Few people know that the income tax was unconstitutional until the passage of the Sixteenth Amendment in 1913. Since then, the income tax has been altered in more ways and more times than one could count.
We frequently encounter people who aren’t entirely sure how our income tax system works, so let’s take a moment to demystify it, as well as discuss the rationale behind it and some alternatives.
Generally speaking, our income tax system is a “progressive” system (not to be confused with the political movement of the same name). In a progressive tax system, a person’s average tax rate becomes progressively higher as their income increases, and for good reason.
Imagine you were parched and stranded in a desert until you came upon a water salesman. You’d likely be willing to pay any amount of money for a single bottle of water, as its use to you would be immeasurable. Thereafter, each bottle of water that you might purchase is relatively less valuable to you than the one before it. Imagine how little, if any, you’d be willing to pay for your one-millionth bottle. Our income tax system attempts to treat money in the same fashion.
The first dollar you earn each year is relatively more useful to you than your ten-millionth dollar, which is why your first dollar is not taxed at all. In fact, currently, your first $16,100 will come to you completely free of income tax.
For income taxation purposes, we set different tax rates for different blocks of income, or what we call “tax brackets”. Because each block of income is of relatively less use to you than the block before it, it is taxed at a higher rate. For example, your 16,101st dollar will be taxed at 10%, while your 656,701st gets taxed at a maximum rate of 37%. Each dollar is taxed at a rate that correlates to its bracket and, contrary to popular belief, moving into the next bracket only affects the tax rate on the next dollar you earn; it is not retroactive to your other income. So, if you’re in the highest bracket, you’ve actually paid tax at eight different rates, ranging from 0-37%.
Not only do you need your first dollar more than your ten-millionth, but people in the lower income brackets benefit relatively less from the services of the government than do people in the highest brackets (contrary to what some may tell you).
Consider that Jeff Bezos benefits more from roads, bridges, tunnels, railways, and airports for movement of goods around the country than you do. Elon Musk benefits more from government subsidies for rocket development and launches than you do. Mark Zuckerberg benefits more from a highly educated and healthy workforce than you do. They all benefit more from a strong military to defend their interests than you do. Inarguably, the wealthy should shoulder more of the tax burden.
An alternative system has been proposed in the past. You may have heard of the flat, or “fair” tax. In this construct, every taxpayer would pay the same rate, regardless of income. That sounds great on the surface until you realize that lower-income workers can’t afford to part with as much of their income as those with very high incomes. The result is that you have lower- and middle-class workers subsidizing the very wealthy. In other words, this system is regressive, as the burden falls most heavily on those with the least ability to shoulder it. It’s hard to see the fairness in that.
This certainly isn’t intended to vilify the wealthy, even if our current oligarchs do resemble a cross between Howard Hughes and a Bond villain.
At one time or another, we’ve all bought a Powerball ticket and dreamed of the ways we’d spend a billion dollars, only to lament that the government would take half of it. As Americans, and believers in the American Dream, we can all see ourselves being very wealthy. In that way, it sometimes becomes easy to defend the interests of the very wealthy against our own.
Nobody imagines being poor.
Our progressive income tax system is not a punishment for success. Instead, it reflects the reality of who benefits most from the services provided by our government and attempts to ensure those who benefit most, shoulder most of the costs.
Stephen Kyne, CFP® is a Partner at Sterling Manor Financial, LLC in Saratoga Springs.
Sterling Manor Financial, LLC is an SEC Registered Investment Advisor and does not provide tax or legal advice, nor is it a third-party administrator. Consult your attorney or accountant prior to implementing any tax or legal strategies.