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Nominal vs. Effective Tax Rates

Understanding how taxes are computed using the tax brackets is an important first step towards  voter competency in judging political claims. But we need to understand how these nominal rates, combined with other laws, result in effective tax rates – the actual percentage of your income that you pay in all federal taxes. The effective tax rate is calculated by the following formula:

                                                Effective Tax Rate = Total Federal Taxes Paid ÷ Taxable Income

Your effective tax rate will always be less than the nominal (marginal) tax bracket you are in for two reasons.

First, except in cases where your income is less than the lowest tax bracket, your income will span several brackets. To return to the Stooges example, their income is $64,000. This income spans the 25, 15, and 10 percent brackets.  Their tax on $64,000 was $9,150. The Stooges’ taxes as a percentage of income is therefore

$9,150 ÷ $64,000  = .143 (14.3%).

Because most incomes are taxed in several brackets, the effective rate of taxation will always be less than the highest tax bracket rate.

Second, all incomes are adjusted using deductions and exemptions to income provided in the tax code.  This will further reduce your taxes – often dramatically. In fact, once deductions are accounted for, you will discover that the tax brackets are almost worthless as a guide to the effective tax rates for the majority of households.

Our 9000 page tax code has provided many ways for tax payers to significantly lower their taxes. These include getting married, having children and buying a house. The tax code also applies a complicated system of different tax rates to other sources of income. Wages are always taxed using the tax brackets.  Income from other sources, such as stock dividends, are taxed at other rates, some as low as 15%. 

Deductions and exemptions can reduce the income tax portion of your federal tax burden to zero!

For example, in 2010 a married couple household could exempt $3700 per person and deduct $11,600 for being a married couple. If the couple's total gross income was $50,000, these provisions in the law reduce the income used for calculation (based on the brackets) to $31,000. Using the 2010 rates, the total taxes they pay would be $3800 (10% of the first $17,000 and 15% on the remaining $14,000). Their effective tax rate is the amount they pay in taxes divided by their total gross taxable income prior to deductions and exemptions. This works out to  7.6% -- only half the 15% bracket..

                                                Effective Tax Rate = $3800 ÷ $50,000 = .076 (7.6%)

Suppose the couple also paid $10,000 in interest payments on a new home loan. This amount is deductable, so the number used for calculating the taxes due would be $21,000. If they had two children, their taxable income is reduced to $13,600. Their taxes are now 10% of $13,600 or $1360. Their effective rate is 2.7%.

                                                Effective Tax Rate = $1360 ÷ $50,000 = .027 (2.7%)

You can see where this is going! Other deductions, such as medical expenses, a home office, investment losses, and professional dues could reduce their income tax burden to nearly zero. Similar considerations apply to nearly every household in every income quintile. These corrections to taxable income make a huge impact on income taxes actually collected from households by the U.S. government. In the first quintile, 93%, in the second, 60%, and in the third, 30% pay no individual income taxes. Overall, about 47% of all households reduce their income taxes to zero (Source: Tax Policy Center). All individuals still pay Social Security taxes and other federal taxes, but effective tax rates – the rates that really matter – are dramatically different than what you might expect from an  uninformed (Three Stooges style) inspection of the tax bracket tables.  

Created on April 2, 2013. Revised 4/2/2013