In this video we will learn about progressive income tax.
By the end of the video you should understand what a progressive income tax system is and
how it operates.
Progressive taxation simply means that as income rises, so does the proportion of that
income that is paid in taxes.
This strategy is pursued by governments to reduce income inequality.
The government revenue generated from higher income earners may be used to support benefits
and income support for those with lower incomes.
So, how does it work?
A progressive tax system operates with increasingly higher marginal tax rates as income increases.
Many people mistakenly believe as you cross over income threshholds your entire salary
is taxed at the new percentage.
That is incorrect.
The portion of your salary in a specific bracket is taxed according to the corresponding marginal
tax rate.
I’ll explain this through the table.
For someone earning less than $15,000 there is no tax owed.
But if you earn over $15,000 then anything up that point will not be taxed.
So the quick calculation of the tax owed on this bracket is $0.
For the second bracket from $15,001 to $50,000 the marginal rate of tax is 15% meaning any
income you earn in this range is taxed at that rate.
If you earn more than $50,000 then the tax you owe on this portion of your income is
equal to 15% of the difference between $50,000 and $15,001.
That’s approximately $5,249.85.
Similarly for the third bracket from $50,001 to $100,000, the marginal rate of tax is 25%
meaning any income you earn in this range is taxed at that rate.
If you earn more than $100,000 then the tax you owe on this portion of your income is
equal to 25% of the difference between $100,000 and $50,001.
That’s approximately $12,499.75.
Now, the fourth and final bracket consists of all income above $100,000.
Since there’s no upper bound we cannot calculate a quick calculation.
All income above this point is taxed at 35%.
To illustrate this, let’s look at an example.
Consider the case of two sisters, Carol and Michelle.
Carol is a software engineer and earns $125,000 a year.
Michelle earns $75,000 as an accountant.
How much tax would they pay?
Let’s calculate it.
If you think you can handle this on your own, pause the video and give it a try.
Otherwise, follow along with my explanation.
Carol earns $125,000.
At the first rate of tax, she pays nothing.
At the second and third level, we can just add the quick calculation.
However, at the 35% bracket we need to calculate her tax owed.
In this case 35% of the amount over $100,001 is equal to approximately $8,749.75.
When we add that all together we see her total tax owed is $26,499.25.
But we’re not finished yet.
Her total tax due is $26,499.25.
We also need to determine her marginal tax rate and average tax rate.
The marginal tax rate is easy.
It’s equal to the highest tax percentage she pays, which is 35% in this case.
Her average tax rate is a little more complicated.
We need to divide her total tax paid by her income which equals approximately 21.2%.
If you’re feeling more confident now, try to calculate for Michelle.
If not, follow along.
Michelle pays $0 in tax for the first bracket and pays the full amount of tax in the second
bracket, $5249.85.
She ends up in the 25% marginal tax bracket and pays $6,249.75 in taxes for that level.
As her income never exceeds $100,000 she is not paying any further taxes.
Totalling her taxes for the 15% bracket and 25% bracket, her total tax due is $11,499.60.
Now let’s calculate her marginal and average rates of taxation.
The highest rate of tax Michelle hit was 25%, so that’s her marginal rate of taxation.
Her average rate of tax is equal to her total tax due divided by her income giving us an
average rate of tax of 15.33%.
As a percentage of her income and marginally, Michelle is paying proportionately less than
her sister Carol.
Hence, the progressive tax system.
By now you should understand what the progressive tax system is and how it operates.
If you have any questions or comments, leave them below and let’s see if the community
can answer them.
That’s us done for now and I’ll see you in the next one!