U.S. Commissioner of Internal Revenue Doug Shulman. Never mind that this is apparently his Bar Mitzvah photo, nor that he opted for the festive ultraviolet at Sears Portrait Studio that day. Get a load of this actual quote: "I use a preparer...I've used one for years. I find it convenient. I find the tax code complex, so I use a preparer.”

Taxes are too high, but not necessarily as high as you think.

This post isn’t going to argue about the merits or weaknesses of our tax system, nor about the obscene amounts of our money that our elected officials spend on our behalf – spending that’s inseparably tied to the taxation and that shows zero signs of abating or even decelerating.

Stop 100 people on the street and ask them the difference between an effective tax rate and a marginal tax rate. 97 of them will stare at you and drool. The remaining 3 will know the answer, but won’t give it to you because they’ll be too busy wondering why you’re stopping random people and asking them finance questions.

The concept of marginality shows up in freshman college economics courses but rarely thereafter, even though it’s critical and often misunderstood. Let’s see if we can explain it without charts. Not that they wouldn’t help, but I can write several paragraphs in the time it takes to create a chart. Besides, dropping one in would create at least the semblance of a dreary academic lecture.

“The highest tax rate in this country is 35%! Why should I bother making money, when 35¢ of every dollar goes to taxes?”

3 reasons, in increasing order of importance:

1. That’s tax on income, i.e. wages and salaries. If you get paid in cash, how much of it you declare is your business. Just don’t get stupid and declare none of it. At least not under your real name. Or at least not under your real Social Security number.

2. There are other ways to earn money, namely capital gains. The IRS calls this “unearned income”, as if you were just walking down the street nonchalantly when a giant cartoon bag of money with a dollar sign on it fell out of the sky and hit you on the head. Capital gains are taxed at their own rate, typically lower than income and in some cases, zero.

3. Alluded to above, the difference between “marginal” and “effective”.

We have these things called “tax brackets” in the United States. Make $34,000 a year*, you’re in one bracket. Make $34,001 and that moves you into a higher bracket, meaning one in which you pay a higher percentage of your income in taxes. Make $373,651, that puts you in the highest bracket of all.

There are 6 brackets. The 3 referred to here are the 15%, 25%, and 35% brackets respectively.

Are we going too fast?

So if I make $34,000, I’ll pay 15% of it in federal income taxes, or $5100. If I make $34,001, I’ll pay 25%, or $8500.25. I make $1 more, but it costs me $3400.25. What a rip.

Alright, apparently we are going too fast.

No. One bracket starts where the previous one stops. If you make $34,001, the IRS treats you like someone in the 15% bracket for the first $34,000 of your income. And treats you like a mid-level tycoon for the remaining dollar, one that they charge you 25% to keep.

This is what a marginal tax rate means. You pay 25% only on the marginal income – i.e., the part of your income that gets you in that particular bracket. There, you just dodged a $3400 bullet.

It’s not even that bad. The 15% bracket also refers to a marginal rate. That bracket starts at $8375, which means that if you make $34,000 (or anything greater), you’re not paying 15% on $34,000 of it. You’re only paying 15% on $25,625 of it. The lowest tax bracket is the 10% bracket, which is for any salary or part of a salary under $8375.

So at $373,651, in the 35% bracket, you’re paying the following:

Is this a big deal? Sure it is. If you were paying 35% on all your income, your tax bill would be $22,000 higher. This total tax bill above represents an effective tax rate of 29% – your total tax as a ratio of your income.

But even the numbers in this example are unduly liberal, because they don’t account for the tax credits and deductions we’re all entitled to – for everything from making mortgage payments to saving receipts for charitable donations. (That’s not even counting the tax benefits available to someone who registers as a corporation rather than as a regular wage earner, instead of merely drawing a salary and letting her boss enjoy said benefits.)

The Beatles wrote a song about marginal rates, “Taxman”. Opening line:

Let me tell you how it will be/
There’s 1 for you, 19 for me.

That’s right – at the time, the highest marginal tax rate in the UK was 95%.

The government set such an absurdly high rate to make “the rich” pay “their fair share”, two subjective phrases that mean nothing. Apparently, whomever thought up such a rate (and its cousin, the 77% marginal rate the United States imposed in the late ‘60s) thought that there existed taxpayers who were

-smart enough to earn lots of money, yet
-too dumb to devise a way around those taxes.

The imposing authorities forget that taxpayers are ambulatory, and that work is voluntary. Why pay 77% in the US when you can pay a lot less by moving to Switzerland or Antigua? Or if you don’t want to pack up and move, then why even bother working beyond a certain point? What incentive is there to contribute anything extra to the nation’s output when you get to keep almost none of that contribution?

Beyond that, plenty of high-income earners put their money in shelters. You know what tax shelters are in theory, but keep in mind that they exist for non-economic reasons. If you’re making good money, you likely don’t put it in a tax shelter to help that money grow, to invest in a new product, or to employ people. You often do it for completely antithetical, defensive reasons – setting up a third party to funnel money through, channeling it offshore, etc. It doesn’t help the economy grow, it just keeps it out of the hands of the IRS. Which is a laudable goal, but a secondary one.

*Assuming you’re single. If you’re married, or recently widowed, or something called “head of household” (long story, and a topic for another day), the cutoff incomes differ.