Progressive Tax

This article in response to me twice being told “I don’t want to get a raise because I’ll pay more taxes”. It’s an absurd comment that after the second time hearing it, even I needed to double check the IRS website to confirm that our federal income tax is indeed a progressive application of various tax rates. I believe there are two reasons why there is so much confusion:

  • When the media talks about an individual’s tax rate they state it at the highest marginal tax rates always, shortcutting the fact that the highest marginal tax rate is not on all wages and thus not the same thing as an effective tax rate that an individual will pay;
  • The 1040 form is poorly laid out, especially in the tax expense section. This is especially the case when an individual has capital gains and Alternative Minimum Taxes which have a different rate on different amounts within Adjusted Gross Income. (Not to mention the fact that many tax payers don’t understand the difference between tax liability and tax expense and throw a party when they get a refund – another lesson that if you do get a refund you should read that first before anything else you do)

Let’s simplify and help understand what progressive tax is. To start let’s start with an individual who only has W2 wages. For this example we will use the new updated 2018 tax rates and assume the person is single and has no deductions such as health care, 401k, etc. For this example you will make taxable income of $250,000. The media would make it seem like you have a marginal tax rate of 35%, the highest marginal tax rate per the tax schedules of an individual who makes $250,000, thus would give the individual a tax expense of $87,500. This application of tax rates would actually mean the effective tax rate on individual’s federal income is 33.40% ($87,500 dividend by $262,000, which is the $250,000 of taxable income plus standard deduction of $12,000)[1].

However this effective tax rate calculation is totally wrong. What really happens is everyone, no matter how much you make, has their income broken into layers or tranches. Each layer is charged a separate tax rate and all of those layers tax expenses are added together to get your total tax expense for the year.

Let’s look again at our example of taxable income of $250,000. This income would be broken into 6 layers.

  • $9,525 would be charged 10% tax expense;
  • $29,175 would be charged 12% tax expense (arrived by taking $38,700 minus layer one of $9,525);
  • $43,800 would be charged 22% tax expense (arrived by taking $82,500 minus layer 2 of $38,700);
  • $75,000 would be charged 24% tax expense (arrived by taking $157,500 minus layer 3 of $82,500);
  • $42,500 would be charged 32% tax expense (arrived by taking $200,000 minus layer 4 of $157,500); and
  • $50,000 would be charged 35% tax expense (arrived by taking $250,000 minus layer 5 of $200,000).

There is actually a 7th layer that could be added if your taxable income is above $500,000, but since that’s a one-percenter and our goal is to get you to a five-percenter, we’ll keep it at $250,000 for this example.

Thus your tax expense for each layer would be:

  • $9,525 of income at 10% would equal a tax of $952.50;
  • $29,175 of income at 12% would equal a tax of $3,501.00;
  • $43,800 of income at 22% would equal a tax of $9,636.00;
  • $75,000 of income at 24% would equal a tax of $18,000.00;
  • $42,500 of income at 32% would equal a tax of $13,600.00; and
  • $50,000 of income at 35% would equal a tax of $17,500.00.

Thus your total tax would be $63,189.50 for an effective tax rate of 24.12%, which is way less than the 35% the media makes it out to be. This again is not taking into account the fact you can lower your wages by using proper tax shelters like 401k, itemized deductions, H.S.A. deduction, etc.  So you can see how complicated this can get and needs to be done at an individual level. I realized I don’t even know my effective tax rate, which is a failure on me and will spend the next night better understand what really our effective rate is and what can I do to keep that number as low as possible.

There also is this idea of the standard deduction, which is for an individual, is tax free earnings. I’m inventing something, which is called the tax day. This is the day you first start paying tax (in theory). So let’s say you make that $65,000, with 261 working days in a year, you start paying taxes on business day 48. Your goal should be to bring that day as close to day 1, so as a 15 year goal, we will want to move that date up 15% to day 41. You should even celebrate that day as tax day.

Going back to the original absurd comment, if we did not have a progressive system, employees would be rejecting raises all over town. Employers would never give salary figure in a range that might cost an employee.  If the taxes were not progressive, then the following income would be rejected by employees as it would cause them a larger tax:

  • Income between $9,525 and $9,741;
  • Income between $38,700 and $43,661;
  • Income between $82,500 and $84,671;
  • Income between $157,500 and $176,029;
  • Income between $200,000 and $223,529; and
  • Income between $250,000 and $261,538.

As you can see this is a wide range and further we have yet to talk about standard deductions or other tax deductions (like 401k) which would just complicate an employee’s decision. Could you really imagine as an employee being given a raise and then need to figure out whether or not to accept it by doing a bunch of tax estimates and calculation. This would hold down wages even more, so be glad we have a progressive tax system.

 

[1] All tax bracket information taken from and confirmed using 2 sites:  https://fa.morganstanley.com/thelicatagroup/mediahandler/media/117520/2018_Tax_Tables.pdf and https://www.forbes.com/sites/kellyphillipserb/2018/03/07/new-irs-announces-2018-tax-rates-standard-deductions-exemption-amounts-and-more/#3b97297c3133

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