Progressive Tax

Today, let's talk taxes. I really hated this topic when I first learned it because understanding the entirety of the tax code can be frustrating.  I am going to try to keep this post as simple and to the point as possible. So, let's see what I've learned shall we?

Taxes: Used by the government to pay for financial obligations.

Every year Congress draws up a budget. The budget determines how much funding each part of the government gets. In order for the government to be able to pay for the budget that Congress passes, they must collect taxes. There are many kinds of taxes such as income, corporate, sales, estate, capital gains, property tax, and many others. These taxes can be progressive, regressive, flat, and negative among others.

Since there is just so much information regarding taxes, I want to focus this post on just the income tax in the United States which is structured to be a progressive tax.

Progressive tax works by increasing the tax rate as the taxable base amount increases. Governments create brackets to separate your income into different ranges. Each bracket is then taxed at a certain percentage. The rate at which a bracket is taxed is called the marginal rate. The brackets and marginal rates stay the same regardless of income. Meaning people making $50,000 or $150,000 will be taxed at the same rate in the same brackets. However the brackets and marginal rates change every year.

Now, bear with me as I try to explain how this works. For the sake of simplicity, I am making up the numbers and percentages. Let's assume you make $100,000 one year in income. First, your income will be split into several different brackets. The US government has six brackets, for our example we will use just three and we will assume there are no deductions possible.

Bracket 1: $0 - $50,000 taxed at 0%
Bracket 2: $50,001 - $75,000 taxed at 10%
Bracket 3: $75,001 - $100,000 taxed at 20%

Bracket 1 has $50,000 and Brackets 2 and 3 have $25,000 each. The first Bracket will not be taxed at all. Bracket 2 will be taxed 10% which gives you $2,500 and Bracket 3 is taxed at 20% which gives $5,000. Here is an illustration for you to visualize it:

From each bracket add up the amount that will be taxed and that is what you will have to pay for your income tax. In the example stated, you will have to pay $7,500 in taxes out of your $100,000 income. This amounts to only 7.5% of your whole income even though your highest marginal rate is almost three times that amount (20%). This 7.5% is called your income tax burden. The pie chart below gives you a nice visual on just how little of your income is taxed with these rates. 

Let’s take what we have learned in the example and loosely apply it to the real world. If you are single the brackets and marginal rates for 2011 are as follows:

Bracket 1: $0 - $8,500 @ 10%
Bracket 2: $8,501 - $34,500 @ 15%
Bracket 3: $34,501 - $83,600 @ 25%
Bracket 4: $83,601 - $174,400 @ 28%
Bracket 5: $174,401 - $379,150 @ 33%
Bracket 6: $379,151+ @ 35%

This means that if you make $100,000 in payroll and take no deductions, you fall into Brackets 1-4. The amount taxed from each bracket is $850 + $3,900 + $12,275 + $4,592. The total the government will collect from you is $21,617.

If you are confused as to where the $4,592 comes from, here it is written out:
Since you made $100,000 in payroll, that is your cap. Subtract $83,600 from that and you get $16,400 which is then taxed at 28%, thus giving you $4,592 to be taxed from that bracket.

The tax burden will be 21.6% of your total income. In actuality this number will go down even more when you start adding in all the deductions applicable to you.

I hope that this explanation is simple enough and now you know the basis for our entire tax code. Deductions and credits and everything else you hear about are ways the government can adjust the totals people in certain brackets pay.

--ElfEnnerji