All is unfair when it comes to taxes, or so it seems. If someone’s income increases enough, he’ll be pushed into a higher tax bracket, thus a bigger chunk of his paycheck goes to the government. So why work hard if all the extra money will be taxed away? Which piece of logic is missing here?
Simplifying with a simple farmer
It is easy to misunderstand how tax brackets work, and that can cost you a lot of money. To simplify this topic, let’s meet Sammy, a poor newlywed in an agricultural kingdom. Luckily, his benevolent ruler granted the young farmer a raw plot of land with enough start-up seeds to get going. The town’s mayor became Sammy’s guide and mentor as he worked to clear the land and plant. At the end of his first growing season, he met the mayor, nervous and worried.
“I worked day and night, but all I’ve grown is 1,000 pounds of grain. We need 1,500 pounds to get through the next year, and the king expects annual taxes too!” The mayor calmed Sammy down and explained the king’s “tax bucket” system. Most local farmers grew 2,000–4,000 pounds annually, but some beginners like Sammy produced much less. Just a few plantation owners piled up more, accumulating as much as four tons of grain. The king’s “progressive” bucket system charged according to ability: those with little grain paid minimal taxes while the wealthy plantation owners “contributed” significant percentages of their produce.
“Sammy, your entry-level amounts will end up in the zero-percent bucket. Not only won’t you be taxed, but the king’s agents will leave you coupons for free grain to tide you over,” the mayor assured Sammy.
The red–hot question
A few days later, the king’s collectors visited Sammy’s modest farm with eight enormous tax buckets. Each colored bucket measured 1,000 pounds of grain, and its color represented the percentage of grain due to the king. The green bucket was marked with a large zero, the pink one had “10%” written on it, and the orange bucket said “25%.” The final five buckets were all blue and marked “50%”, representing a clean split with the royal treasury. Sammy’s small pile of wheat barely touched the green bucket’s brim. As the mayor had promised, the tax collectors took nothing, instead leaving royal coupons worth 500 pounds of grain. Sammy was relieved and pleased that none of his toils were being “shared.”
The young farmer was still puzzled, though. His energetic friend Tom grew about 4,000 pounds of wheat to feed his large family. But after taxes, how did Tom survive? Since the fourth, blue bucket was marked “50%,” Tom would have to give up half of his grain to the king, leaving him with just 2,000 pounds! Was Tom, who produced four times what Sammy produced, left with only slightly more food? Sammy knew there was no way Tom could survive a 50% tax. How did this “each paying by ability” work? Sammy decided to follow the collectors and see it all for himself.
Now he gets it
Making sure to keep a healthy distance, Sammy followed the tax collectors to Tom’s farm and found a hidden spot where he could see the whole scene. The collectors set up the eight colored buckets, and Tom’s workers began shoveling grain first into the green bucket, then into the pink and orange containers. Finally, the bottom layer of the 4,000 pounds of wheat was shoveled into the fourth, bright blue bucket. The king’s men began measuring out the royal cut. Although Tom’s final pounds of grain had hit the 50% mark, the soldiers removed nothing from the green bucket, just a bit from the pink, and slightly more from the orange bucket. It was only from the blue container that they poured out half for taxes!
Now Sammy finally got it. The tax percentage marked on each bucket only applied to what was in that bucket. The king’s men had removed 0% tax from the green bucket, 10% from the pink, 25% from the orange, and 50% from the blue. The combined tax was not 2,000 pounds (50%) but 850 (21%), an amount equal to the contents of less than one of Tom’s four buckets. (0 + 100 + 250 + 500 = 850 or 21% of the 4,000 pounds Tom grew.) Tom surely wasn’t thrilled with the tax, but at least it left him with enough to live on plus a bit more.
Marginally better
The USA’s tax system is far more complicated than a farming kingdom’s and this parable is a grossly simplified one . But it also utilizes tax brackets (buckets) to charge progressively higher amounts on income above the freebie “green bucket” (the standard deduction.) And like Tom’s grain in the blue bucket, income that shifts into a higher tax level only affects what’s in that bracket.
Put it into practice
Let’s use a Mr. Schiller as an example. Say he has annual income of the previous year was $80,000, putting him in the 12% tax bracket, leaving him with a take-home income of $70,400. ($80,000 taxable income less 12% tax = $70,400.) This year’s pretax profit was projected to increase by $10,000. His total federal tax bill on taxable income of $90,000 is $11,517. This means Mr. Schiller’s effective, or average, tax rate is about 10% of his full gross income ($24,400 deduction income + $90,000 taxable income.) The extra $10,000 he earns will be taxed at the rate of 22%, not his entire projected $90,000 in taxable earnings. This 22% rate represents Mr. Schiller’s marginal tax rate because it affects only the income earned at the edge or above (or margin).
Controlling the marginal tax rate is one of the keys to lowering overall tax bills. While the IRS taking 10% of his hard-earned money isn’t pleasant, it’s a lot less than the 22% marginal rate that one mistakenly think he would be required to pay. Of course, he also has social security and state taxes to deal with, but managing one tax crisis at a time is enough.
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