How Do Tax Brackets Actually Work?

There are a few topics that are considered off-limits at my family’s Thanksgiving table, and one of them is TAXES, or more specifically, the American tax SYSTEM.

Virtually everyone has a strong opinion about it: It’s unfair!

It doesn’t go far enough!

It’s too complicated!

Cable news and social media are filled with passionate debates about it, but how many people actually know how our current tax system works?

If your eyes glaze over when you hear phrases like “progressive taxation” and “marginal brackets,” you’re not alone.

Even some of our law-makers seem to have a shaky grip on the concept.

But if you hope to have a say in a system that impacts your wallet every day, you should understand how—and why—it ended up this way.

Let’s start with something all of us can agree on.

The U.S. tax code is complicated.

Really complicated.

It’s one of the most complicated systems in the world, taking the average citizen 13 hours to file each year.

Compare that to, say, Japan, where it’s closer to 15 minutes.

And one reason we have such a confusing system is because our income is taxed at different rates, depending on how much we earn.

For nearly 100 years, our country had no income tax.

The first one was levied in 1861 during the civil war at a flat 3% tax on income over $800.The next year, in 1862, the first “progressive tax bracket” appeared, with the 3% rate AND a 5% rate for any income earned over $10,000.

Then in 1872, the income tax was repealed because — get this — the government no longer needed the money.

Can you even imagine…?

Then in 1913 with the 16th Amendment, progressive taxes made a permanent come-back.

It gave the Federal government the free reign to tax workers’ income in every state.

So what is a “progressive tax”?

Well, you can think of tax systems coming in one of three main flavors.

Regressive, Proportional, or Progressive.

A regressive tax impacts lower paid workers more severely.

Paying sales tax on groceries or clothing will end up being a higher portion of a low-earner’s pay check than a high-earner.

A worker earning $20,000 a year who pays $1,000 in sales tax will be parting with 5% of his income.

Another making $100,000 paying that same tax for the same goods will only be charged 1% of her income for the same thing.

A simpler solution would be a proportional tax, where, simply put, everybody pays the same percentage of their income, no matter how much they make.

Nine states currently impose a proportional, flat state income tax.

That means no matter how much you make, your tax rate stays the same.

For example, 5% of every dollar earned.

Finally there’s the progressive tax, a system that has a heavier impact on high earners.

Low earners may end up paying little or nothing, with only the wealthiest people paying the highest tax rates.

How does this actually work?

Through a series of different tax levels or “marginal tax brackets”.

Buckle up, it’s about to get exciting!

Let’s say you’re a single person making $60,000/yr.

A quick look at the IRS Tax Brackets will tell you that you fall into the 22% bracket.

Do you have to give the government 22% of your income?

No!

A common misconception is that entering a higher tax bracket means your whole income is taxed at the higher rate.

So how much are you actually paying?

After taking your available deductions, you’re left with $47,800 in “Taxable income”.

As of 2019 we have 7 marginal tax brackets between 10 and 37%.

Each bracket along the way applies to one specific chunk of your income, not the whole thing.

Bracket 1 is for your first $9,525, and it gets taxed at 10%.

Next stop is Bracket 2.

This applies to $29,175, and is taxed at a rate of 12%.

Last stop is Bracket 3, where your remaining income of $9,100 will be taxed at 22%.

Even though you’re in the 22% tax bracket, your “effective tax rate” is only 10%, thanks to the marginal rates in our progressive tax system.

So a single-filer with a taxable income of $500,001 may be in the highest tax-bracket of 37%, but only $1.00 is taxed at that rate.

The effective rate will be much lower.

This system is definitely more complicated than a flat-tax.

But is it fair?

Simply put; no.

A progressive tax system, by definition is unfair.

It allows lower earners to pay very little tax… In fact more than 44% of Americans pay no federal income taxes.

And the more money you make, the less of it you will keep.

Opponents of progressive taxation tend to be higher earners, arguing that the system “punishes” wealthy people, and actively discourages making a higher income.

They claim that a flat-tax would be simpler, easier, and more fair.

Supporters of a progressive tax, however, point to the real-world human impact on struggling families and low wage earners.

They argue that if people have a greater ability to pay, then they should pay more.

And a progressive tax system, they claim, can counteract the regressive nature of sales taxes, easing the impact of taxes on your rent or groceries, while hitting you harder in your ability to take vacations or buy luxury goods.

And while nobody loves paying taxes, the average US tax-payer actually pays less than almost any other developed nation.

Compared to, say Belgium, we get off pretty easy.

Their lowest tax-bracket is 25%, and the highest is 50% for anything over 38,080 Euros!

Do you feel our progressive tax-system encourages laziness?

Does it discourage people from earning more money?

Or is it giving a leg-up to people with lower salaries?

Whatever your opinion, now that you understand the mechanics of marginal brackets and progressive taxation, you’ll be in a much better place to argue about it over your next Thanksgiving dinner.

Or in the comments section.

And that’s our two cents!