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The Three Stooges Effect: The Irrational Fear of Tax Brackets
The Stooges promptly emit gasps of horror: “What, and go into the next income tax bracket?” The Stooges run off, forsaking the money.
Is their fear of going into a higher tax bracket justified? Let’s look at some real data. Shown below, in round numbers, are the income tax brackets for 2006 (for married couples filing jointly):
Up to $15K – 10%
Up to $61K – 15%
Up to $123K – 25%
Up to $188K – 28%
Up to $336K – 33%
Over $336K – 35%
Suppose you get a raise and your household income increases from $60,000 to $64,000. According to the Stooges logic, your raise puts you in a new bracket. Here is how the Stooges would figure it:
1. Before your raise, your income is less than $61,000. Therefore, your taxes before the raise are 15% of $60,000, or $9000. Your take home pay before the raise is $60,000 - $9,000, or $51,000.
2. After the raise your income is over $61,000, so you are in a new tax bracket. Your taxes after the raise are 25% or $64,000 or $16,000.
Take home pay after the raise is $64,000 - $16,000, or $48,000.
Looks like the raise set you back! Your take home pay is actually $3000 less after the raise. Better to turn down the raise and flee like the Three Stooges.
The Stooges are, of course, totally wrong. The brackets represent levels of income that you may be in simultaneously. Tax brackets are a way of gradually, not suddenly, increasing your taxes as your income increases. Let’s do the calculation correctly, using the tax brackets for 2006 and assuming you earn $64,000. The first $15,000 you earn is taxed at 10%. The next $46,000 you earn (from $15,000 up to $61,000) is taxed at 15%. And finally, the last $3000 you earn (the difference between $64,000 and $61,000) is taxed at 25%. The calculation is as follows:
10% of $15,000 = $1500
15% of $46,000 = $6900
25% of $3,000 = $750
Totals $64,000 $9150 (taxes on $64,000 vs. Stooge computation of $16,000)
Because the brackets only tax specific parts of your income, your taxes on an income of $64,000 is only $9150, not $16,000. Repeating the calculation method for $60,000 will show that the taxes on it are $8250. A raise of $4000 costs you only $900 in extra taxes ($9150 - $8250 = $900). Therefore, your raise gains you $3100. The Stooges were wrong.
Keep in mind that the computation of your nominal taxes is based on the rates applied to the specific amounts you make in each bracket. If your income is less than $15,000, you are in only one bracket. If you make $750,000, you pay tax on your income in every bracket currently in place: you are taxed at a 10% rate on your first $15,000, increasing rates in the middle brackets, and a 35% rate for all income over the upper limit of the top bracket (over $336,000).
Exercise: Using the table above (2006, married, filing jointly) what are your taxes if your income is $250,000? Hint: the calculation is already started for you; just continue the example for $64,000 above.
Let’s not completely dismiss The Stooges as our financial advisors, however. The Stooges may have had an irrational fear about going from one tax bracket to another, but there are rational fears about high taxes that the Stooges’ reaction represents. If your income is already high, any raise you receive will be taxed at a high rate. The Stooges’ reaction to getting more money represents a rational fear that trying to earn more may be a poor tradeoff. Suppose you already have an income over $336,000 and your company offers you an extra $10,000 per year for working all day every Saturday. The question you face is whether or not it is worth the effort if the $10,000 is taxed at 35% In effect, your company is actually offering you $6500 ($10,000 minus 35%). From this example, you can see that on a broader, social scale, tax rates will influence personal choices about possible costs and benefits and will therefore affect the economy as a whole. When deciding on tax policy, you need to understand the rational relationships among tax rates, the motivations of workers, social costs, and social benefits.
The story of taxes does not end here by any means. If the computation of taxes were so simple that even the Stooges – with a little tutoring – could figure it out, why does it seem so complicated to most people? The answer is that the computations above are only the first pass in a process that will adjust your taxes according to an incredibly complex set of government-controlled incentives and forced savings programs. Learn more about these incentives and savings programs in the next module (forthcoming).
Created on April 2, 2013. Revised 4/2/2013