Then you pay 15 percent of every additional dollar you earn, up to $35,350. So our person with $10,000 in taxable income pays $870 in 10 percent taxes on their first $8,700, then 15 percent of their next $1,300 in income, or $195, for a total of $1,065 in taxes.

Someone who earns $100,000 in taxable income pays as follows:

  • $870 in 10 percent taxes on their first $8,700
  • $3,997.50 in 15 percent taxes on the $26,650 in income between $8,700 and $35,350
  • $12,575 in 25 percent taxes on the $50,300 in income between $35,350 and $85,650
  • $4,018 in 28 percent taxes on the $14,350 in income between $85,650 and $100,000

For a total of $21,460.50 in taxes.

If they had paid 28 percent taxes on their entire income, they would pay $28,000, or $6,539.50 more.

This is so much more complicated than a system where you pay one percentage rate on your income. So if you’re going to have a progressive tax system with brackets, why use marginal rates?

It’s a simple matter of incentives. If popping into a higher tax bracket means you pay more taxes on all your income, there’s a powerful disincentive to enter that next tax bracket. Someone who earned $85,649 in taxes would pay $21,412.25 in 25 percent taxes on all their income. Earning ONE MORE DOLLAR would mean you’d pay 28 percent taxes on all your income, for a total of $23,982. That means earning one more dollar actually cost you money — $2,568.75, to be precise.

If that were the case, people would deliberately try to earn less money, to stay out of higher tax brackets.

With a marginal tax rate system, you still get disincentives to earn more money, but they’re orders of magnitude smaller. In no case in the basic tax system (the AMT and other complicated taxes may be a different story, I don’t know) does earning an extra dollar cost you negative dollars. Instead, simply those extra dollars over the new tax threshold are taxed at the higher rate — each dollar earned over $388,350 is really 65 cents, while your 388,349th dollar is really 67 cents, and your 50,000th dollar is really 75 cents.

If new income puts you into a new tax bracket, all your previous money is taxed at the same rate. Only the new income is taxed more.

So when President Obama calls to raise taxes on individuals earning more than $250,000 per year, he’s really calling to raise taxes on income over $250,000. Someone who earns $800,000 per year would still pay the same taxes on their first $250,000 in taxable income. They would then pay higher taxes on the $550,000 in income from $250,000 to $800,000.

The same applies for the $1,000,000 tax bracket proposed by House Speaker John Boehner in his doomed “Plan B.”

Tags: taxes