Graduated income tax refers to a situation where tax rates change as you make more money. The United States federal government uses what's called a progressive graduated income tax, where earnings between certain levels are taxed at certain rates, increasing as you make more money. Some states use a graduated income tax, while others use a flat tax, where all income is taxed at the same rate.
Graduated Tax Definition
A graduated tax is a system where the tax rate is divided into tax brackets, and earnings between certain levels are taxed at certain rates. For example, the first $10,000 of earnings might be tax-free, with earnings between $10,000 and $25,000 taxed at 2 percent and earnings above $25,000 taxed at 4 percent.
Note that in most graduated income tax systems in use today, including the United States federal income tax, each person's income is taxed according to each bracket it passes through. Using the example brackets above, a person making $50,000 would pay no tax on the first $10,000, 2 percent on the next $15,000 and 4 percent tax on the next $25,000, for a total tax of 0 * 10,000 + 0.02 * $15,000 + 0.04 * $25,000 for a total of $1,300 in total tax.
Simply taxing all income at the highest tax bracket a person enters would create scenarios where people would be incentivized not to work more, since their total tax could increase more than their pay increase at certain thresholds.
Progressive Income Tax Definition
A progressive tax is one where higher earners pay a higher portion of their income in tax. The opposite is a regressive tax, where people earning more money pay a lower portion of their income in tax. The opposite of a graduated income tax is a flat income tax, where all incomes are taxed at the same rate. For example, all income could be taxed at 33 percent, and for each dollar you earn, you would pay 33 cents.
The terms are widely used in economics and aren't meant to be political or to criticize one type of tax or the other. Some sales taxes are seen as examples of regressive taxes, since they can lead to lower income people paying a higher percentage of their income in sales tax since they must spend a higher percentage of their income on necessities like food and clothing.
United States Federal Income Taxes
The United States federal tax system uses a system of increasing income tax brackets so that, before deductions, credits and other adjustments are taken into account, people earning more money will be in the same or a higher rate income tax bracket compared to people earning less money. This is considered a graduated income tax, since it is divided into brackets, and a progressive income tax, since those brackets offer increasing tax rates.
The exact brackets shift over time to adjust for inflation and changes to the tax laws set by Congress. At present, the highest tax bracket pays 37 percent in tax, and the lowest bracket pays 10 percent.
State Income Taxes
Many states in the United States use a progressive, graduated income tax system similar to the federal system. Those states include New York, California and Georgia. Other states, including Massachusetts, Indiana and Illinois, impose a flat income tax. Texas, Florida and Washington are among the states that do not have any state income tax.
Some jurisdictions also have city and county income taxes. State and local taxes can be deducted to some extent from federal taxable income.
If you live in one tax jurisdiction and work in others, keep homes in multiple jurisdictions or move from one jurisdiction to another, you may owe tax in multiple places. How your income is taxed between the jurisdictions depends on agreements between the states and the exact nature of your income. Consult a tax adviser or tax software if you're not sure how to compute your tax.
Social Security and Medicare Taxes
The Social Security tax in the United States is often called a regressive tax. It taxes earnings from work up to a certain threshold, set at $132,900 for the 2019 tax year and $137,700 for 2020. Employees and employers each pay 6.2 percent of wages or salary, and beyond that, income is not taxed. Social Security tax supports income for elderly and disabled people, as well as some widows, widowers and children of deceased people.
The Medicare tax, which supports health insurance for elderly and disabled people, is a flat tax on earnings from work. Employees and employers each pay 1.45 percent of wages or salary with no cap.
Self-employed people pay both the employer and employee portion of these taxes, although there are some credits and deductions available to offset that.
Credits and Deductions
While the United States generally has a progressive federal income tax system, credits and deductions can make things more complicated. Tax credits directly offset taxes owed, while tax deductions allow you to offset or effectively reduce some of your taxable income.
For example, if you make $10,000, putting you in a 10 percent income tax bracket, you would normally owe $1,000 in federal income tax before any credits or deductions. If you received a tax credit of $1,000, you would owe no tax, since the $1,000 would offset the $1,000 you owe in tax. If you instead received a tax deduction of $1,000, you would pay tax as if you had earned $10,000 - $1,000 = $9,000, meaning you would owe 10 percent of $9,000, or $900.
Some income tax credits are refundable, and you can receive money from the government if your credits exceed your taxes. That is, if you have $1,000 in tax liability and receive a $1,500 tax credit, you will receive $500 back from the government. Check with the Internal Revenue Service, work with tax software or a tax preparer to figure out which credits and deductions you are eligible for, how to claim them and if they are refundable or not.
Because some higher income taxpayers may offset a lot of their income with tax deductions and credits, it is possible for someone to earn more money than someone else yet pay less in total tax, despite the progressive tax brackets.
Capital Gains Tax
Long-term capital gains tax is generally paid when you sell an investment, such as stocks or real estate, for a profit after holding on to it for at least a year. Capital gains tax brackets are also progressive, with rates set at 0 percent, 15 percent or 20 percent depending on total income. Most taxpayers pay a 15 percent capital gains tax rate. Unlike other income tax, all of your capital gains taxes are paid at a single rate, so you do not exhaust the 0 percent bracket before moving into the 15 percent bracket, and so on.
Capital gains tax offers its own set of deductions and special exemptions, such as for transaction costs like stock trading commissions and certain deductions related to buying and selling real estate.
- Investopedia: Progressive Tax Definition
- Bankrate: 2018-2019 Tax Brackets
- Investopedia: Flat Tax
- Investopedia: The Social Security Cap
- Massachusetts: Income Tax Rate to Drop to 5.05% on Jan. 1
- Bankrate: State Taxes: Colorado
- Bankrate: State Taxes: New York
- Bankrate: State Taxes: Georgia
- Bankrate: State Taxes: California
- Bankrate: State Taxes: Illinois
- Business Insider: States with No Income Tax
- IRS: Topic No. 751 Social Security and Medicare Withholding Rates
- Nerdwallet: Tax Credits vs. Tax Deductions
- Investopedia: Capital Gains Tax