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Friday, May 7, 2021

Misunderstanding Tax Brackets

 Jason L. Saving and Alan D. Viard at AEI:
A simple example illustrates how tax brackets work for the 2020 tax returns that are due on May 17. (For simplicity, we assume that taxpayers compute their taxes from the exact tax rate schedule rather than the tables that the IRS has constructed to approximate the rate schedule.) For married couples filing jointly, the bottom 10 percent bracket applies to the first $19,750 of taxable income, so that a couple with an income of $19,750 owes $1,975 in tax.

The 12 percent tax bracket then begins. This has no effect on the first $19,750 of income, which is still taxed at the 10 percent rate. Only income above $19,750 is taxed at the 12 percent rate. So, a couple with an income of $19,751 owes the $1,975 mentioned in the previous paragraph plus 12 cents from the additional dollar earned, for a total of $1,975.12.

The example also illustrates how tax brackets do not work. Taxpayers in the 12 percent bracket do not pay the 12 percent rate on their entire taxable income. If the brackets did work that way, a couple with an income of $19,751 would owe tax equal to 12 percent of that amount, or $2,370.12. In that case, the final dollar of income would trigger $395.12 of additional tax, so that the couple would have ended up with $394.12 more money without the dollar.

That abrupt jump in tax liability presents a stark contrast with the actual tax-liability increase of $0.12. ...

Unfortunately, many Americans mistakenly think that tax brackets operate in such a capricious manner. One of us (Viard) repeatedly encountered — and sought with partial success to correct — that misconception among his undergraduate public finance students. Professor Joel Slemrod of the University of Michigan has described similar experiences with his students.

A recent survey commissioned by Credello and conducted using the online platform Pollfish confirms that the misconception is not limited to students. A sample of 1,000 Americans aged 18 to 56 was asked to choose which of the following statements is true: “You pay your marginal tax rate on all of your income” or “You pay the same rate as others on income up to a certain amount, then a higher rate on every dollar up to the next threshold.”

Disturbingly, 51 percent incorrectly chose the first statement, with 49 percent correctly choosing the second statement. Although better question wording and survey methodology might have yielded a more rigorous measure of public beliefs, the results clearly reveal widespread misunderstanding. And this misunderstanding can slow economic growth if it leads people to work less or turn down pay raises because they think that slightly increasing their earnings will force them to pay a higher tax rate on all of their income.

A decade ago, Joseph Bishop-Henchman wrote at The Tax Foundation:

As a West Wing fan, I should note that in the fourth season episode “Red Haven’s on Fire,” Lowe’s character makes its last appearance and is replaced by Will Bailey, played by Joshua Malina. In that episode, Bailey makes the case for a surtax on high-income taxpayers, but his argument is sloppy and completely wrong in that he confuses marginal tax rates with effective tax rates. A person in the 35 percent tax bracket does not pay 35 percent on all of his income, but rather only on the income above a certain level.