Join Jim Stice for an in-depth discussion in this video Tax brackets, part of Finance Foundations: Income Taxes.
- Now, we're going to talk about a simple income tax system. We're going to use a lot of terms. For example, we'll go through and define each one of these: a tax rate, a tax bracket, the average tax rate, the marginal tax rate. What's the difference between those two? We'll talk about a progressive tax system. Will introduce us to the term tax deduction, tax credit. What's ordinary income? Capital gains income? We're going to talk about these terms and illustrate these terms using a simple tax system. Now, in this simple tax system we have the following criteria.
For income from 0 to $50, you're not going to pay any tax. No income tax at all. For all income above $50, the income tax rate is 50%. So in this simple tax system, how much income tax would you pay if you made $50? Or $51? Or $100? Now, for all income over $50 you've got to pay a rate of 50%. So this is going to make our calculation very simple. Again, this has all the elements of the tax systems of the United States and the European Union, and Hong Kong and China, and everywhere else.
We'll use this to represent the tax systems around the world. We'll answer these questions. Under this tax system, how much tax would you pay if you make $50? What if you made $51? What if you made $100? Lets do the computation in each one of these three cases. First of all, if you make $50 you don't pay any income tax under this system. The first $50 is tax-free. So that's a pretty easy computation to do. All right. But what if you make $51? Okay. Again, the first $50 you still pay no taxes.
That 51st dollar you're going to pay tax at a rate of 50%. So your total tax that you're going to pay is 50 cents. This illustrates the important notion of the tax bracket. You'll sometimes hear people complain that, "I got a raise so now I'm in the next tax bracket." Well that's kind of a naive comment and I'll show you why. The tax bracket is this, the first tax bracket in this case is from zero to $50 and the rate on this first $50 is always zero no matter how much you ever make.
So when you make the 51st dollar, when you go up into that next track bracket where your income is taxed at a rate of 50%. That is not applied retroactively. You don't have to go back and pay 50% on the first $50. The first $50 is never taxed and the rate is always zero. That's the first tax bracket. The second tax bracket in this simple example is everything over $50. And at the second tax bracket yes, the tax rate is 50%, but lets think.
Should we be sad that we got a raise in this case? We went from making $50 to $51. Has that cost us any money? Well no. It does not cost us because when I make $50, I have the $50 and I don't pay any tax. If I make $51 yes, it's true that I now have to pay half of that 51st dollar in tax. So I have to pay 50 cents in tax and I get to keep half of the 51st dollar so I have $50 and 50 cents. Going to the next tax bracket doesn't cost you any money.
It just means that you have to pay a different tax rate on the extra income that you're going to make. So don't be afraid to making more money and going into the next tax bracket. That is a cause for celebration.
This is a self-contained introductory course to income tax, but if you'd like more information about accounting in general, check out the Stices' foundational course, Accounting Fundamentals.
NOTE: The information in this course applies only to the United States.
- The history of income tax
- Tax brackets, rates, deductions, and credits
- Completing a basic tax return (1040A)
- Tax planning
- Shifting income
- Understanding corporate income taxes
- Avoiding tax-evasion schemes
- Tax issues for small businesses