Half Of Americans Don’t Understand Marginal Taxes So I Made A Web Page To Showing How It Works
Because it frustrates me that people are making financial and political decisions based on misconceptions
(This is the link, for those who want to see the page)
According to a YouGov poll from 2013, 48% of people surveyed answered incorrectly when asked about the consequences of being bumped up a tax bracket, showing the nation’s staggering lack of understanding about marginal taxes. (Yes that survey is fairly old now, but I doubt that the figure has changed much since then.) This has real consequences, because people could make poor decisions based on this.
I’m writing this to explain marginal taxes in a simple example, free of all other factors. I am not trying to get into the intricacies of the US tax system like standard and itemized deductions, taxable income, and whatever else. Tax accounting lobbyists have done a lot of work making it way more complicated than I’m qualified to explain.
Look at the web page for clarity
What are marginal taxes, and how do people misunderstand them?
The US works on a system of marginal taxes. Here are the tax brackets for single individuals as of April 2021.
Income is grouped into ranges. Each extra dollar earned within a range gets taxed at the range’s tax rate. In other words, for someone earning $40,000, the first $9,950 gets taxed at 10%, and the $30,050 in the range of 9951 to $40,000 get taxed at 12%, for a total of $3606.
The common misunderstanding is that people believe that the entire income is taxed at the corresponding rate (the marginal tax rate), such as someone earning $40,000 being taxed at 12% for a total of $4,800, but that’s not how it works, because it would be stupid to have situations where getting a raise can make you have less take-home pay because it bumped you up a tax bracket.
Why does it matter?
With marginal taxes, your actual tax rate is always less than the rate in your tax bracket. Someone earning $40,000 actually pays $4,601, an effective rate of 11.5% rather than the 12% marginal rate. On my web page, you can see the actual tax rate in the table for incomes up to $1 million. Note that every single row after the first tax bracket has an actual tax rate lower than the marginal tax rate.
Furthermore, you never take home less pay when your income increases, because the money you already earned was already taxed at a predetermined rate. You can see in the table that when income goes up, the income remaining always goes up.
So if your boss gives you a raise, always take it. You have nothing to lose, even if you go up a tax bracket.
Another interesting takeaway is that it’s nice to be rich. The effective tax rate (bottom right graph) starts growing really fast as you go from broke to middle income, but it starts to flatten out, meaning that the amount of money that the rich get taxed starts to be about the same (eventually it gets close to 37%, the rate of the highest bracket), regardless of whether they earn $1 million or $10 million, whereas the actual tax rate increases really fast if you go from earning $10,000 to $100,000. It’s like taxes favor the rich or something. 🤔
Conclusion
I don’t really have a good ending to this. This was a two-day project born out of frustration over how people don’t understand something so simple, yet so important in life.
I hope that if you didn’t understand marginal taxes before, that this was able to help. Alternatively, I hope that if you did understand marginal taxes, that you can use this to help explain it to people who don’t.
