How Marginal Tax Rates Work

Well although philosophically I feel that the children of these lower income people should find relief through private charity and not governmental handouts, I could probably live with the fact that people get free stuff for their kids if they weren’t also getting a $4000 annual boost in their income. If you make $24000 a year, an extra four grand is almost a 17% raise.

The problem is that people like us stuck in these type jobs can’t really get a 17% raise through conventional means of working harder at that same job, so instead these people focus their efforts on using the tax system to siphon more money off people who earn more.

I just think we’re better off leaving people in my spot better incentives to learn things that pay more, which creates more value in society. Say one day I accomplish my goal of becoming a CPA and move out of this low end bracket. Everyone wins: there’s now a valuable CPA and the cost of those services goes down, I make more money, and the wages of the people who can’t leave these retail jobs goes up as there’s now fewer available workers.

Granted a CPA entry level job starts at about 40k a year so maybe that was a bad example, someone else stuck in this situation may only be capable of doing something that pays another 4 thousand a year or so. But why try any harder when the government just gives you more and more of a backdoor welfare payment via income tax every year?

And no, my coworker aren’t bad or dumb or evil, but I feel this whole scheme does them a disservice.

To me letting them solve their own problems, well that’s better than giving them other people’s money.

It seems that all media sources who talk about personal finance, blogs included, should educate themselves about concepts like marginal tax rates before giving advice on things like investing, saving, or spending. Don’t you agree?

Jim said exactly what I was going to. Don’t forget all the “other” taxes we have to pay in addition to income tax.

It’s not fair, but no system is.

Snowballer – good luck on your goal of becoming a CPA. I’ve been one for 5 years and it’s a good field to be in.

rugman11 (comment #44) – as I understand the proposal, it would cap those deductions at 28% for earners currently in any bracket above 28%. That means going from 249,999 to 250,000 in income would make no difference in how much of a deduction you would get for charitable donations.

Jim,

The SS security tax I agree is regressive in the fact that the amount of income taxed is limited. There is the tier that pays the tax and the tier that doesn’t, though I doubt that will be the case for long.

Other than that it seemed to me that determining a progressive vs regressive tax by how much discretionary or total income one has is dishonest. Words mean things and regressive means percentage of that marginal dollar goes down as total goes up. That’s the definition used by economists and tax professionals as far as I know.

As far as my lottery *tax* comment, I consider it a tax because the government collects the money and it goes to pay for things that taxes might otherwise pay for, and it is a fact that poor people buy more lottery tickets than rich people. They pay not only a higher percentage of their income, but also the total collected. It fits the definition of a regressive tax (though it is a voluntary tax). Lottery tickets are a bad math tax, and poor people are more likely to have bad math skills.

As far as sales tax, I never said it wasn’t a bigger burden for poor people. If a low income person and a high income person both spent the same amount it would be a regressive tax, but as a general rule that isn’t the case. And that is the argument for why basic needs (like food) aren’t typically subject to sales tax. It may be slightly regressive, but you can’t spend money you don’t have (at least not for long). And I was questioning the statement that high income people don’t spend if they have more money. That argument doesn’t hold water at all with the observed tendency of most of us to lifestyle inflation.

Finally regarding the gas tax: If a low income person doesn’t have the money they shouldn’t have a car. Though it limits ones options in life there are plenty of people who forgo the expense, or who get by with a single vehicle for their household. However I considered it a flat tax like the sales tax for the same reason: If you don’t have money you are more likely to drive an economical car that uses less fuel for the same number of miles, hence keeping spending in line with your income.

Generally as your income goes up your consumption goes up. And I know there are special cases. There are people who have to drive long miles and burn ridiculous amounts of fuel though they are poor. I am speaking in generalities as tax law based on special cases doesn’t make for very good law. There are people who read this site who live as though they have significantly lower income than they do and therefore pay a much lower percentage of their income in consumption taxes, just as their are low income people who spend more than they make and pay a very high percentage in consumption tax.

But my original point and questions still stand. What taxes have been reduced on the poor in the 20th century that resulted in a boom in the economy (because they typically have very low tax burden so a reduction in tax doesn’t mean a whole lot more money being spent)? And isn’t the call to spend money to circulate through and provide jobs and the trickle down effect pretty much the same thing?

The simplest thing to do is figure out how much tax will be saved from your mortgage interest (easiest if you aren’t borderline between two tax brackets) subtracting the standard deduction from your annual mortgage interest (which is a shrinking number) and multiplying it by the tax rate of your income bracket. Then divide that savings by your interest total and multiply that by your original APR. This is now your effective mortgage interest rate. Compare that to alternate investments. If you save enough in taxes and have a low interest rate such that you only pay 4% effective mortgage interest and can make more than 4% net profit -after taxes- elsewhere (determining that is a lot harder), don’t pay off your mortgage early. OK that doesn’t sound EASY but it is basic math and if you write it all down and put the numbers in the right place, you can decide what’s best for you.

“We are currently in a real estate market with very low prices and mortgage rates at all time historical lows. How many times during ones’ life does this happen?”

Some CA real estate valuations may have fallen 30% or so, but they still are up hugely above the inflation rate since 2000 (+60% ?). There aren’t many places on the coasts where one could reasonably suggest that housing prices are “low” yet, just lower than the former rediculous heights.

Better to wait until interest rates go UP (and downpayments are required). At that point, you will see what “low” housing prices look like, because they will then be firmly tied to incomes, rather than to how much of someone elses money you can convince a shady mortgage broker to lend “justified” by his crooked appraiser.

Principal is “forever” (well, 15 to 30 years at least), while interest rates are cyclic.

I don’t know why people in the $250k crowd are whining about a couple of percentage points. Historically, they should still be very, very, very happy. Keep in mind that top marginal tax rates were at over 90% during years past and as recently as the 1980s, 50% was the norm. Be thankful that tax rates are historically low and if you’re smart about managing your tax situation, the impact should be minimal. For example, if you get paid $1 million this year and have access to a non-qualified deferred compensation plan, you can defer the last $750,000 of income and still be at the $250k. For business owners, this gets even easier…but I digress. On the historical scale, this tax increase is like going from a 5% mortgage rate to 5.125%. Big deal.

@Jim / #54

“Gasoline taxes take a much higher % of the income of poor people compared to rich. Please don’t argue that driving is proportional to income.”

Even though it’s true?

You would prefer we ignore the fact that not only do rich people tend to drive MORE (having jobs to go to and taking vacations – keeping in mind airline fuel is also taxed, and tacked on to your ticket price), they also drive BIGGER vehicles that require more gas? Truly poor people don’t drive at all. They often don’t have jobs. Even if they do, they can’t afford a car, so they walk or take the bus. Thus, they pay no gas tax at all.

So why were we supposed to give you that point for free, without “arguing?”

Thanks for the explanation of this strange issue. While people who aren’t math-challenged may think all this is “simple math,” I sure don’t. It’s inexcusably complicated. How did our tax system get to be so convoluted? And shouldn’t it be simplified, so each person can do his or her own tax return without having to hire a professional to get it right?

Gee, I’m sorry about the poor guy (41) who has to scrape by on $100,000 after taxes. Life is rough, eh? Maybe he’d like to try to get by on my after-tax income of around $34,000, or the $24,000 I will be trying to live on after I retire or get laid off.

I live in a state adjacent to California. While most of our housing prices never bloated as much as they did on the Coast (some did: my housing value tripled during the bubble, and it’s still possible to buy houses in the million-dollar range within walking distance of my very ordinary home), other costs are comparable to California’s. Our sales taxes are almost 10%. Our gas rose to around $4/gallon in the late fuel inflation. Our electricity costs are among the highest in the nation–partly because our rates support a nuclear reactor that supplies power to California. Our water bills would take your breath away. Food is no cheaper here than in California, and we have neither the choice nor the quality that Californians have. Our public schools are laughable — in university classrooms, I’ve heard the products of those schools say that Wisconsin is a Rocky Mountain State, that all black children are by definition “children at risk,” and that World War I was the only thing of note that happened during the 19th century. Please: let me struggle along on a hundred grand in San Francisco or Santa Barbara…somehow I think I could make do.

As for Shara’s remark (59), “If a low income person doesn’t have the money they shouldn’t have a car. Though it limits ones options in life…” In a city that has no viable public transportation — which describes most cities in the United States — one of the options it limits out of existence is the option of going to work at all. I drive 18 miles one-way (36 miles a day) for the privilege of earning enough to fork over $18,806 in taxes. That’s not considered an especially long commute here. To get to work, you have no other reasonable option than to drive. I tried the bus: two hours going and two and a half hours coming back, in a conveyance so rickety it delivered a ride way too rough for commuters to do any work or even to read a book. Do you really think a 4 1/2-hour commute to cover 36 miles makes sense?

Well, among the many things that don’t make sense in our lives, the tax system ranks among the foremost. The whole lash-up needs an overhaul!

“I know PhDs who lived on ramen for years, MDs who slept only a handful of hours while as residents, engineers who worked in some of the harshest conditions, and small business owners who worked out of their cars hauling other people’s poop (clogged sewer lines are a bitch, but someone has to clear them).”

Spare me. Not one of them would trade places with a farm worker who has worked all their life just as hard and gets paid a lot less. And that farm worker produces a lot more value than most of the investment bankers and mortgage brokers of the world.

There is a HUGE difference between a “rich” person who doesn’t have to work or is traveling on their company’s dime while screwing over the common workers and a working couple in an area with a high standard of living (such as NYC or other metro areas) who are making $250k combined. Making 6 figures does not make you rich, it makes you middle class in much of the country. Maybe not in the middle of nowhere where you can buy a house for $100g, but in the urban parts where $400g barely gets you a starter home, that extra taxes you pay hurts, especially since you have lost a lot of the tax deductions that lower income people take for granted. The tax hikes hurt people in areas where the cost of the standard of living is high and helps people where the standard of living is cheap.

And anyone can be a farmer. Doctors and lawyers put in the time to learn a skill that the farmer cannot do. Sure, the farmer works hard, but a premium is paid for SKILLS that are needed. If you have no skills, or skills that no one has a use for and therefore aren’t willing to pay for, then do not complain that you are getting a low wage.

And no, I’m not making anywhere near that much money, and I’m not someone with an advanced degree.

“And anyone can be a farmer.”

Well, no they can’t. As any number of well-educated hobby farmers have discovered. But I was talking about farm workers.

“Sure, the farmer works hard, but a premium is paid for SKILLS that are needed.”

Which has nothing to do with how hard they work or have worked. It mostly has to do with the opportunities they had.

Anyone who is in the United States ought to understand their standard of living is based more on the country they live in than their own skills or effort.

“in the urban parts where $400g barely gets you a starter home, that extra taxes you pay hurts, especially since you have lost a lot of the tax deductions that lower income people take for granted”

What deductions are those? The fact is that most “lower income people” are not eligible for many deductions that wealthy people take for granted. When their retirement accounts went south last fall they had no ability to write off the losses the way those with investments could.

$400,000 is well above the median home price in all but a handful of markets. And where it isn’t, the folks making $250,000 are getting compensated accordingly. That is often not true for the folks with a median income in those same cities.

“So now hopefully you realize that the virtually all of us are nowhere near paying our fair share and the country is really being propped up on the backs of the very richest.”

That simply is not true. You are taking the entire federal budget and pretending the only revenue is from the income tax.

If my wife and I only had to pay $14000 in federal taxes we would be deliriously happy. Just to be clear – that is 25% of $56,000. And social security taxes alone are over 6% – 13% if you include our employer’s portions. Then there is the gas and other excise taxes we pay directly on the products we buy. And there is the corporate income tax and excise taxes that get included in the price of things we buy. Only the income tax collects more from the rich than others and that accounts for less than half of federal revenue.

And when you look at the state level you see an even more pronounced pattern with regressive sales and property taxes as the primary source of revenue.

If you want to argue everyone should pay the same amount, perhaps you can explain why an infant should pay the same share as a wealthy adult. It ought to be clear rich people get more benefits out of government. They benefit more from living in United States. They have a bigger stake in the country. They place a larger burden on government – demanding more services to support their wealth.They ought to pay more, the same way someone with an expensive car or home has to pay higher insurance.

I just want to note that the self employment tax is only 2.9% (medicare) after the cap of 94k. Self employment tax like regular social security is capped.

I’m personally less concerned with the tax rates. I generally support what the changes are trying to do. For instance I do not believe mortgage interest should be deductible at all. Why reward people for buying too much house? The bigger problem is the growing complexity of th tax code. The whole thing needs to be torn down and rebuilt.

@Ross Williams
“It ought to be clear rich people get more benefits out of government. They benefit more from living in United States. They have a bigger stake in the country. They place a larger burden on government – demanding more services to support their wealth.”

The rich don’t get “more benefits out of the government” or “place burdens” on it. What you mean is that the rich have “made the most of a capitalist economic system and a republic that values liberty”.

If the government were the source of liberty, I’d agree we should pay it royalties on its patented idea in proportion to how much we benefit. But the government is not the source, it is the guardian.

Mr. Obama was stated that US Constitution is deficient because does not list many things that the government should do, only things that it should not do. He misses the point. The GENIUS of the Constitution is that it IS a list of things the government should not do!

What an interesting discussion. Two points call out for a response:

Don @ 30: Normally our income falls in the 15% marginal bracket because we make between $16050 and $65100 of taxable income.

Effectively, in the region where our AGI is between $44000-50700.48 our Federal marginal tax rate is (15 + 0.85*15)% = 27.75%.

Don, this is a thought-provoking example–specifically because the case you’re talking about is (presumably Social Security) disability income.

You’re basically taking the side of people who don’t want to pay more taxes, even though a substantial portion of your own family’s income derives from the social safety net that is funded from those taxpayer dollars. Interesting.

I would guess that the rationale behind this kind of phased treatement of disability income is because it’s meant to keep people out of dire poverty. And when you’re talking a family that’s at about the median household income for the US (which is in the neighborhood of $45K), that’s not dire poverty.

If you can see the justification for people to want to lower their tax bill by working less, perhaps you can understand why it makes sense for the federal government (i.e., the taxpayers) to recoup some of that disability income when it doesn’t meet the means test.

I am NOT knocking SSI disability, by the way–my mother is supported by it and it is literally a life saver. I’m just sort of bemused that someone who is funded by “the system” is knocking “the system”. It sure seems like cutting off your nose to spite your face.

Secondly, Tyler at 41, your post was quite eloquent and your frustration is evident. But when I was reading it, I was again reminded that people are wired to be much more aware of what they DON’T have than what they DO have.

If you’re making $142K and paying $42K a year–and because you don’t mention spouse or offspring, which significantly impact finances and taxes–I assume that you must be single with no kids. And dude, if you’re a single person clearing $100K a year after taxes, you are truly in the elite of the wealthiest people on earth. I am not making this up. It’s a lot easier to be aware of what you don’t have (a $500K house) than what you do.

My suggestion to you is to travel. Specifically, take some time in some developing countries and get a good sense of exactly what your citizenship in America buys you.

Even spending a little time in places where there is no sewer system or electricity, where little kids beg on the street (think about that–think about all the implications of that, what effects that must have all their lives, no school, probably no literacy), where civil engineering is so far behind that one good rain shower shuts down the main highway for a full day, where health care is rudimentary…it is bound to have a huge impact.

It will put into sharp relief exactly what you’re “buying” with your tax dollars. Maybe you could even take it as far as Warren Buffett does, and realize that it wouldn’t be possible for you to be where you are today without the baseline standard of living (sanitation, education, transportation, etc, etc, etc) that the US has enjoyed for a long time.

Even if you personally have come a long way from an impoverished background, the society around you–that has built the structures that lets you succeed now–rest on the contributions of those who came before.

Would you really have it another way?

Finally: Tyler, if you’re making $142K/year, by traditional lending standards you’d still be able to afford a $500K house, or damn close to it. (A loan 3X income plus a 10 or 20% down payment would get you there.) Last–do you really think that $500K houses would stay at that price point if magically all taxes went away?

“Sure nobody actually loses money by working more, but doesn’t the return eventually get low enough to make it not worth the effort?”

If $25/hour is not worth the effort then how do you get anyone to work for minimum wage?

“he gets to keep 65 cents of it. Maybe he only gets to keep 45 cents of each dollar after that”

Maybe not. If you look above, the highest bracket is 35%. The next lowest is 33%, so the actual difference is between 67 cents and 65 cents. Or, in the case of our attorney, $67 net versus $65 for a little less than an hour’s work.

I think the idea that tax brackets have any real impact on people’s willingness to work is mostly imaginary. Its based on that common misunderstanding of marginal tax rates.

“You really think someone who makes $100/hr would be enticed to work more for minimum wage?”

I thought we were talking about someone who was only making $45/hour after taxes.

And that is not entirely a quip. The reality is that what people get paid anticipates, to some extent, their tax bill. Because they are competing for jobs with people who will be paying the same taxes.

That lawyer sets the number of hours he will work and then bills his clients at the highest rate he can to maximize his income. If his taxes were lower, he might lower his price. He might also choose to work less. It is highly doubtful he would decide to work more.

“Until you reach that point, however, it’s an individual choice as to whether the increased work is worth the additional money; even with a marginal tax rate of 99%, there might be people who feel earning an extra $100 to keep an extra dollar is worthwhile.”

I think this misses the point to some extent. The question is whether making a $1 is worth the effort. It doesn’t really matter whether you get paid $1 per hour and get to keep 100% of it or get paid $100 per hour and get to keep only 1%.

The only way moving into the top tax bracket would matter is if you think its worth working at $134/hour but not at $130/hour. That being the difference in taxes for someone making $200/hour, which is close to what you have to be making to reach that top bracket.

“John decides that an hour of his time is worth $20, and thus turns down the overtime and spends the weekend with his family.
-Ted calculates that his time is worth $15 an hour, and leaps at the chance to work the overtime.”

That isn’t the question here. The question is whether that extra $2 would have changed John’s calculation.

The consequences, if that $2 makes a difference, is that there is more work for Ted. Of course, if he really needs John, the employer will simply raise the pay offer by to $34 and John will jump to it because he would be making his $20.

BTW – why does this employer think either one of these guys is going to do extra work for only $30/hour? He must be paying them close to $200/hour for their regular work in order for them to be in the imaginary 40% tax bracket.

The actual top bracket is 35% which means these guys would be taking home $19.50. And if they were in the next lowest bracket it would be 20.10. So the actual difference is $.60 per hour. I think you hit it on the head when you said the cost of gas. That and parking are going to be bigger economic factors than the tax rate.

@ Ross: This is the trouble with coming up with examples off the top of my head; I have a tendency to come up numbers that make no sense. I was just using round numbers for the hourly wage and the tax bracket, to make the math simple. You can either tack on an extra zero to that figure (for $300/hour gross) or assume that the example took place in the past, when the tax brackets were much higher and inflation hadn’t bumped up salaries quite so much. (Or the near future, when we might have to raise taxes on everyone (including two pencil-pushers making a fairly low hourly wage) to cut down the deficit and cover other spending.)

You are right, about the effect of the tax rate in discouraging or encouraging work. (I haven’t been disagreeing with you, just trying to clarify my thought process.) The higher the marginal tax rate, the more people (in theory, at least, see below) will decide that it isn’t worth the extra time and effort to make more money. The result will be either more work for those willing to work for the effectively lower wages or great compensation to serve as further inducement.

Of course, we’ve been dancing around the fact that most people usually don’t calculate out the value of their time, or for that matter, consider the effect of taxes on their real wages. Most people, when offered overtime, would think in terms of their gross hourly wage (or 1.5 times their gross hourly wage, as the case may be) without bothering to sit down and figure out how much they’ll actually be taking home after taxes, transportation costs, and any other applicable expenses. Ask someone how much they make, after all, and most like they’ll give you a gross number, either in hourly or yearly terms.

As a result of this, people have a tendency to act in ways that have little to do with the idea of maximizing marginal utility.

Perhaps I missed it, but did you define effective tax rates?

I have a friend who was all upset and HAD to like others make sure he did not go over 250K. He owns his own business now, How can he be so confused? This carries over from the days of being an employee. You work X hours and take home Y in your paycheck. Then you work 1 or 2 hours overtime and X goes up but Y goes down. Most of us know that this is due to moving to a higher withholding bracket and at the end of the year there wasa real benifit to working those overtime hours. This is where the big misconception takes place. Even my own wife saw it this way. Before the election she was (amongst many other reasons) opposed to Obama and the tax increases. One year we did make 400K. I showed her that with the tax increase we only would pay 4K more than we did. I really would not care about paying the extra 4K if I could ever make that much again. I only care about how it is being spent.