March 3, 2020

Four Simple Scenarios That Show How Marginal Rates and Tax Breaks Affect What People Actually Pay

As the 2020 campaign season swings into gear, the national debate about taxes — including tax rates, tax types, and tax fairness — is gaining prominence. Tax policy is a critical component of our nation’s economic and fiscal landscape, but for individual Americans, the tax system can seem overly complex.

This complexity means that the percentage of income that Americans pay in taxes can vary widely and depend on many factors. The United States features a generally progressive income tax structure at the federal level. As income rises, so does an individual’s tax rate. At the same time, high-income Americans benefit disproportionately from tax breaks, otherwise known as tax expenditures, which cost $1.5 trillion per year.

Let’s look at a few examples of how individual Americans would compute their income tax liabilities:

Four Simple Scenarios That Show How Marginal Rates and Tax Breaks Affect What People Actually Pay

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In the next example, David earns significantly more than Olivia, but he pays a lower percentage of his income, largely because he receives the child tax credit.

Four Simple Scenarios That Show How Marginal Rates and Tax Breaks Affect What People Actually Pay

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In the scenario below, Carmen reduced her taxable income in two ways. The first was by making contributions to an employer-sponsored retirement plan, such as a 401(k) or IRA. That is one of the most expensive tax breaks — it cost the government $250 billion in lost revenues in 2019. The second way that she reduced her taxable income was by making a charitable contribution.

Four Simple Scenarios That Show How Marginal Rates and Tax Breaks Affect What People Actually Pay

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Noah and Emma are in the top percentile of income earners in the United States, and they are taking advantage of the mortgage interest and state and local tax (SALT) deductions — both of which tend to benefit high-income wage earners more than lower-income groups.

Four Simple Scenarios That Show How Marginal Rates and Tax Breaks Affect What People Actually Pay

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As the scenarios above illustrate, our tax system can be complex and confusing. While the fairness of that system is much debated, many economists agree that simplifying the tax code would promote economic growth and opportunity.


Related: Quiz: How Much Do You Know About the U.S. Tax System?


 

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