Kristina Collins, a chiropractor in McLean, Va., said she and her husband planned to closely monitor the business income from their joint practice to avoid crossing the income threshold for higher taxes outlined by President Obama on earnings above $200,000 for individuals and $250,000 for couples. Ms. Collins said she felt torn by being near the cutoff line and disappointed that federal tax policy was providing a disincentive to keep expanding a business she founded in 1998. "If we're really close and it's near the end-year, maybe we'll just close down for a while and go on vacation," she said.
This is a surprisingly popular- but incorrect- view of how taxes are calculated. When you hear about "tax brackets," what people are actually referring to are the different marginal tax rates charged at different levels of income. For example, for 2012, tax brackets are as follows for an individual in the U.S.:
- 10% on taxable income from $0 to $8,700
- 15% on taxable income over $8,700 to $35,350
- 25% on taxable income over $35,350 to $85,650
- 28% on taxable income over $85,650 to $178,650
- 33% on taxable income over $178,650 to $388,350
- 35% on taxable income over $388,350
(See here for a more complete listing of tax rates.) These rates do NOT mean, however, that if my income increases from $85,650 to $85,651, for example, all of a sudden I am paying an overall tax rate of 28% rather than 25%. Instead, the higher 28% tax rate is levied only on the portion of income that exceeds $85,650 ($1 in this example), and the tax bill on the old income remains the same. One important feature of this system is that, unlike the chiropractor seemed to assume, it's not possible for a higher pre-tax income to result in a lower after-tax income. (For this to occur, the marginal tax rates as listed above would have to get higher then 100 percent.) The downside of this system is that calculating an effective tax rate is not the simplest thing in the world. Luckily, the Internet can do it for you.
On the other hand, there are tax proposals on the table that would break this rule and create what Nate Silver calls bubbles in the tax code. Yikes.
As a reminder, you can read more about different types of taxes here.