A Lesson on Marginal Tax Rates

March 13, 2009

President Obama has plans to raise taxes on upper income taxpayers, and he has often quoted $250,000 as the income level at which these tax increases will start to take effect for married couples. These plans include letting the top two income tax rates revert to their pre-Bush levels of 36% and 39.6% (currently 33% and 35% respectively), limiting itemized deductions, and imposing a 20% rate on capital gains and dividends, in addition to some other provisions.

According to the ABC News story, this expected tax increase has prompted some people to search for ways to get their income below $250,000 so as to avoid Obama’s tax increases, as if the tax hikes would mean they would be better off earning less money. That idea is ridiculous. A tax hike will of course raise your taxes, but in terms of after-tax income you would never be better off earning less money in order to avoid the tax increase. It seems that such a notion stems from a misunderstanding of how marginal tax rates work.

Income taxes in the US are based on a marginal tax rate system where increasing taxable income is taxed at increasingly higher rates (called your marginal tax rate; see Table 1). In a marginal tax rate system a taxpayer is taxed at the given rate only for income within the bracket range associated with that rate. This means that the statutory rate that people often quote is the rate at which their last dollar of income is taxed, not the rate at which all of their income is taxed (unless they are in the bottom bracket). For instance, a single filer with $15,000 of taxable income is taxed 10% on the amount of income between zero and $8350, and 15% on the income over $8350 ($15,000 – $8350 = $6650). So the calculation would look like this:

(10% * $8350) + (15% * $6650) = $1832.50

Notice that even though the taxpayer would say that she is “in the 15% bracket”, not all of her income is taxed at 15%. Only that income which is within the 15% bracket range is actually taxed at 15%; the rest is taxed at lower rates (in this case 10% for income up to $8350).

Table 1. 2009 Income Tax Brackets For Single Filers

________Taxable Income________

Marginal Rate

Over

But not over

0

8,350

10.0%

8,350

33,950

15.0%

33,950

82,250

25.0%

82.250

171,550

28.0%

171,550

372,950

33.0%

372,950

35.0%

People sometimes misunderstand marginal tax rates to mean that as soon as your taxable income crosses into the next bracket, all income is taxed at the next higher rate. If this were the case, there would be a strong disincentive to earn more money because entering a new bracket could leave you with less after-tax income. People might even be induced to reduce their income to get into a lower bracket, as some are apparently doing according to the article above. But this is not the case. There are no such “cliffs” associated with a marginal tax rate structure, that is, you will never be worse off by earning more money, even if you do enter a higher tax bracket.

To illustrate this point further, we’ll look at an example of a taxpayer who is close to entering a new tax bracket. Consider someone with $8000 in taxable income. Since the 10% bracket ends at $8350 and his income is less than this threshold, his marginal tax rate is 10% (Table 1). All of his taxable income is taxed at the lowest rate, so his tax calculation would look like this:

Tax = $8000 * 10% = $800

After-Tax Income = $8000 – $800 = $7200

Now imagine he gets a raise and his taxable income increases from $8000 to $9000. Notice that the increase pushes him into the 15% bracket. So now some of that extra $1000 will be taxed at the original 10% rate and some (the $650 above the $8350 threshold) will be taxed at 15%:

Tax = ($8350 * 10%) + ($650 * 15%) = $932.50

After-Tax Income = $9000 – $932.50 = $8067.50

Notice that while he entered the next tax bracket and his tax increased, he is still left with more after-tax income after entering the new bracket than before.

What is the point? People should never worry about entering a new tax bracket. Your tax will always increase when you earn more money whether or not you enter a new bracket, but that doesn’t mean you will be worse off by earning more. The same is generally true for other tax increases that do not involve actual tax rates: they may hurt, but you would never be better off earning less to avoid the tax increase.

A worthwhile discussion may be to consider how marginal tax rates affect incentives. That is, since the marginal rate applies to the last dollar earned, it can affect how people make decisions about work. For instance, is it worth while to put in the extra hours to earn more money when that extra income may be taxed at a higher rate, say 35%? Maybe. What if your marginal tax rate is over 90%, as it could have been between 1944 and 1963? That would mean that for every extra hour you worked, you would spend 54 of those minutes working to pay the federal government and only 6 for yourself. You might think twice about putting in the extra hours. But this is a whole other discussion.

Catherine Rampell at the New York Times Economix blog recently wrote a piece helping to set the record straight on marginal tax rates. Check it out.


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