Some of you are not accounting majors, or have yet to do a serious personal income tax return on your own. This is a primer on how tax rates work in practice.
In principal, taxes should be easy. You establish a tax rate. Say, 20%. You figure out a tax base, like $300 you have laying around, and you pay $60 of tax.
A tax like that is called flat: one rate applies to the entire base.
Keep in mind what you know from micro: even a flat tax creates distortions.
Except that there’s pretty much no tax that’s flat. If 2 or more rates apply, it’s not flat. And the number of separate distortions, if there are x different rates, is no smaller than 2x-1. This is because there’s a deadweight loss that’s different for each rate, plus behavioral responses that can get a little weird around each borderline. Legislators appear to have little clue about this as they install new gimmicks into the tax code.
With brackets, your tax base is divided up. At it’s simplest this is something like your first thousand, and then everything beyond that. For example, we might have two rates: 10% on the first thousand, and 20% on everything after that. In this case, you’d pay $60 on $600, but $220 on $1,600 ($100 on the first thousand, and 20% of the $600 after that).
Sounds simple, right? Except in the U.S. we have 7 brackets. Personally, my family has to pay in four of them. Here’s a history of the recent brackets. The Republican tax reform lowered rates in 5 of the 7 brackets. The 1986 reform, the gold standard for actually reforming, reduced the code from 15 to (eventually) 3 brackets. Then they started adding them back.
Except technically there’s an eighth bracket. An exemption is a certain amount you can claim for each person in your household. No tax is owed on this. (At low incomes, there’s also the earned income tax credit that creates a 9th bracket).
Then there are deductions. Exemptions are per person, while deductions are per household. Deductions don’t really create a new bracket, but they are distortionary (e.g., the mortgage interest deduction makes it easier for people to buy bigger houses than they might otherwise).
The real problem with all of this is that if the designers of the law can’t or won’t do the math, they could end up with some pretty dumb marginal tax rates (the marginal one is the one you have with your base right now, and that would apply if you changed your behavior). University of Chicago economist Casey Mulligan argued that the well-intentioned HAMP program (intended to keep people struggling with their mortgages both paying and in their homes) amounted to a marginal tax rate of 390% on someone exploring the alternative of getting a second job. That’s taking four times all the extra money you earned. Mulligan is well-known for opposing Obamacare because it amounted to an increase in marginal tax rates on the poor.
… Estimates from the Congressional Budget Office conclude that more than 20 percent of low- and moderate-income taxpayers face marginal tax rates of 40 percent or more …
That’s a rate only the rich people are supposed to pay in our country. She further noted that the overlay of federal with state systems can lead to situations where the poor face a less than 100% marginal rate in one state, and a rate over 100% in another.
Unfortunately, flat (income) tax rates have gotten a bad rap in the U.S., mostly because they were associated with unsuccessful Republican presidential candidates of a generation ago. The thing is, almost every tax we have, including FICA, most sales taxes, and corporate income tax are … already pretty flat.
The motivation for a non-flat income tax is a desire for progressivity: the rich should pay more and the poor should pay less. Fair enough, but a flat tax does that too. What we really mean is that the rich should pay a bigger percentage of their income. Again, fair enough, but you can get that with a flat rate and an exemption/deduction. For example, the bottom half of taxpayers only pay 3% of the total amount, and we could shift that down to 0% with a standard deduction of about $35K (which is not too far off where the Republicans just went with their increase to $24K). You could then match what we currently bring in with a single rate in the 30% range. Politically, what happens though, is that this is seen as too high on the lower part of the upper class, and then a special lower bracket is introduced for incomes that are not too high, but this loses revenue overall, so they need to raise the rate on the rich, and so on …