The income tax is one of the most significant sources of revenue for the federal government. It is also one of the biggest revenue sources for state governments. Here in the State of New York, for instance, income taxes contribute a sizeable percentage to the public coffers. Because we focus so heavily on tax debt resolution here at MC&C, it makes sense that we should look at the various aspects of income tax.
Income taxes tend to cause a big chunk of back tax debt. Taxpayers earn income, rack up a big income tax liability, and then fail to deal with this liability for one reason or another. This problem is all too common. One of the goals of our blog is to educate our readers so they can better understand the tax system in all its complexity. Better understanding will lead to better decisions and ultimately better outcomes in the future.
In this post, we will focus on a few terms which are related to the income tax. The average taxpayer is very likely to come across one or more of these terms at some point. But the typical person has a poor grasp of the meaning of these terms. Let’s go over the definitions of some core income tax terminology.
Marginal Tax Rate
The marginal tax rate is the rate that applies to each additional dollar of income. In other words, it is the tax rate that applies to income within a certain tax bracket. This is distinguishable from the average tax rate, which refers to the total amount of tax measured against a taxpayer’s total income. In our graduated or progressive income tax system, the term “marginal tax rate” is fairly important. Usually, this term refers to the tax rate applied to a given taxpayer’s last dollar. Accordingly, we also hear the variant term “top marginal tax rate.” If 30% is the highest rate that applies to a given person, then 30% is that person’s top marginal tax rate.
Effective Tax Rate
The effective tax rate, a/k/a the average tax rate, refers to the average tax paid by a person. This is true whether the person is an individual or corporation. The effective tax rate is calculated by taking total tax paid and measuring it against a person’s total income. This way, the effective tax rate is essentially an amalgam of all the marginal tax rates paid by a person. If a person has an income of $100,000 and pays $20,000 in taxes, their effective tax rate is 20%. This is so even though that person may have broken into a top marginal tax rate higher than 20%.
Simply stated, gross income refers to the income of an individual or corporation before any deductions are taken. Gross income has a slightly different meaning for individuals for corporations. Nonetheless, both definitions capture the same basic idea. For individuals, gross income refers to a person’s total income before deductions or other adjustments. For corporations, gross income refers to total revenue minus cost of goods sold.
Adjusted Gross Income
Adjusted gross income refers to a given taxpayer’s income which is left after subtracting above-the-line deductions from gross income. Gross income refers to total income; this includes wages, dividends, rental income, tips, capital gains, interest and so forth. Taxpayer’s may subtract certain amounts from this gross amount before taking other, below-the-line deductions. These amounts are referred to as “above-the-line deductions,” or adjustments to income. These are used to calculate adjusted gross income, or AGI.
After computing AGI, the next step is to calculate “taxable income”. Taxable income refers to the income which is subject to tax following all below-the-line deductions and other adjustments. In other words, taxable income is the income to which the various tax rates in our system apply. If you hire a good CPA, you can find all available deductions and compute the lowest possible taxable income.
Progressive Tax Structure
A progressive tax structure, or graduated tax structure, is a system where different tax rates apply to different income levels. In other words, in this system, taxes are greater for higher levels of income than for lower income levels. This contrasts with a flat tax system in which a single tax rate applies uniformly to all levels of income. The United States has a progressive tax structure featuring multiple tax brackets for various levels of income. These brackets historically change over time. Nonetheless, we’ve had a progressive tax structure even since the implementation of the income tax.
These are just a few of the central terms pertaining to the income tax. In the future, we may come back and discuss a few more core terms. Again, the more education we provide, the better our clients will be able to build solid financial lives. At Mackay, Caswell & Callahan, P.C., we help our clients create positive financial outcomes. We specialize in complex debt resolution, including settlements, installments and other strategies. If you need debt resolution assistance, please call one of our New York City tax attorneys today.