Today, the balance in my bank account is $3,142 smaller. The IRS deducted that amount from our account because that is what we owe in Federal taxes. Of that amount, $30 is a penalty because the almost $13,000 that had been withheld from our paychecks was not more than 90% of our overall tax liability. What does this mean? My wife and I owe $17,039 in Federal income taxes and after credits that amount is reduced to $16,088. Only $12,976 was withheld from our paychecks. That left us $3,112 short. Some quick math says we only had 76.2% of our $17,039 tax liability withheld during the year. Line 77 of our tax return requires us to pay the penalty because we still owe more than $1,000 and our annual withholding was not at least $15,335. Keep in mind this is only the amounts owed for Federal income taxes and not the amounts we paid in state and FICA taxes.
As you can see, this is one of the thousands of complexities that exist in our tax laws. My wife and I rely on our employers to withhold the amounts required by the IRS. I have no doubt they follow the required tables based on the number of exemptions we give them. The problem is the tables don’t seem to be accurate since our withholding was not within 90% of our final tax liability. Complexities exist not only in rules but also in terminology.
Take the term marginal tax rate. Most people properly relate this term to tax brackets and the idea that as we earn more money we pay an increasingly higher rate in taxes. The key word that most people don’t understand is the term “marginal”. In economic terms, marginal means one more. It is used in conjunction with other terms such as “marginal propensity to consume”, “marginal propensity to save”, “law of diminishing marginal utility”, “marginal cost”, and “marginal tax rate” to name a few. A brief explanation of each might help in understanding the term. If one were to earn one more dollar of income, calculating how much of that dollar is spent and how much is saved are your MPC and MPS. The amount of additional satisfaction you would get if you consumed one more of something would decrease the more you consumed of that item. That is what is meant by diminishing marginal utility. Businesses can calculate the cost of producing one more unit of a particular product as their marginal cost. Our individual marginal tax rate is the additional amount of taxes one would pay if they earned one more dollar of income. Can you see what they all have in common? They describe what would happen if something increased by one.
Most people assume their marginal tax rate is what they pay for ALL dollars earned. This is not the case. As we earn additional dollars, eventually we will fall into the next tax bracket up the scale. Assume for a moment you were at the highest income one could have before jumping up to the next bracket. Your boss awards you a $1 bonus and now your income falls into the next bracket. That first dollar in that scale is the ONLY dollar taxed at that rate. All the other dollars are taxed at the lower rate(s). Let’s use a simple example to help illustrate how this works. Suppose the government charges a 10% tax on income up to $1,000 then 20% from $1,001 to $2,000. You make $1,000 of taxable income (a term to describe the income we actually pay taxes on after deductions and exemptions are subtracted from our income). You would owe $100 in taxes since 10% of $1,000 is $100.
Now your boss gives you that bonus. Your taxable income is now $1,001. What is your tax liability? Start with the $100 you owe on the first $1,000 and add to that the tax on the extra dollar which is taxed at 20%. The tax would be 20 cents. So your total tax liability would be $100.20. You do not pay 20% of all dollars earned, just on those over $1,000.
Suppose your income doubled to $2,000. What would your tax liability be in that case? Start with the $100 owed on the first $1,000 and add to that 20% of the additional $1,000 for a total of $300. You would have paid 10% on part and 20% on the other part which averages out to 15%. The average rate can’t be the same as the marginal rate which brings me to the next point about complexities in terms.
Many people often assume their marginal tax rate is the same as their effective tax rate. Think of your effective rate being like the average in the previous example but with one difference. The effective tax rate is defined as the Federal income taxes paid as a percentage of overall or total income. Recall above I used the term taxable income. The government requires us to begin by identifying all sources of income then allows us to reduce that income through deductions and exemptions. The tax forms take us from total income to adjusted gross income to taxable income. Compare lines 1,4, & 6 if you filed a 1040EZ form; lines 15, 21, & 27 if you completed a 1040A form and finally lines 22, 37, & 43 if you completed the full 1040 form. Notice they may all be different but they do go down from top to bottom.
Your effective tax rate is calculated by taking the final taxes you owed (even if you got a refund there is a good chance you still paid taxes) and dividing that by your total income. What you will find is your effective tax rate is much, much, lower than you probably thought. Three main factors account for your effective rate being low. Part of your income is taxed at different rates and some of your income is not taxed at all due to exemptions and deductions. Finally, many receive credits which reduce dollar for dollar the amount of taxes owed.
Our tax code is indeed complex and needs to be changed but the next time someone confuses their effective rate with their marginal rate, you can educate them on the difference. Only through education can we all seek to find common ground by which to solve our complex tax problems.