As confusion over tax rates and the fiscal cliff dominates the conversation in Washington, it is becoming apparent people do not understand how a progressive tax code works. . A progressive tax code increases a person’s tax rate as their income increases unlike more regressive taxes, which set a uniform rate regardless of income. The federal income tax, being the most progressive tax, has 5 different brackets or tiers. As an individual earns more, that income is taxed at a higher rate with rates set at 10%, 25%, 28%, 33%, 35%. The top rate of 35%, which gets all the attention, is only paid on income over $200,000 for an individual or over $250,000 for a couple.
Now, if a person makes $251,000 a year, all that income is not then taxed at 35%. Only $1,000 (the amount over $250,000) is taxed at 35%. Everybody, from business owners to the working poor, pays the same amount in taxes on the same amount of income. Whether it’s a CEO who makes a million dollars a year or a factory workers who makes $50,000 a year, both pay the same tax rate on the first $50,000 they earn. The difference is the CEO goes on to make much more, and that money, and only that money, is taxed at a higher rate.
Understanding people will not all of a sudden be forced to pay exorbitantly more in taxes because they make more money has important implications for a lot of the arguments thrown around in tax rate discussions.
It seriously weakens the argument that raising taxes will disincentivize people to make more money – the “why work harder if Uncle Sam is just gonna take my money” people. This argument falsely assumes if you make too much money then you will be bumped up into the next tax bracket and therefore have a greater tax burden. As noted before, it is only those dollars above the set limits that are taxed at the higher rate; it’s only the dollars greater than $250,000 that are taxed at 35%.
This also has important implications for the debate over whether or not to let the Bush tax cuts expire. The Bush tax cuts were across the board cuts for every income bracket. If they do expire the 10%, 25%, 28%, 33%, and 35% rates will increase to 15%, 28%, 31%, 36%, and 39.6% respectively. It is unlikely we will see all these rates go up, but what is likely to happen is the top two rates will go up (33% to 36% and 35% to 39.6%). This has prompted rage from the Republican Party, and is the basis for the claim that the President is engaging in class warfare. The richest Americans will pay higher taxes on some of their income, but as Ezra Klein has pointed out, “It’s an under appreciated fact that extending the Bush tax cuts on income up to $250,000 cuts taxes for rich people, too.”
Republicans also defend low rates on the top 2 percent of people by deeming it as an attack on small businesses citing those that file their earnings as personal income. Small businesses, ones that pay their taxes on an individual basis and make more than $250,000 would see a higher tax burden if those top rates expired. But, those businesses still receive a tax cut on their income up to $250,000. And 97 percent of small businesses do not fall into this upper echelon.
So as the parties continue to wage debates over tax rates and the Bush tax cuts remember the importance of a progressive tax code in all these discussions.