Most discussions about income tax rates quote the largest marginal tax rate for ordinary income (currently 35%). This rate is often presented as though it represents the overall level of taxes. Is the highest marginal income tax rate a good indicator of the overall tax burden on households?
In the United States, “ordinary” income (income earned as salary or wages) is taxed on a progressive scale, with higher income taxed at a higher rate. This results in a number of marginal income tax rates, depending on the level of income. For example, these are the 2011 tax brackets:
Table 1. 2011 Personal Income Tax Brackets | ||||||
Married Filing Jointly | Married Filing Separately | |||||
Taxable Income | Marginal | Taxable Income | Marginal | |||
Over | But Not Over | Tax Rate | Over | But Not Over | Tax Rate | |
$0 | $17,000 | 10% | $0 | $8,500 | 10% | |
$17,000 | $69,000 | 15% | $8,500 | $34,500 | 15% | |
$69,000 | $139,350 | 25% | $34,500 | $69,675 | 25% | |
$139,350 | $212,300 | 28% | $69,675 | $106,150 | 28% | |
$212,300 | $379,150 | 33% | $106,150 | $189,575 | 33% | |
$379,150 | - | 35% | $189,575 | - | 35% | |
Single | Head of Household | |||||
Taxable Income | Marginal | Taxable Income | Marginal | |||
Over | But Not Over | Tax Rate | Over | But Not Over | Tax Rate | |
$0 | $8,500 | 10% | $0 | $12,150 | 10% | |
$8,500 | $34,500 | 15% | $12,150 | $46,250 | 15% | |
$34,500 | $83,600 | 25% | $46,250 | $119,400 | 25% | |
$83,600 | $174,400 | 28% | $119,400 | $193,350 | 28% | |
$174,400 | $379,150 | 33% | $193,350 | $379,150 | 33% | |
$379,150 | - | 35% | $379,150 | - | 35% | |
Marginal rates are important because they affect
· How much tax is paid
· Individual behavior and analysis of changes to individuals’ income
· The distribution of income (via the distribution of the tax burden)
Although marginal rates are a key part of income taxes, they are not the only factor that determines how much tax is paid. The highest marginal income tax rate is a poor measure of tax rates because:
· The tax bracket ranges are just as important as the rates themselves. Changes to bracket ranges can change taxes paid even without changes to the marginal rates.
· The highest marginal income tax rate only applies to ordinary income in the highest tax bracket. Income in lower tax brackets is taxed at a lower rate. The average tax rate for total taxable income therefore is lower than the top marginal tax rate (Figure 1 shows the difference between the marginal income tax rates and the average income tax rate for different taxable income levels for Married Filing Jointly households). The average tax rate only approaches the highest marginal tax rate for the highest-income earners, and even then cannot reach the maximum rate.
· Most households do not earn enough income to reach the highest income tax bracket. Only the highest income of the highest earners will be taxed at the top marginal income tax rate.
· Different types of income are taxed at different rates. Capital gains and some dividends are currently taxed at a flat rate of 15%.
· Tax rates are applied to income after deductions (“taxable income”). All tax payers are allowed standard income deductions, and many taxpayers are able to make additional deductions. These deductions result in a much lower level of taxable income. This results in a much lower average tax rate on total income compared to taxable income.
· Many tax payers are eligible to receive tax credits, which decrease the amount of income tax owed. This also lowers the effective tax rate.
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| Figure 1 (click to enlarge) |
The most meaningful rate about income tax levels for the economy as a whole is the overall average, or “effective,” income tax rate: total personal income taxes paid divided by total personal income. The effective income tax rate is based on all income earned and all income taxes paid. The effective rate reflects the effects of
· Marginal tax rates and bracket ranges
· Total amount of income, type of income, and type of tax
· Income deductions
· Tax credits
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| Figure 2 (click to enlarge) |
The effective income tax rate is much lower than the highest marginal tax rate. While the top marginal federal income tax rate has been as high as 94% (in 1944 and 1945), and has almost always been well above 30% since World War II, the effective income tax rate for federal, state, and local income taxes has almost always been in the 10% to 15% range since at least the late 1940s (see Figure 2). This most accurately represents the impact of personal income tax on personal disposable income and the burden of income taxes on households.
Focusing on the highest marginal rate or even marginal rates in general can be misleading. They do not represent the level of taxes and do not reflect the cyclical changes of the tax burden. The maximum rate does not apply to most households’ taxable income, and the total tax impact is much smaller than is suggested by the marginal tax rates. The effective income tax rate reflects the true economic impact of income taxes.
