The federal personal income tax is the largest single source of tax revenue in the United States; most states and many cities tax income as well. All income tax systems apply a variety of exclusions to a taxpayer’s total income before arriving at taxable income, the amount of income that is actually subject to the tax. In the U.S. federal income tax system, for example, a family deducted $3,200 from total income earned in 2005 for each member of the family as part of its computation of taxable income.
Income taxes can be structured to be regressive, proportional, or progressive. Income tax systems in use today are progressive.
In analyzing the impact of a progressive tax system on taxpayer choice, economists focus on the marginal tax rate. This is the tax rate that would apply to an additional $1 of taxable income earned. Suppose an individual was earning taxable income of $8,025 and paid federal income taxes of $802.50, or 10% of taxable income (we are ignoring exemptions that would eliminate taxes for such an individual). If the taxpayer were to receive $100 more of taxable income, however, that $100 would be taxed at a rate of 15%, the rate that applied in 2008 to taxable incomes between $8,025–$32,550 for individuals. That person thus faced a marginal tax rate of 15%.
Economists argue that choices are made at the margin; it is thus the marginal tax rate that is most likely to affect decisions. Say that the individual in our example is considering taking on additional work that would increase his or her income to $15,025 per year. With a marginal tax rate of 15%, the individual would keep $5,950 of the additional $7,000 earned. It is that $5,950 that the individual will weigh against the opportunity cost in forgone leisure in deciding whether to do the extra work.
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