Taxes — November 20, 2012 at 12:29 pm

Do YOU understand how tax brackets work???


A tax primer for everyone

Note: This is a repost of a Daily Kos diary I published about a year and a half ago. I was inspired to repost it by the current story about a business owner who’s afraid to earn more than $250,000 because she thinks she’ll lose money by doing so.

When I reposted it last night over at Daily Kos, it hit the Rec list and the poll received over 500 responses. According to those results, 23% of Daily Kos readers didn’t understand how tax brackets worked before reading the diary.

Think about that — this is a pretty highly-educated, policy-savvy, math-and-science-aware, reality-based community overall, and almost a quarter of them weren’t/aren’t aware of one of the most basic tenets of the tax code.

Please understand that I’m not pointing this out to embarrass anyone. There are plenty of subjects that I don’t know much about myself. However, it does point out one of the core problems when it comes to having a serious discussion about tax “fairness”.

Basically, a HUGE part of the problem with trying to have any rational discussion about tax policy is that there is a huge number of people who don’t have a basic understanding of what “marginal tax rates” are.

To put it simply, there’s a whole lot of people out there, including some who are very intelligent and/or successful professional types, who believe that if their income nudges them over into the next-higher tax bracket by even $1.00, that this somehow means that the *entire* amount they owe in taxes goes up to that percentage.

This problem is disturbingly widespread. It’s not just Republicans/right-wingers/Tea Party people; there are a lot of Democrats/progressives/other left-leaning folks who apparently don’t “grok” the concept either.

With that in mind — and at the risk of sounding patronizing — here’s a very basic demonstration of the problem and the reality:

Here’s a modified version of the current Federal Income Tax Brackets (I’ve rounded off the numbers to make it easier to follow):

Taxable Income / Tax Rate
$0 – $10,000 / 10%
$10,000 – $30,000 / 15%
$30,000 – $80,000 / 25%
$80,000 – $200,000 / 28%
$200,000 – $400,000 / 33%
More than $400,000 / 35%

So, let’s suppose that someone made $80,000 (taxable) last year, but makes $80,001 (taxable) this year.

It’s VERY important to remember the taxable part–this person may have grossed $100,000 but had $20,000 in deductions right off the bat, leaving them with $80,000 in taxable income.

OK, so again, they had $80,000 in taxable income last year, and $80,001 in taxable income this year.

The folks I’m talking about THINK that they paid 25% in taxes last year ($20,000), and they THINK that this year, because they made $1 more (pushing them into the 28% tax bracket) that they’re going to owe 28% on everything ($22,400).

That is, they *think* that they owe an extra $2,400 in taxes even though they only made $1 more in income, and therefore are going to *lose* $2,399.

However, they’re wrong about both what they owed last year AND what they’ll owe this year.

Last year, they owed:

10% on the first $10,000 = $1,000
15% on the next $20,000 = $3,000
25% on the next $50,000 = $12,500
= a grand total of $16,500

…as opposed to the $20,000 that they thought they owed.

This year, they’ll owe:

10% on the first $10,000 = $1,000
15% on the next $20,000 = $3,000
25% on the next $50,000 = $12,500
28% on the next $1 = $0.28

= a grand total of $16,500.28

…or just $0.28 more than last year, not $2,400 more, and certainly not the $22,400 they thought they owed.

The same holds true at every level: You’re only paying the higher rate on any income ABOVE the threshold in question, not on EVERYTHING.

So, to summarize:

They THOUGHT that they paid 25% last year. In reality, their effective tax rate was 16.5%.

They THINK that they’ll have to pay 28% this year. In reality, their effective tax rate would be…again, 16.5%.

Hope this helps some folks when talking to others, and hope I didn’t come off as a dick in doing so…

Addition: As someone in the dKos comments pointed out:

For those people who don’t understand this, but aren’t really affected by the marginal tax rate, you’re not stupid, not dumb. Not anymore than I’m dumb for not knowing how to fix an automatic transmission. We all have our knowledge base, borne of experience.

But people who presume to speak as experts about business, who fail to understand something as relatively simple as marginal tax rates? That’s like a farmer screaming at the president about dairy policy by talking about how the milk from the chickens he raises is taxed too much…