Clearing up a common misunderstanding of progressive tax rates
Imagine you’re out to dinner with a group of friends. Someone mentions a tax article they read in the news, and grumbles that taxes are so complicated. You nod your head in agreement. You’re a CPA and you know there are many, many rules in the tax code, subject to change at any time.
“The More You Make…”
Then another guest, Joe Shmoe*, responds that he hates taxes. “The more you make, the more they take,” he says. Joe goes on to say that he doesn’t even want to get a raise at work and make it to the next tax bracket, because he doesn’t want “Uncle Sam taking 40% of [his] whole paycheck.”
SIGH. You don’t love talking about taxes outside of work. But it seems like you hear this comment fairly often. This comment bothers you. It’s oversimplified, and not completely accurate.
With any tax (including a flat tax system), the more you make, the more taxes are owed from a dollar perspective. So the “more you make, more they take” comment is technically true. But the second part? The “40% of my whole paycheck” bit – that’s not how it works.
So, what’s a progressive tax? We call our federal income tax system progressive because the tax rate increases (progresses) as a person’s income increases.
As of 2023, the US has 7 tax brackets (ranges of income) set by the IRS.
The tax rates for the current federal income tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
Reason for Progressive Tax
Why is the system this way? Why can’t everyone just pay the same percentage?
One reason the US has a progressive tax system is to reduce the tax burden on people with the lowest income. People earning minimum wage face many challenges in today’s economic environment. With a progressive tax system, the people earning the least income are subject to the lowest tax rate.
Complaint of Progressive Tax
A common complaint about progressive tax is that it places a higher tax burden on the highest-earners in the US, with a 37% tax rate for single taxpayers earning $578,125. Some say the higher tax rate on higher incomes is a disincentive or even a punishment for success.
How Was Joe Wrong About Progressive Tax?
Joe has a fairly common misunderstanding of progressive tax. He believes that if he earned enough money to bump his income into the next tax bracket, all of his income would be taxed at the higher tax rate. Thankfully, that’s not true.
Joe’s a single person with no dependents. His taxable income is $40,000 (12% tax bracket) and he’s concerned about getting a raise to bump his taxable income up to $45,000 (22% tax bracket). As much as you like to avoid accounting discussions after work, you want to clear things up for Joe so that he doesn’t sabotage his job and avoid getting a raise!
With taxable income of $40,000, Joe’s income isn’t all taxed at 12%. The first chunk of money is taxed at the lowest tax bracket – 10% for the first $11,000. Then his income from $11,001 to $40,000 ($29,000 total) is taxed at 12%.
$40,000 taxable income
$11,000 at 10% = $1,100
$29,000 at 12% = $3,480
Total federal income tax = $4,580
The 12% tax rate bracket goes up to $44,725. So if Joe gets a raise and his taxable income is $45,000, here’s how his tax breakdown would look for tax year 2023:
$45,000 taxable income
$11,000 at 10% = $1,100
$33,725 at 12% = $4,047
$275 at 22% = $60.50
Total federal income tax = $5,207.50
The progressive tax system in the US is intended to place a lower tax burden on low income earners and relies more heavily on high earners to fund public systems and infrastructure.
However, an increase in a person’s income does not increase the tax rate imposed on every dollar of their earnings. The first $11,000 of your taxable income, for everyone, is taxed at 10% (in 2023). If your taxable income reaches the second, third, or fourth income tax bracket, that tax rate only applies to a chunk of your income – not all of it.
There’s no shame in not understanding taxes. Most people do not, simply because it’s not their area of expertise. Hopefully this discussion has cleared things up for Joe, and anyone else that was fuzzy on the progressive tax system. For questions about your specific tax situation, reach out to your CPA or tax advisor.
*Joe Shmoe is a fictional person. No offense to anyone named Joe.
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