by Charles Davisson
Government runs on money! Our governments provide us with all kinds of services, from national defense to elementary schools. Mostly, they fund these services with taxes.
For a discussion about taxes, you need to understand several concepts: Disposable income, regressive taxes and progressive taxes.
Disposable income is income left over after paying for essentials, such as food, housing, clothing, a means of transportation and health care. Some don’t include health care in this definition, but when you have to choose between going to the doctor or paying the rent, health care becomes an essential cost of living. Low income people don’t have much, if any, disposable income. High income people do.
Regressive taxes — essentially flat taxes — take a larger percentage of income from low income people than from high income people. A fixed rate is applied to something of value, which seems fair. We all pay 7% sales tax when buying a car. But, the guy buying the $100,000 car doesn’t care; $7,000 doesn’t mean as much to him.
Progressive taxes, such as federal income taxes, take a larger percentage of income from high income people than from low income people. Taxes are complicated because there are so many different ways of earning income and of taxing different types of income. For most people, it’s simple: You have salaries and wages.
Your income is taxed in layers or brackets, with each layer taxed at a progressively higher rate as the income increases. Most West Virginians will find themselves in the bottom three brackets: 10%, 12% and 22%. If you are in the 22% bracket, some of your income will be taxed at 10%, some at 12% and some at 22%. Being in the 22% bracket does not mean all your income will be taxed at 22%.
There is a standard deduction that, depending on your filing status, will allow you to deduct an amount from your salaries and wages to determine your taxable income. In effect, this is a 0% layer of income below your 10% layer.
Let’s do some examples. Let’s have two married couples filing as “married filing jointly” and their standard deduction will be $25,100.
Couple A earns $45,000. After subtracting $25,100, their taxable income will be $19,900. The first bracket goes from $0 to $19,900. All their taxable income will be taxed at 10% for a total of $1,990. Their effective rate is 4.4% (1,990 ÷ 45,000). My definition of “effective rate” is the “total tax” divided by “total income.” The effective rate shows your actual rate is less than your top bracket rate because of deductions and the tiered rate structure. Couple A’s after-tax income is $43,010.
Couple B earns $160,000. After subtracting $25,100, their taxable income will be $134,900. Their first $19,900 will be taxed at 10% for a tax of $1,990. The second bracket goes from $19,900 to $81,050, so their next $61,150 will be taxed at 12%, or $7,338. The third bracket goes from $81,050 to $172,750. Their next $53,850 will be taxed at 22%, or $11,847. Their total tax is $21,175. Their effective rate is 13.2% (21,175 ÷ 160,000), and their after-tax income is $138,825.
If we had a couple whose taxable income was $1,000,000, we could work our way through all seven brackets, including $371,700 taxed at 37%, or $306,523 — an effective rate of 30.7%. Their after-tax income is $693,477.
It’s important to note the higher rates in the higher brackets have no effect on the rates or taxes of people in the lower brackets. Progressive taxes are better, because additional brackets with higher taxes can be added on top without affecting the bottom.
Wealthy people do pay more, because they are taxed at higher rates on more income. However, they have more disposable income, so they can afford to pay more.
Charles Davisson is a retired CPA with over 40 years in public accounting, serving businesses and their owners, employees and related retirement and welfare plans. He was born and raised in Charleston, served seven years in the Navy, graduated from WVU and was recruited by a national CPA firm to Pittsburgh, where he spent most of his career.
