Federal and state governments rely heavily on income tax as a key revenue source. Box 1 describes how the income tax is calculated.
The federal income tax is the most progressive major revenue source in the US. It is one of the key reasons why the overall public finance system, which includes taxes and spending by all levels of governments, is progressive.
At the federal level a combination of standard and special tax provisions results in a large share of taxpayers (estimated at about 46 percent in 2016) not paying individual income tax. This group had increased to 50 percent earlier in the decade because of the 2008 economic downturn and tax policy changes of the early 2000s. The majority of these taxpayers do pay payroll tax along with other federal, state, and local taxes.
For those who pay the income tax, rates vary depending on a person’s income and marital status. In 2016, the federal income tax rates range from 10 percent to 39.6 percent.
Overview of Individual Income Tax Concepts
At its essence, the income tax is calculated in four basic steps:
Calculate gross income by adding together all sources of income.
Calculate taxable income by subtracting various deductions and exemptions.
Calculate the preliminary amount of taxes owed by applying the appropriate tax rates to taxable income.
Calculate the final amount of taxes owed by subtracting any credits (such as the child credit, the earned income tax credit, etc.).
Tax structures vary according to what counts as income, what deductions are allowed, what tax rates are applied, what the schedule is for applying those rates, and what credits are available.
Tax rates, rate schedules, and brackets—the federal government and many states levy taxes using a graduated rate structure or “schedule.” (This type of tax structure is also described as “progressive” because higher-income people pay a larger share of their income in taxes than do lower-income people.) The following chart gives an example of such a structure:
Sample graduated rate structure
In this example the lowest tax rate of 10 percent applies to the first $50,000 of income. The middle tax rate of 20 percent applies to the next $50,000 of income. The top tax rate of 30 percent applies to any income in excess of $100,000. These income ranges are sometimes referred to as “tax brackets.” Here, income up to $50,000 is in the 10 percent bracket, while income of more than $100,000 is in the 30 percent bracket.
The term “marginal tax rate” refers to the rate paid on an additional dollar of income. In this example, someone whose total taxable income is less than $50,000 has a marginal tax rate of 10 percent. That is, if the person were to earn another dollar of income, that additional dollar would be taxed at a rate of 10 percent. For someone with total taxable income greater than $100,000, each additional dollar of income would be taxed at a rate of 30 percent.
Importantly, people in the top income bracket face a tax rate of 30 percent only on the amount of income they have in excess of $100,000. The overall rate they pay on all their income (also known as the “effective” tax rate) is lower. Consider someone with $140,000 in taxable income. She pays 10 percent of the first $50,000, 20 percent of the next $50,000, and 30 percent of income over $100,000. Her effective tax rate (the total amount of taxes owed as a share of annual income) is 19 percent.
Credits vs. deductions—credits and deductions are two ways to lower the amount of taxes owed. They work very differently.
Tax credits directly reduce the amount of taxes owed. For example, if someone claims a tax credit of $1,000, the amount of taxes owed will be $1,000 lower than it otherwise would have been.
Tax deductions, in contrast, reduce the amount of income that is subject to tax. The value of a tax deduction in reducing the amount of taxes owed depends on the taxpayer’s marginal tax rate. Consider someone with $30,000 in income who is eligible for a tax deduction of $1,000. The value of the deduction is the difference between the taxes owed before and after taking into account the deduction. The deduction would lower the amount of income subject to tax to $29,000. For someone with a marginal tax rate of 10 percent, the tax liability before considering the deduction would be $3,000; the tax liability after the deduction would be $2,900. The amount of taxes owed would be $100 lower as a result.
The higher the marginal tax rate, the higher the value of the deduction. For example, consider the effect of a 20 percent marginal tax rate on the tax liability of a person with $30,000 in income. The liability before the deduction would be $6,000; after the deduction it would be $5,800. The $1,000 deduction reduces the amount of taxes owed by $200, or 20 percent of the size of the deduction.