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.”
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