Incremental Tax

What Is an Incremental Tax?

The term incremental tax refers to a tax system in which the percentage of taxes a person pays increases based on their income level. In an incremental tax system, those with higher incomes pay a larger portion of the taxes and, therefore, contribute more to the government's revenue than those with lower incomes. Income levels are sorted into tax brackets in this type of system. Each bracket pays a different percentage of their gross income to the government.

How Incremental Tax Works

Incremental tax systems involve taxing people at different rates. As such, incremental tax is also called a progressive income tax or a marginal rate tax. Rates are set by the government. Taxpayers fall into brackets based on their incomes. They are also taxed based on their marital status—whether they file their returns as individuals or as married couples.

The table below shows the rates and income levels for each type of filer in 2021: single, married filing jointly, and heads of household. 

Each increment in the tax table pays a different level of tax, and increments are taxed for every taxpayer progressively through the scale. This is the most misunderstood aspect of incremental taxes. The top earners who are in the 37% tax bracket do not pay 37% of their income to the federal government.

All earners who make less than $9,700 per year pay only 10% of their money in taxes, and with the standard deduction (for single filers, it's $12,200) you pay nothing at all in federal taxes—though you may have to pay state, local, and FICA taxes.

If you make more than $523,600 as a single filer, you pay 10% on the first $9,700, 12% on the next $29,300, 22% on the next $44,725, 32% on the next $76,525, 35% on the next $43,375, and 37% on the next $306,200 for a final total of $167,288.75 or 32.78% of your income—not the top bracket rate of 37%. You end up saving $20,000 with the incremental method.

Incremental Tax vs. Other Types of Taxes

Incremental taxes make up just one type of tax system, which is charged on income. But there are other types that taxpayers must pay.

Flat or Proportional Tax

Like incremental taxes, a flat or proportional system taxes individuals based on their incomes. But instead of brackets, everyone is charged the same regardless of how much they make or their net worth. Flat taxes allow people to earn more and keep more of that income in their pockets—you'll pay the same amount whether you make $30,000 or $150,000 every year.

Nine states have a flat tax system in place. As of 2020, these include Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah.

Regressive Taxes

Like the flat tax, regressive taxes are charged uniformly regardless of a person's income. People with lower incomes, though, are affected by regressive taxes to a higher degree than high-income earners. That's because the people in the latter group can afford to pay more. Regressive taxes may include things like sales tax, property and school taxes, and sin taxes—taxes that are levied on items like alcohol and tobacco.

For example, New Jersey charges all individuals 6.625% sales tax on most items. Everyone who shops in the state is charged this amount. But the tax negatively affects low-income people. A $500 item costs $533.12 after tax ($500 x 1.06625). Someone who only earns $1,000 each month may find it difficult to afford this item, while an individual with a monthly salary of $4,000 probably won't have much of an issue.

Example of Incremental Tax

Here's a hypothetical situation to show how the incremental tax system works. Let's say an individual earns $38,000 every year. That income level puts them in a tax bracket with individuals who gross between $9,700 and $39,475 per year. In that tax bracket, the Internal Revenue Service (IRS) requires this person to pay $970 plus 12% of any amount over $9,700 but below $39,475, which in this case is $3,417. So, $970 plus $3,417 equals a total of $4,417 that this person must pay in taxes. This means they net $33,583.

This person may decide that they want to earn extra money. If they take on a part-time job and earn an extra $2,000 per year, they now fall within a new tax bracket because they earn $40,000. This bracket includes individuals who gross between $39,475 and $84,200.

In this bracket, the individual must now pay $4,417 plus 22% of the amount over $39,475, which in this case is now $525. The total tax they now owe is $4,532.50. After paying taxes, they net $35,467.50. They still make more money with a small increase in income, despite being in a new tax bracket.

It is important to note that this example does not account for any deductions, including the standard deduction, which also affects the amount of tax that a person pays when filing their tax returns. It also does not account for any state, local, and FICA taxes.