- Let's talk about income taxes.
Income tax accounting is its own specialized field.
With income tax accounting there's an important element
of income tax compliance.
You have to make sure that you are obeying the law.
There's also the element of income tax planning,
meaning that you want to try to structure your affairs
so that you don't have to pay any more income tax
than you are legally required to pay.
And of course for you and me,
there's just the routine element of filling out
our income tax form each year.
To facilitate our discussion of income tax systems,
I have designed a very simple income tax system
that contains the important elements
of all income tax systems around the world.
In this simple system,
for income from zero to $50,
you don't pay any income tax at all.
You are allowed to make that money tax-free.
This feature is common in governmental tax systems
around the world.
Now in my system for all income over $50
the tax rate is 50%.
This is going to make our calculations simple.
We can accurately use this simple tax system
to represent systems in place around the world.
Using this simple tax system we will answer these questions,
how much tax would you pay if you made $50?
What if you made $51?
What if you made $100?
And what if you made $1,000?
Let's do the computations in each one of these four cases.
Well, if you make $50,
you don't pay any income tax at all under this system.
The first $50 of income is tax-free,
so that's a pretty easy computation to do.
All right, but what if you make $51?
Okay, on the first $50, you still pay no tax.
On that 51st dollar, you'll pay tax at the rate of 50%,
so your total tax is half a dollar, or 50 cents.
Now this computation illustrates the important notion
of the tax bracket.
You'll sometimes hear people say sadly,
oh, I got a raise,
so now I'm in a higher tax bracket.
Well that's a naive comment, and I'll show you why.
The first tax bracket in this case
is from zero to $50,
and the rate on that first $50 is always zero,
no matter how much you make.
So when you make that 51st dollar,
and move up into the next tax bracket,
the new rate of 50% is not applied retroactively,
you don't have to go back and pay 50% on that first $50,
the first $50 is never taxed.
Going to the next tax bracket doesn't cost you any money,
it just means you have pay a different rate
on the extra income that you're going to make.
So, don't be afraid of making more money,
and going into the next tax bracket.
A raise is always a cause for celebration.
Under this simple tax system,
how much tax do you pay if you make $100?
Well again, the first $50 is never taxed,
so the tax that you pay is zero.
The second $50 is taxed at the rate of 50%,
so you're going to pay a total of $25 tax
if your taxable income is $100.
And if you make $1000,
well again, the first $50 is not taxed,
the remaining $950 is taxed at the rate of 50%.
So you'll pay a total of $475 tax
if your taxable income is $1000.
This simple system shows how tax brackets,
and tax rates are used to determine
the amount of tax you should pay.