- $450,000 – Amount a married couple taking the minimum federal personal exemptions would have to earn in adjusted gross income to pay an average tax rate of 28 percent.
- $200,000 – Amount a single person would have to earn in adjusted gross income to pay 7 percent of their earnings in Minnesota income tax.
Just because you are in a “28 percent tax bracket” does not mean that you pay 28 percent of your income in taxes. That’s obvious to accountants and economists but baffles many other people. Such misunderstandings add to the confusion in debates about tax changes.
For example, a recent letter to the editor asserted, “… I pay 28 percent of my income to the federal government, over 7 percent to the state and thousands more in real estate and sales taxes.”
That assertion may be true. But it is more likely that the writer was confusing marginal tax rates with average ones. His tax burden probably is not as crushing as he purports. Someone in a 28 percent marginal tax bracket pays 28 cents on the dollars falling in that bracket, but a much smaller proportion overall. That is because no tax is due on the “zero bracket amount” or on the per-person exclusion currently at $3,100. And income lower than the threshold for the 28 percent bracket is taxed at much lower rates.
The best way to explain the difference is with a simple example. Consider an income tax with a flat rate of 10 percent on all income. The only exception is that the first $1000 of income is exempt from the tax.
A person earning just $1,000 would pay no tax. Someone earning $1,200 would pay $20 in tax — nothing on the first $1,000 but 10 percent of the $200 above that “zero-bracket” amount.
The average tax rate is the total tax paid divided by total income. In this case, the average tax rate would be $20 divided by $1,200 or 1.67 percent of all income earned.
The marginal rate — how much extra you pay in tax for an extra dollar of income — remains 10 percent.
If that person’s income increased to $1,500, the total tax due would be $50. Again, nothing is due on the first $1,000. Ten percent of the next $500 yields $50. The average tax rate is now $50 divided by $1,500 or 3.33 percent.
Increasing that income to $2,500 would increase the tax due to $150. The marginal rate remains 10 cents on each additional dollar. The average, however, is now up to 6 percent. At $5,000, the total tax due would be $400 and the average 8 percent.
As the initial amount exempted from any tax shrinks in proportion to the total, the average tax rate gets closer to the flat marginal rate of 10 percent but never quite equals it.
The federal income tax is more complicated. The initial amount excluded from taxation depends on “filing status”: single, married, head-of-household, etc. It also depends on whether a standard exclusion of $3,100 per person is claimed or if, instead, the household itemizes deductible expenses such as mortgage interest, taxes and charitable contributions.
Consider the reader who believes he is paying 28 percent of his income in U.S. government income taxes. That is possible if he is very wealthy. But if he is married and he and his wife take the minimal $3,100 personal exemptions, their adjusted gross income will have to exceed $450,000 before the amount of tax paid actually reaches 28 percent of income.
Moreover, the marginal rate at this point will be 35 percent, two brackets higher than the average rate of 28 percent.
Few people with incomes of $450,000 take the $3,100 deduction. The letter writer says he pays thousands in real estate and sales taxes. The real estate taxes are deductible. Assume these total $5,000 and that the couple has mortgage interest of $20,000. They also donate 2 percent of their gross income to charity.
With $29,500 in itemized deductions, the couple’s adjusted gross would have to top $570,000 before the average hit 28 percent.
The same relationships hold for Minnesota’s income tax, which currently has three tax brackets. The highest bracket for an individual is 7.85 percent on taxable income above $65,330.
To reach the 7 percent of total income claimed by the letter writer, a single person would have to earn adjusted gross income of $200,000.
Critics of Minnesota’s taxes may argue that comparisons between marginal and average rates emphasize a distinction without any important difference. Minnesotans still pay a lot of income tax compared with citizens of many other states.
Moreover, according to economists, it is marginal changes that motivate human decisions. Our single earner would pay $7.85 out of each additional $100 of earnings once her adjusted gross income passed $70,000 or so.
This is all true. The average, however, helps put claims of total tax burdens into context. If someone claims to be paying nearly 36 percent of their total income in Minnesota and federal income tax, they are either misinformed or have very high incomes.
© 2005 Edward Lotterman
Chanarambie Consulting, Inc.