The U.S. is known for having a pretty complex taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. code. The individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. code alone has several provisions that interact with one another and impact how much taxes people pay at all income levels. Provisions that phase-in and phase-out create spikes in peoples’ marginal tax rates. If the tax code is advertising a 10 percent marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. on your next dollar, but takes away a little bit of your Earned Income Tax CreditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. , what you are really paying is higher than 10 percent. This complexity masks what the tax rates actually are.
The Basic Individual Income Tax
The United States has a progressive individual income tax. This means that as individuals earn more income, they face higher marginal tax rates on each dollar. Chart 1 shows what this looks like for a single individual with no children for each dollar between $1 and $500,000. As income increases (the X-axis), the marginal tax rate increases (Y-axis). For instance, an individual who earns $40,000, will pay a 15 percent tax rate on the next dollar, while an individual who earns $150,000 will pay 28 percent on the next dollar. In total there are 8 marginal tax rates (including the 0 bracket created by the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and personal exemption) that range from 0 percent to 39.6 percent.
Adding in Additional Provisions
If we were then to look at the phase-ins and phase-outs of provisions that affect both and individual’s tax rate and their taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. , there are far more marginal tax rates than are advertised.
Chart 2 shows the marginal tax rates from $1 to $500,000 for a single individual with no children that earns wage income and takes into account the effect of the tax brackets plus the Earned Income Tax Credit, the state and local income tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. (assuming a 5 percent state income tax), the phase-out of the personal exemption, and the limit on itemized deductions on marginal tax rates.
The number of marginal tax rates faced by a single taxpayer with no children increases from 8 to 14 different marginal tax rates that range from -7.65 percent to 38.8 percent.
At lower income levels (between $1 and about $30,000) marginal tax rates bounce around a lot. This is due to the Earned Income Tax Credit (EITC).
The EITC phases in at 7.65 percent, meaning that for every dollar an individual earns the federal government will supply an additional 7.65 cents. This creates an implicit marginal tax rate of negative 7.65 percent. Once a taxpayer reaches a certain level of income, however, the EITC phases-out. This creates an implicit marginal tax rate of 7.65 percent. Combined with the 10 percent tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. , an individual earning $10,300 of wage income faces a marginal tax rate of 17.65 percent, which is a higher marginal tax rate than someone earning $30,000 of wage income would face.
At the very high end of the chart (between $200,000 and $500,000) there are a few more marginal tax rates.
This is due to the phase-out of the personal exemption (PEP) and the Pease Limitation on itemized deductions. Starting at $258,250, the $4,000 personal exemption phases-out at 2 percent each additional $2,500 you make. This means that the government counts every $2,500 of income as $2,580. This has the effect of adding an additional 1 percent to your marginal tax rate between $258,250 and $380,000. The Pease limitation adds an additional 1.18 percent on every dollar over $258,250.
Other provisions that were not included, such as payroll taxes, the child tax credit for taxpayers with children, and state and local income taxes (and the phase-ins and phase-outs associated with them) all add to the number of marginal tax rates for individuals.
There are convincing arguments for some of these features of the tax code, such as the EITC, but it is important that in general a tax code avoid hidden marginal tax rates. It makes the code complex, which hides peoples’ true tax rate. Tax reform on the individual side should limit these sorts of games.
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