Tax Structure: Tax Base, Tax Rate, Proportional, Regressive, and Progressive Taxation

The tax structure of an economy depends on its tax base, tax rate, and how the tax rate varies. The tax base is the amount to which a tax rate is applied. The tax rate is the percentage of the tax base that must be paid in taxes. To calculate most taxes, it is necessary to know the tax base and the tax rate. So if the tax base equals $100 and the tax rate is 9%, then the tax will be $9 (=100 × 0.09). Proportional taxes (aka flat taxes) apply the same tax rate to any income level, or for any size tax base. So if Bill earns $50,000 and Jane earns $100,000, and the tax rate is 10%, then Bill will owe $5,000 in taxes while Jane will owe $10,000. Many state income taxes and almost all sales taxes are proportional taxes. Social Security and Medicare taxes are also proportional since the same tax rate is applied to any earned income up to the Social Security wage base limit, which, for 2015, is $118,500. The Medicare tax is a proportional tax that applies to all earned income and is equal to 2.9%.

A regressive tax is one that is inversely proportional to income — the lower the income, the higher the tax in relation to income. Most regressive taxes are assessed on products and services in which the tax is a percentage of the cost of the product or service. Hence, when paying the tax, a poor person pays as much as the wealthy person. The most common forms of regressive taxes are sales taxes and value added taxes (VAT). The inequitable effects of a regressive tax is often mitigated by payments to the poor and by exempting essential products and services, such as food, from the regressive tax.

A progressive tax applies a higher tax rate to higher incomes. So if the tax rate on $50,000 is 10% and 20% for $100,000, then, continuing the above example, Bill still owes $5,000 in taxes while Jane will have to pay $20,000 in taxes. However, almost all progressive taxes are structured as a marginal tax, which means that the progressive tax rate is only applied to that part of the income which is greater than a certain amount. The portion of the tax base that is subject to a particular tax rate, known as a tax bracket, always has lower and upper limits, except for the top tax bracket, which has no upper limit. The following tax brackets apply for 2013 and thereafter: 10%, 15%, 25%, 28%, 33%, 35%, 39.6%. The 39.6% bracket was added in 2013. To see the current rates published by the IRS, scroll down to the bottom of the current tax table from the instructions for Form 1040.

Continuing the above example, if the 20% tax rate is only applied to that portion of the income between $50,000 and $100,000, then Jane would owe $5000 on the first $50,000 of income and $10,000 on the 2nd $50,000 of income, resulting in a total tax liability of $15,000.

Without marginal tax rates, a progressive tax would skew economic decisions and would be viewed as unfair. For instance, if the 20% tax rate was applied to all earned income and Jane only earned $60,000, then she would have to pay $12,000 in taxes, which is 2.4 times more than Bill's taxes, even though she only made 1.2 times more than Bill. To take a more extreme example, consider what happens if Jane makes $50,001. She would have to pay slightly more than $10,000 which is $5000 more than what Bill would have to pay, even though he earned only $1 less. Hence, without marginal tax rates, a pay increase could actually result in a decrease in disposable income. A person's tax bracket is the highest tax bracket applicable to her income level.

A progressive, marginal tax rate also makes economic sense, since money, like everything else, has a declining marginal utility. In other words, $1 is worth a lot more to someone who earns $10,000 per year than to someone who makes $10 million per year. Poor people need the money to buy essentials, whereas rich people spend their money for luxuries, so the wealthy can pay higher taxes without seriously lowering their standard of living.

Because of marginal tax rates, the tax rate that one actually pays is not knowable just from their tax bracket, so another rate, called the effective tax rate (aka average tax rate), is calculated by dividing the actual taxes paid by the tax base. In other words, the total tax calculated by multiplying earned income times the effective tax rate will equal the same tax that is calculated by multiplying the amount of income in each tax bracket by the respective marginal tax rate and summing them all up. So in example 2, since Jane earned $100,000 and paid $15,000 in taxes, her effective tax rate is 15% (= $15,000 ÷ $100,000).

The federal income tax and many state taxes are progressive. Although the federal income tax itself is progressive, the effective tax rate that is based on all the taxes collected by the federal government is progressive only until the Social Security limit is reached. Thereafter, the effective tax rate either declines or levels off with increasing income, since people who make more than the Social Security limit do not have to pay the 12.4% Social Security rate on any income earned above the limit, as can be seen from the following table for a single person who is not a head of the household (Note: For a self-employed person, the tax code allows the deduction of the employer's half of the payroll tax, which results in a net self-employment tax of 14.13%. The tax code also allows the deduction of the employer's portion of the tax, the value of which depends on the taxpayer's marginal tax bracket, but since this does not change the effective tax rate very much, it is ignored in the table below. The following table assumes that a single person with no dependents pays the entire payroll tax, which is true for the self-employed, but also applies to employees. Even though employees technically only pay ½ of the payroll tax, most economists agree, that most employees pay the other half through lower wages or through higher unemployment. For more info, see Tax Incidence: How The Tax Burden Is Shared Between Buyers And Sellers):

2011 Effective Tax Rate on Earned Income
Earned IncomeIncome TaxesPayroll TaxesTotal Taxes PaidEffective Tax Rate
$10,000.00$0.00$1,412.96$1,412.9614.13%
$20,000.00$840.00$2,825.91$3,665.9118.33%
$30,000.00$2,335.00$4,238.87$6,573.8721.91%
$40,000.00$3,835.00$5,651.82$9,486.8223.72%
$50,000.00$5,725.00$7,064.78$12,789.7825.58%
$100,000.00$18,369.00$14,129.55$32,498.5532.50%
$150,000.00$32,369.00$17,260.43$49,629.4333.09%
$200,000.00$47,069.00$18,599.50$65,668.5032.83%
$250,000.00$63,569.00$19,938.58$83,507.5833.40%
$300,000.00$80,069.00$21,277.65$101,346.6533.78%
$350,000.00$96,569.00$22,616.73$119,185.7334.05%
$400,000.00$113,254.00$23,955.80$137,209.8034.30%
$450,000.00$130,754.00$25,294.88$156,048.8834.68%
$500,000.00$148,254.00$26,633.95$174,887.9534.98%
$550,000.00$165,754.00$27,973.03$193,727.0335.22%
$600,000.00$183,254.00$29,312.10$212,566.1035.43%
$650,000.00$200,754.00$30,651.18$231,405.1835.60%
$700,000.00$218,254.00$31,990.25$250,244.2535.75%
$750,000.00$235,754.00$33,329.33$269,083.3335.88%
$800,000.00$253,254.00$34,668.40$287,922.4035.99%
$850,000.00$270,754.00$36,007.48$306,761.4836.09%
$900,000.00$288,254.00$37,346.55$325,600.5536.18%
$950,000.00$305,754.00$38,685.63$344,439.6236.26%
$1,000,000.00$323,254.00$40,024.70$363,278.7036.33%

The 2011 standard deduction of $5,800 and the personal exemption of $3,700 for a single person was deducted from the earned income to calculate the income tax in the above table. However, payroll taxes applies to all earned income. As you can see from the chart below, the federal tax on earned income is not nearly as progressive as it might seem by just looking at marginal tax rates. For instance, note the fact that someone who makes $1 million has an effective tax rate of 36.33%, and someone who earns $100,000 has an effective tax rate of 32.5%, so the millionaire pays taxes at a rate that is only 3.83% less. Although these figures are now several years old, this basic tax structure, as of 2016, is still the same — the current numbers are only a little bit higher.

Chart showing the relationship between earned income and the effective tax rate assessed on the income.

The Wealthy Really Do Have It Better

The above table is misleading because it shows only the taxes assessed on working income, which is the most highly taxed form of income. It suggests that the wealthy pay a higher effective tax rate on their income than poorer people. However, because of favorable tax treatment for investment income and, especially for capital gains, and because large amounts of wealth can be transferred through gifts and inheritance (collectively, gratuitous transfers) tax-free, the wealthy actually pay a far lower effective tax rate if the taxes that they paid is divided by all of their income, including investment income and inherited wealth.

For instance, according to IRS statistics, in 2007, the top 400 taxpayers of the United States received an average of $344.8 million and paid only 17.2% of that income in taxes, including payroll taxes that they may have paid. If you look at the above table again, you will note that someone who makes a mere $20,000 per year pays an effective tax rate of 19.2% — even after subtracting the standard deduction and personal exemption! Furthermore, hedge fund managers, some who make more than $1 billion per year, are exempted from paying any payroll taxes on their performance fee, which is usually most of their compensation if they are profitable, thanks to their Republican friends in Congress.

However, the largest single factor that has created this inequity in taxation is the fact that earned income is the most highly taxed income, even though, for maximum economic growth, earned income should be the least taxed, because the higher price of wages due to these income taxes decreases the demand for labor while the lower amount received by the suppliers of this labor reduces supply — in other words, it lowers the incentive for work. In economics, this is referred to as the deadweight loss of taxation. Indeed, it is only work that increases the economic wealth of any society. Even investments cannot create true economic wealth unless it is used to put people to work, and transferred wealth actually reduces economic wealth because the people that receive it have a reduced incentive to actually work. Hence, the prudent economic policy of any government should be to tax work the least and gratuitous transfers the most.