“Taxes, the most exciting and fun personal finance topic” – said no one ever
In all seriousness, taxes are foundational to the American financial system and involve a plethora of complex accounting methods. They are often extremely overwhelming to current college students and recent graduates since there are so many different tax forms and reporting nuances to be aware of and schools seldom teach students about the tax filing system.
In Benjamin Franklin’s own words, “the only 2 certainties in life are death and taxes.” And the reality is that taxes are only headed in one direction: UP! Currently, the 2023 maximum individual income tax bracket is 37% and the corporate tax rate is 21%, but we must not forget that these top rates were much much higher not too long ago. In 1981, the top individual income rate was 70% and in 2017 the corporate tax rate was 35%. The future will likely look much closer to the latter rates than the prior.
So, what does the government do with all of this tax revenue and what forms of tax take the most money out of our pockets?
The majority of tax revenue is spent on governmental programs like social security checks, healthcare for the elderly, and other benefits. From the infographic below, we can see that most of the Federal Government spending is considered “mandatory”, comprising over $4.5T of the total Federal expenditures in 2020. We will see later how 50% of this is funded by Federal income taxes on individuals. Thus, taxes are here to stay! And keep in mind, there are myriad other taxes like state income taxes, social security, sales, property, Medicare, etc.
The pie chart below shows a rough breakdown of Federal tax revenue in fiscal year 2019. Individual taxes currently make up over 50% of revenue in fiscal year 2023, a trend that is continuing to go up and signals a greater reliance on individual income taxes to fund the government’s operations. Check out this site for some interesting graphs and statistics on how revenue has changed over recent years.
With all of this individual income tax talk, you may be wondering how the taxes actually work?
The US has a progressive tax system, meaning that as you make more income, you will be taxed at higher rates. Take a look at the 2023 tax brackets below for an idea of how this would look.
These are all marginal tax rates on the left-hand side of the table, and they phase out each time an individual passes a certain threshold of income such as the switch from a 10% to 12% tax rate once you cross $11,000 in income as a single tax filer. Thus, your income is not taxed at a fixed rate.
Now, let’s calculate an individual’s federal income tax with an income of $100,000 for the year.
| Tax Bracket | Single Tax Filer Amount Due | Total |
| 10% | 11,000 x .10 = | $1,100 |
| 12% | (44,726 – 11,000) x .12 = | $4,047 |
| 22% | (95,375 – 44,726) x .22 = | $11,143 |
| 24% | (100,000 – 95,376) x .24 = | $1,110 |
| 32% | 0 (doesn’t reach this tax rate) | 0 |
We see that a salary of $100,000 is not taxed over the 24% marginal tax bracket because an individual must make more than $182,101 to be taxed at the next rate, 32%. Further, we can add each marginal tax bracket amount up to get the total income tax owed by a person to the federal government. This gives us a $17,400 tax liability on a $100,000 salary for 2023.
This lets us calculate an individual’s effective tax rate: total tax / total income = 17,400 / 100,000 = 17.4% tax rate. This shows that even though we finished in the 24% marginal tax bracket, our effective tax rate was much lower at just 17.4%.
This was a very simple example, but it shows you how to calculate federal income taxes and the difference between marginal and effective rates.
Note: Tax brackets and their respective phase-out amounts are subject to change each year and, in reality, there are other taxes that will affect your take-home pay such as state income tax, property, sales, Medicare, and social security.