Welcome to WCS Money Tutorials. Today’s topic is tax brackets.
How tax brackets work and why they exist. In most countries, most of the country’s wealth is
held by the top 10% of wealthiest people, usually more than 50% of the total national wealth.
Wealthier people can more easily afford to pay taxes, since they have much more
money than what they need to live. By contrast, poor people need all the
money they receive simply to live, so even low taxes can be extremely burdensome.
Therefore, it makes sense to assess higher tax rates on the wealthy.
But what is the best way to do that? It is well known in economics that the
marginal utility of money declines with increasing wealth. Because the value of
each additional dollar of income is worth much less for a wealthy person than for a poor person,
wealthy people can be taxed at higher rates without decreasing their standard of living.
There are number of ways to assess taxes. Flat taxes are a fixed amount and do
not depend on income or transaction values, such as a $10 per capita tax.
Other types of taxes depend on the tax rate and a tax base,
the amount subject to the tax rate. Proportional taxes, also called flat-rate
taxes, apply the same tax rate to any income level or for any size tax base.
A progressive tax applies a higher tax rate to higher incomes.
Most progressive taxes are structured as a marginal tax, meaning that the progressive
tax rate is actually a series of tax rates that apply to different ranges of income.
A tax bracket is a range of income to which a particular tax rate applies.
A regressive tax is either higher or is a greater burden at lower incomes. The most
prominent regressive tax is the Social Security tax because the tax drops to 0,
when earned income exceeds the Social Security wage base limit, which was $147,000 for 2022.
But even flat taxes and proportional taxes can be regressive. Even though flat taxes are the
same for everyone, they represent a higher percentage of the poor person’s income.
Even though proportional taxes apply the same rate for everyone, poor people need
all of their money to live, so even taking a small percentage lowers their standard of living.
For instance, taking 10% of someone who earns
$20,000 annually makes it difficult for them to live, but taking 10% of someone
who makes $1 million annually will not lower their standard of living, even though the tax
revenue from the rich person is $100,000 while the tax revenue from the poor person is only $2000.
A progressive proportional tax would also be unfair if the tax rate applied to
all of the taxpayer’s income since people making slightly more money may pay a lot
more in taxes than someone who made only a little bit less, as shown in this example.
A tax bracket is the range of income to which a particular tax rate applies.
Tax brackets ensure that people who are earning more money will take home
more pay since higher tax rates only apply to higher ranges of income. So if Sally earns $60,000
and the tax rate on the 1st $50,000 is 10% and the tax rate on income exceeding that amount is 20%,
then Sally only has to pay 10% of $50,000 + 20% of $10,000 for a total tax of $7000.
These are the 2021 and 2022 tax brackets on income earned from work
and from short-term investments. The upper tax brackets may seem a little high,
but the real tax burden on richer people is actually much less than what would
be suggested by these marginal tax rates. Tax brackets only apply to taxable income.
Because of tax deductions and excluded income and lower tax rates on investment income,
someone in a high tax bracket may actually have a very low tax burden compared to someone who
receives all their income by working for it. This is a list of income that is excluded from
taxation. Notice that many of these exclusions apply to income that accrues mostly to the
wealthy, which means that their tax burden is not nearly as burdensome as would be suggested
by the top tax rates, depending on how much of this type of income they receive.
Tax brackets on long-term capital gains and on qualified dividends are wider and lower.
The capital gains tax is easier to calculate since you simply add the 15% tax to the 20% tax.
This example shows how applying tax brackets only to taxable income reduces the tax burden
to less than what would be implied by the tax rate.
In 2022, the top of the 0% capital gains rate for a married couple filing jointly was $83,350,
but they can actually earn up to $109,250 and still get the 0% rate,
because the tax bracket only applies after the standard deduction is subtracted from income.
So the true tax burden is much less than what would be suggested
by the tax rate percentage of the top tax bracket.
The effective tax rate is a better measure of the tax burden
because it simply divides the total taxes paid by the total income received by the taxpayer.
However, the effective tax rate does not account for the higher marginal
utility of money for lower income people. As you can see from this graph, the effective
tax rate approaches, but never equals, the top marginal tax rate as taxable income increases.
However, taxpayers who receive a lot of nontaxable income can actually have a very high income but
a much lower effective tax rate. For instance, a beneficiary could
inherit $1 billion and would not have to pay a single penny in federal taxes.
Although there is an estate tax, there is no tax on the income received by beneficiaries.
So they have a tax rate of 0% on their inheritance regardless of how much they receive,
and their inheritance will not increase the tax rates on any other income they receive.
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