I’ve been telling you that understanding taxes is really quite simple. Except when it’s not. One of the biggest misunderstandings about tax policy is how progressive taxes work. Progressive income taxation is commonly thought of as the more you make, the more you pay — as in Sam pays 10% of earnings in taxes because he makes \$20,000, but Sally pays 20% in taxes because she makes \$50,000. Well, it’s a little more complicated than that.

Taxes are like a tiered cake.

Our federal income tax system uses graduated marginal rates. This is how to think about it: Imagine each dollar that you earn is stacked one on top of the other. Next, picture a large wedding cake next to the stack of dollar bills. Each tier of the cake (called the tax bracket) has a corresponding tax rate that increases as you go up each tier. So in the example pictured, the bottom tier is 0%, the next tier 10%, the next 15%, and so on. (Note that this picture is based on information from 2008. The 2010 tax brackets are listed at the bottom of this post.)

When you calculate your taxes, the first part of your stack of bills (dollars \$1-\$7,200) gets taxed at 0%. The next part (dollars \$7,201 to \$14,200) gets taxed at 10%. The next part (dollars \$14,201 to \$33,450) gets taxed at 15% and so on. You only incur the higher tax rate if your stack of bills reaches that layer. After the taxes on the various layers are tallied, the percentage of your income that actually goes to tax is called your effective rate. Notice how “fair” is defined in this system — everyone gets the first \$7,200 of their income exempt from taxes. The same dollars are subject to the same tax.

Is it progressive?

There are at least three general ways to make an income tax progressive (by progressive I mean that it reduces inequality, see definition in this blog post). One is to increase the rates. That’s what most people think of when we say “we are raising taxes.” Another is to change the tax brackets. For example, we could increase the dollars subject to 0% tax from \$7,200 to \$10,000 (as well as make various changes in the other tax brackets).

Notice the top layer of cake. This is commonly referred to as the top rate. In 2008, if someone made \$300,000, the \$4,450 she made in that tax bracket is subject to the 35% rate (\$300,000 minus \$295,550 — remember it only applies to the dollars in that bracket) — the same tax rate as someone who makes \$2 million. In other words, our federal income tax is graduated at the lower end of the scale, but doesn’t differentiate at all between high earners and the mega-earnings of CEOs. It starts progressive, but then goes flat.

The third way is to increase the number of brackets. The Tax Reform Act of 1986 enacted by Ronald Reagan’s administration collapsed our income tax brackets from fifteen to four, with the top rate being 28% (in the 1950′s the top rate was 91%). Let me state that again — it went from fifteen brackets to four! Obviously, this legislation had the effect of making our tax system more regressive than it had been previously. There are lots of ways to play with these three options in combinations to come up with a very finely tuned definition of “fair” with regard to taxes.

How much is enough?

Much of debate about taxes focuses on the tax rates, less on the brackets, and nearly nothing on the top rate — largely because of our economy’s assumption of scarcity (and because it requires some explaining). If we assume that more is better and that we can never really have enough, then we are focused on tax rates to help us answer the question, “How much of what I earn do I get to keep?”

But what happens if we shift our focus to this question: how much is enough for a person to earn? What does a person need to thrive — and among those things, how much does he or she need to earn to do that? These are the questions that start from sufficiency, discovering and exploring the place of enough and enough for whom. Answering these questions helps us think about what constitutes a life worth living, what is basic and essential, and what is reserved for the “deserving” if we believe in such a thing. The answers to “enough for whom” start to reveal how we think about other people — our judgments, assumptions and prejudices about them. We can start to observe how we think of others and whom we consider deserving of what.

So, how many brackets do you think our tax system should have? What would your top rate be and where would it start? Where do you think we can say as a society to an individual, “You have enough, and now it’s time to share the wealth.”

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Note: The picture uses 2008 tax brackets and was easier to use than trying to draw my own cake. Here are the tax brackets for 2010:

Single Filing Status 2010 [Tax Rate Schedule X, Internal Revenue Code section 1(c)]

• 10% on income between \$0 and \$8,375
• 15% on the income between \$8,375 and \$34,000
• 25% on the income between \$34,000 and \$82,400
• 28% on the income between \$82,400 and \$171,850
• 33% on the income between \$171,850 and \$373,650
• 35% on the income over \$373,650

Married Filing Jointly 2010 [Tax Rate Schedule Y-1, Internal Revenue Code section 1(a)]

• 10% on the income between \$0 and \$16,750
• 15% on the income between \$16,750 and \$68,000
• 25% on the income between \$68,000 and \$137,300
• 28% on the income between \$137,300 and \$209,250
• 33% on the income between \$209,250 and \$373,650
• 35% on the income over \$373,650

• Pete Manzo

Kimberly,

Thanks for this excellent post. People often do forget the layer cake structure, which means they discount that even if the upper income tax cuts from 2001 were to expire, people earning over \$250,000 still would receive about a \$6000-7000 reduction on the income from their first dollar to the 250,000th, so they would receive at least as much of a benefit in absolute dollar terms as lower income people.

In addition to keeping the stepped nature of income taxes in mind, to take the most balanced view, we also need to keep in mind the total tax burden, as I’m sure you know. That means not just looking at income taxes, but all taxes – payroll, sales taxes, state taxes and more – as a percentage of each person’s total revenue. My recollection is that when we take that view, we find that the bottom 20% of earners pay about the same percentage of their revenue as the multi-millionaires at the top. ((I think David Cay Johnston (sp?) had a chart showing top and bottom quintiles paid about 17% of total income in taxes, while the middle quintiles paid about 15% and 16%. Viewed that way, we already essentially have a flat tax.) It’s just that the income tax makes a larger share of total tax for wealthy people, and payroll and sales tax make a higher share for lower income folks.

Keeping that holistic view also will help us avoid the false logic behind, for example, saying that because the top 1% of earners pay 38% of total income tax dollars collected, that they are paying more than their fair share. They take in almost the same share or more of total income, and again, their total tax burden, when all taxes are figured in, typically is same as lower income people.

Thanks for all your hard work on this blog.

• YT

I have always felt like the taxes issue was just too complicated for me to even begin to understand. Thank you for helping to simplify it. Looking forward to reading your other posts (will read back from this point as I see there are earlier tax-related posts).

• Anonymous

Hi Kim. Great explanation. I wish all tax discussions would use effective tax rate since it removes all the politicization. I think one thing that would also help people to understand the nuance is why it is designed this way. If you didnt break tax rates into tiers, you’d have a scenario where moving up to a higher tax bracket might actually cost you money. For example, say the tax brackets were 20% for under \$100,000 and 30% for \$100,000 and above (using easy numbers to make a point) and that they were applied equally to your entire income. If you made \$90,000, you’d owe \$18,000 in taxes leaving you with a net \$72,000. But if you got a \$10,000 raise to \$100,000, then you’d owe \$30,000 in taxes, for a net \$70,000, ie, you’d make less money because you made more. I know there are people who still believe this is how it works. Essentially we need to have a tiered system (or something similar) in order to avoid that situation.

The questions you ask in your last paragraph are interesting. The fact that we have a progressive tax system obviously does imply that we have the belief that one’s financial burden for supporting society should increase with one’s wealth. This even extends past taxpayers and applies to states as well (for example, there are states that raise less federal income tax revenue than they consume in services. Obviously, there are others that create a surplus, at least relatively speaking–when there is deficit spending we probably never have any actual surplus states.) But I think the question of whether some people can simply have too much for fairness’ sake is a tricky one. It is one thing to ask for funding for running society (ie government), and perhaps quite a different thing to ask for funding to ‘equalize wealth’. Obviously, there are some people who believe those are the same thing, but others who believe they are distinct (and those people probably believe the latter to be immoral), and probably a bunch of people somewhere in between. There are a lot of people who believe we should place a limit on how much CEOs can make relative to their workers. But that is different than redistributing their wealth after the fact via taxes. And things are even more complicated by the fact that many CEOs are paid more via stock options than via salary (read taxed at dividend and capital gains rates instead of at income tax rates, ie, just discussing tax rates is not enough to answer the question given that there are alternatives to work around higher income tax rate burdens).

Personally, I think we are going to need to have a public debate about these issues because we are getting to the point where essentially no one wants to fund government even though many people believe in the services. Even worse, we are starting to see arguments that de-funding education is as benign as de-funding infrastructure or similar even though we know kids’ minds have a relatively short window of opportunity for development. This may involve a discussion about what it means for an economic system to be sustainable. One can argue all day long about how and where to cut and trim as a goal to ‘sustainability’, but if in the long run that ends up costing you exponentially more in prisons and law enforcement and entitlements, have you really achieved sustainability?