The Tax Base, or What Do We Tax?

The Government focuses on several different aspects of wealth for their revenue. Nearly half of the government’s revenue comes from income tax, which assesses a progressive marginal tax on a person’s entire income. The government also collects payroll taxes, which are regressive marginal taxes on a person’s wages. The third category of taxes that individuals will pay are excise taxes, which are usually a flat tax on the taxpayer’s spending.

Income Tax

When most people talk about the income tax, they are referring to taxation of wages: income earned from providing a service. 

The US federal income tax (and that of most states) is progressive, meaning that the more money you earn, the higher your tax rate is. But a common misconception is that higher tax rates for higher income earners affects all of their income. That is NOT the case.

HOW DOES THE INDIVIDUAL INCOME TAX WORK?

The income tax functions through a brackets structure, as exhibited below. Notice that the respective rates apply to specific windows of income. This means that when an individual pays income tax, their highest tax rate will only apply to the proportion of their income that falls within that highest income bracket. The rest of their income is taxed at lower rates.

The tax brackets for unmarried individuals in 2021 are as follows:

  • $ 0 - 9,950: 10%

  • $ 9,951 - 40,525: 12%

  • $ 40,526 - 86,375: 22%

  • $ 86,376 - 164,925: 24%

  • $ 164,926 - 209,425: 32%

  • $ 209,426 - 523,600: 35%

  • $ 523,601 and up: 37%

Let’s compare, for example, individuals who earn $9,000/year to individuals who earn $10,000/year.

Scenario 1: According to the brackets above, individuals earning $9,000/year would pay 10% on all that income, owing $900 at the end of the year.

Scenario 2: Individuals earning $10,000/year would pay a 10% tax rate on their first $9,950 of income ($995). Then, they would pay 12% on their income greater than $9,950 ($10,000-$9,950=$50), which is 12% * $50 = $6 owed. We then add these two amounts together, leaving the $10,000/yr income earner with $6+$995=$1,001 in taxes owed. 

HOW DOES THE CAPITAL GAINS INCOME TAX WORK?

As previously stated, capital income – “capital gains” – is income that is income generated by an asset (e.g., stocks, bonds, real estate) over time, rather than from work done. For example, suppose that in 2021, Bob buys 100 shares of stock at $10/share. The following year, if the stock price increases to $15/share, then Bob has capital gains of 100 shares * ($15 - $10) = $500. 

If an individual or corporation who owns an asset does not sell the asset, any capital gains remain “unrealized” and will not be taxed. So, if Bob decides to keep all of his 100 shares, then he will not be taxed on the $500 worth of capital gains. 

However, if an individual or entity does sell their assets, it’s a different story. There are two different types of capital gains: short-term and long-term. This distinction depends on how long the asset in question is held.

  • When an asset is sold after only being held for one year or less, that is called “short-term capital gains.” Short-term capital gains are taxed as regular income. Suppose that 1) Bob sells his 100 shares of stock six months after he had initially purchased them; and 2) Bob makes $60,000 a year and thus falls within the 22% tax bracket. Since Bob’s holding period was less than one year, his $500 worth of gains are short-term capital gains that are taxed at 22%. 

  • When an asset is sold after being held for more than a year, that is called “long-term capital gains.” In contrast, long-term capital gains are taxed at either 0%, 15% or 20%. The reason for lower long-term capital gains tax rates is to encourage long-term holding of assets and discourage market volatility. See below for the 2021 capital gains tax rates.

    • $ 0 - 40,400: 0%

    • $ 40,401 - 445,850: 15%

    • $ 434,551 and up: 20%

Payroll Tax

Payroll Taxes are a regressive marginal tax on only wages. This tax is not assessed on passive income, or any type of income other than wages. The payroll tax funds social security and medicare programs that provide benefits for retirees and people with disabilities.

The payroll tax is regressive and contains two tax brackets;

  • $0 to $142,800: 15.3% (taxing for both social security and medicare)

  • $142,800 and up: 2.9% (taxing only for medicare)

Most Americans’ entire incomes consist of wages, so most people effectively see an income tax that consists of the income tax and payroll tax combined. Because of the way the brackets are constructed, until a person earns about $62,000, they are actually paying more in payroll taxes than income taxes. For further discussion on this, see Death of the Income Tax.

Half of payroll taxes (7.65 percent) are paid by employers, with the other half withheld from employees’ paychecks. However, practically speaking, you may also bear at least the partial burden of your employer’s “half” of the payroll tax, in the form of decreased wages.

Excise Taxes

Excise taxes are typically flat-rate taxes that are levied against certain goods when sold, like gasoline or tobacco products. Excise taxes constitute a small portion of the federal government’s revenues.

Next: Read What Don’t We Tax?