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: