Income Tax Part 1: Federal

Tax is the friend that nobody wants at the party.

The Final Jeopardy question on June 4, 2018, read: “In a 1789 letter, Benjamin Franklin relates the durability of the new Constitution to these two things:”

The correct answer?

“What are death and taxes.”

So… unfortunately, income tax is here and is here to stay.

Yet (often like the disliked friend), they are often misunderstood.

Most people recognize that the US government taxes your hard earned income. And you’ve probably heard or seen a tax bracket that looks like this:

Source: Nerdwallet

There are actually two additional ways that your earned income (like a salary) is taxed. Federal Income Tax + Payroll Tax + State Income Tax. Today, we’ll touch on the biggest tax: Federal Income Tax.

First, a story:

I overheard two friends talking at a Starbucks. It went something like this. Let’s call this friend Amy:

Amy: I’m getting a raise at work, but that raise will push me into the next tax bracket, and by doing so will actually reduce my pay!

Friend:

Amy: I am near the top of the 24% tax bracket, so that means I can't make any more money, because doing so would push me into the 32% tax bracket. I'm actually better off making $1,000 less, because once I cross into the next tax bracket, my tax obligation will increase significantly and I'll be paying 32% instead of 24% on all my earnings!

First of all… good for Amy for getting that raise. You go girl. But she is wrong about how taxes work, fortunately in a good way. But Amy is not alone, this is a common misconception and I literally heard this same conversation between two workout bros at the gym.

Amy correctly understands that the U.S. federal income tax system is a progressive tax system, in which people with higher earnings pay higher tax rates. But any amount you makes before crossing into the 32% tax bracket is still taxed at the lower 24% tax rate. Only the additional dollars — those that put you above the 24% tax bracket — will be taxed at the higher rate. 

A progressive tax environment like the U.S. system uses a set of increasing tax brackets to define the rate at which each extra amount of income gets taxed. The first chunk of income gets taxed at a low rate, the next chunk is taxed at a slightly higher rate, and then each successive amount of income gets taxed at a progressively higher rate.

Here’s a video that explains this better. Vox: How Tax Brackets Actually Work

Progressive tax systems like the U.S. federal income tax system are often thought to be a more socially advanced way to tax the community: They distribute wealth from the highest earners, whose income is taxed at higher rates as it increases, to the least well off.

Two other tax models include:

• Flat tax system — features a single tax rate, regardless of the amount of taxable income. The most common example of a flat tax system in the United States is sales tax — which, where used, applies equally to all purchasers, regardless of income. Other examples may include the Medicare tax on income and, in most places, property tax. Ten U.S. states also have a flat income tax system — the total is 17, if you count the seven states with zero state income tax — as do 25 countries. Greenland has the highest flat tax; although it varies by municipality (which takes the lion's share of the revenue), it tops out at 44% in some spots. The largest country with a flat tax is Russia, which has a flat tax of 13%. 

• Regressive tax system — the opposite of a progressive one, imposing a lower tax rate on those with increasing income. Actual regressive tax systems are rare, because they impose lower tax rates on the rich — a politically unpalatable notion. Yet many tax frameworks are considered regressive in nature, because they impose a greater burden on lower-income families. One example is the "head tax" or "poll tax," a per-person tax that was common in some states during the Jim Crow era. Sales tax on essentials, such as basic food items, is also considered regressive since it proportionately affects the wealthy less. (Someone who's 10 times wealthier than another person probably doesn't drink 10 times more milk.) The Social Security tax, which is applied to only a certain level of income, may also be considered regressive. 

Let's go back to Amy. As it turns out, what Amy was describing was the marginal tax rate: the tax rate she would pay on each additional dollar she earns. On the other hand, the effective tax rate is the average tax rate paid across every dollar earned. To calculate the average tax rate, divide a your total tax liability — that is, the amount due to the federal government in a given year — by your taxable income. 

Next time you have a friend that humble brags about their raise and how it’s going to decrease their income, you can give them a lesson on the difference between marginal tax rates and effective tax rates.

If you can’t get enough of the Federal income tax, here’s a short and fun podcast on the history of it: Planet Money: A Brief History of Income Tax