Letting the Bush Tax Cuts Expire--Primer on Marginal Tax Rates...It is FUN!...Really, it is!!

     Congress is in the midst of deciding to extend or let expire the "Bush Tax Cuts" of 2001-03 (In the original law, there was a "natural" expiration date of 2011).   These tax cuts were initiated as part of a fiscal stimulus plan to get the economy out of a recession that further deteriorated as a result of the events of 9/11.  The tax cuts were on Marginal Tax Rates applied to individual  incomes. 
     Marginal is a fancy word economists use to mean "each additional". In the US we have what is termed a progressive tax structure, which means the more you earn beyond certain levels of income, a higher tax rate is levied on each of those additional dollars.  Currently we have 6 levels of income that when each level is exceeded, the tax rate applied on each additional dollar is higher than the tax rate on the previous level of income (confusing, I know...example to follow).
    First, look at the graph below.  The current marginal tax rates are in the first column. The benchmark level of income that is subjected to each marginal tax rate is in the third column. The fourth column are the previous (pre-2001) marginal tax rates and the ones that we will return to if the tax cuts are allowed to expire. These columns are the ones we want to examine.

  Important definition:  In the third column you can assume these numbers represent "Taxable Income".  Taxable income is the income left over AFTER you take any tax deductions and/or tax credits you may be entitled to. Also, the FIRST $5,350 of income you earn is exempt from taxation.  In other words, you likely earned more than this amount, but not all of it is subjected to Federal taxation. 
     Look at the first line in our graph. Right now, if your TAXABLE INCOME, is between $1.00 and $16,750 you pay 10% of that income in Federal Income Taxes.  Assume you take all your deductions and credits you are entitled to take and you are left with a taxable income of exactly $16,750.  Currently, when you do your tax return you would owe 10% of that, or $1,675.  If the tax cuts expire, you would pay 15%, or $2,512.50.  One caveat here: Congress has the discretion (important word!) to keep any of the current tax rates or change any one of them.  It is NOT likely they would make lower income people pay this much more, percentage-wise, but for illustration purposes I will assume they do.
    Lets assume instead of $16,750 your taxable income was $17,750.  Under the current tax rates you would pay 10% of the first $16,750 or $1,675 PLUS 15% of the $1,000 over $16,750, which is $150.  Per our definition, each additional dollar over $16,50 is taxed at a higher tax rate (15%).  So, now your total tax would be $1,675 + $150 = $1,825.  Using the numbers from the previous paragraph, you can easily calculate what the total tax bill would be on $17,750 if the tax cuts were allowed to expire. Note: the 15% marginal tax rate is the only one that stays the same.  I forget the main idea behind this, but I have to assume that this level of income represented middle class America back then.
   Another example: You are now a high paying executive and are doing your taxes. After deductions/credits you find you have a taxable income of $250,000 (which means you ACTUALLY earned $300,000+). Nice going!!! Lets calculate your Federal income tax:

Looking at the above table under CURRENT TAX RATES
The first $16,750 of earnings times 10% =                                        $1,675.00
The amt. between $16,750 and $68,000 = $51,250 times 15%=         $7,687.50
The amt. between $68,001 and $137,300 = 69,299 times 28% =      $19,403.72
The amt. between $137,301 and $209,250 = $71,949 times 31%=   $22,304.19
The amt. between $209,251 and $250,000 = $40,749 time 33%=     $13,447.17
Phew!!!
Federal income tax owed on a taxable income of $250,000  =  $64,517.58

While you are in the 33% tax bracket ($250,000 is in between $209,251 and $373,650 with a marginal tax rate of 33%) your EFFECTIVE TAX RATE is $64,517.58 divided by $250,000 multiplied by 100 = 25.8%.  In other words, you are actually paying 25.8% of your taxable income in federal taxes, not 33%. And in terms of your gross income, say $300,000, you are effectively paying ($64,517.58 divided by $300,000 mulitplied by 100) 21.5% of your income in Federal taxes.   This is a technical issue, but important to know if you want to be literate on the issue...
    Now, YOUR homework is to calculate what the amount of tax in dollars AND the effective tax rate is on $250,000 IF the Bush Tax Cuts are allowed to expire. How do the two compare?  We will use this for class discussion on Fiscal Policy, tax policy and  Automatic Stabilizers...