Series 79: A1.8.1. Overview Of Income Tax

A1.8.1. Overview of Income Tax

The best way to understand the concept of a progressive tax system such as we have in the U.S. is to imagine that the government allows you to fill up a series of imaginary buckets with a portion of your earned income (wages, earnings from your business, rental properties, etc.), with each bucket being taxed at a different rate. Everything you can fit into the first bucket is taxed at the lowest income tax rate. If you have more earned income than can fit into that first bucket, what is left overflows to the next bucket, which is then taxed at a higher rate. This does not mean the first bucket is then taxed at a higher rate … only the additional money that overflows to that next bucket.

If the first two buckets (they are actually called tax brackets) can’t hold all the earned income a taxpayer has for the current year, then the remainder flows over to the next highest tax rate bucket, and so on. Each bucket has a tax rate that is higher than the previous bucket, so the people making the least pay the lowest tax rate and the people making the most pay the highest tax rate—this is the core idea in our progressive tax system. This stands in contrast to a regressive tax system, where individuals are taxed uniformly at each income level. Proponents of this approach often call it a “flat tax,” which it is, since someone earning $50,000 per year would pay the same tax rate (or percentage of taxable income) as someone earning $1 million