Friedman’s Law of the First Thing, as Applied to Income Taxes: Marginal Tax Brackets

Tuesday, November 20, 2012 at 3pm
By John Friedman

Friedman’s Law of the First thing says that, for each aspect of your financial life, you should know, at least, the first thing about it.

Now, it might be that some of you should know, or might benefit handily from knowing, the second, third, fourth and even the x’th thing about a given aspect of your financial life (you know who you are!), but clearly some of you should stick to knowing just the first thing (you know who you are too!). So for some, it’s more-is-better; for most, though, it’s just-the-first-thing’s-plenty-enough.

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The first thing anyone needs to know about income taxes is what marginal tax brackets are all about

Like clockwork, though, we see stories in the media of people who do not understand what marginal tax brackets are all about, and who, as a result, are likely to diminish their overall financial health.

So here’s a piece to help you know the first thing about taxes.

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Marginal tax brackets are best understood through illustration; fortunately, there are some great online tools to help you see how these things work and, doubly fortunately, you have your friendly neighborhood financial health advisor slash blogger to help as well. Take your pick! Or try both!

My favorite site for online financial tools is MoneyChimp. Its tools are good at illustrating concepts, and many of the tools also do a decent to great job of explaining concepts as well.

So please do, if you wish, click through to MoneyChimp’s tax calculator and learn about how marginal tax brackets work.

For those not wishing to go to MoneyChimp, as well as for those who went there and want to see how I explain this stuff, please do read on.

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Marginal tax brackets are all about chunks of income, which you can think of as ever-increasing amounts of income. The first chunk of your income is taxed at one rate, while the second chunk — which is money you earn in excess of the first chunk but that’s also less than the third chunk — is taxed at another rate, and so on.

Now lets get real. In 2012, the federal tax rate on taxable incomes of married people who file their taxes together is:

10% of the couple’s taxable income from $0 to $8,700, plus
15% of the couple’s taxable income from $8,701 to $35,350 plus
25% of the couple’s taxable income from $35,351 to $86,650.

 

So the first chunk is taxed at 10%, the second at 15%, and the third at 25%.

These days we also have a few more chunks in the chunk-tree, but to keep it simple, we’ll leave it at three.

A couple with taxable income of $8,000, then, pays $800 of tax — that much is eyeballable (10% of $8,000 = $800). From there on, though, everyday eyeballability evaporates because you have to do the same calculation for each chunk of income.

For instance, a couple with $9,000 of taxable income pays $915 of tax, calculated as follows:

First marginal tax bracket: 10% of $8,700 = $870
   plus
Second marginal tax bracket: 15% of $300 = 45

Do you see where the $300 comes from? It is the couple’s $9,000 of taxable income minus the $8,700 of the couple’s taxable income that was taxed in the first bracket. That $300 — the leftovers from the first bracket — falls entirely into the second marginal tax bracket, and is therefore taxed entirely at the rate for the second marginal tax bracket, i.e., at 15%.

 

Now let’s scope this whole thing out, shall we? And let’s do that by looking at the couple’s overall tax rate.

Since some of the couple’s taxable income is taxed at 10% and since whatever’s *not* taxed at 10% is instead taxed at 15%, it stands to reason — and to math — that the couple with $9k of taxable income is income-taxed at a rate of more than 10% but less than 15%, right?

More specifically, the couple’s overall effective tax rate on their taxable income is 10.1666666666% — $915 divided by $9,000 is to 10.16666666 (and more 6s continuing forever . . . ) divided by 100.

Likewise, a couple with $10k of taxable income would pay an extra $150 over what the previous couple paid (because all of this couple’s taxable income that exceeded the other couple’s taxable income falls within the 15% marginal income tax bracket), for a total of $1,065 in taxes, which comes to 10.65% — or about a half a percent higher overall effective income tax rate.

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As you can see then, in this simple marginal tax bracket framework, earning an extra dollar can never result in paying more than a dollar of additional taxes. The arithmetic simply cannot work that way — only a marginal tax bracket higher than 100% could accomplish that. And so far we have not done that (though I suspect that those who practice at the outer fringes of tax lunacy have come across bass ackward instances where similar such things have happened).

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So now you know the first thing about taxes.

And that means that, the next time you hear some Pat or Terry say that making more money would decrease their after-tax income, you’ll know that s/he — literally, by Friedman’s Law of the First thing — doesn’t know the first thing about what s/he’s talking about.

 

About 850 words (a nine-minute read, sans linked-to content)

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