The World Needs More Ninjas

In the next post, I’ll talk about what type of accounts you can and should use for retirement savings. At this point, I’ll add a brief interlude about tax rates since your choice of retirement savings (and many other forms of savings, such as college) is largely influenced by tax consequences. Specifically, I’ll focus on your marginal income tax rate.

Basically, your marginal tax rate is what fraction of each additional dollar you earn will go towards taxes. I’ll focus primarily on income taxes since this is generally the rate over which you have the most control in the US tax system. Our income tax system is progressive which means, as your income increases, your marginal tax rate increases. The rates for the 2005 year are given in the following table:

(Source: Yahoo! Finance)

Let’s use single filers as an example (note that this is simplified because in reality, there are a slew of deductions and credits which affect your marginal tax rate). Let’s say your company provides you with a fixed bonus each year, regardless of your salary (just for illustration, obviously most bonuses are pegged to your salary). If your bonus is $1000, then let’s look at the tax consequences for two people, say, Bob and Alice. Bob earns $50K per year whereas Alice earns $150K. To whom is the bonus more valuable? Well, Bob’s marginal tax rate is 25%, so that means this additional $1K of income will be taxed at that rate. In other words, he’ll keep $750 of his bonus. Alice, by contrast, has a marginal rate of 33%, so she’ll only get to keep $667 of her bonus. So, the bonus if about 12% more valuable (750/667) to Bob than it is to Alice. In this case, Bob has a slightly increased incentive to earn the bonus when compared to Alice.

As an economic incentive, the marginal rate can have significant consequences. At the extremes, let’s say a government chooses to not tax your first $50K of income and then every dollar over $50K is taxed at a rate of 100%. It’s relatively easy to see that a worker’s optimal strategy economically is to work just hard enough to earn and keep a $50K/year job and exert no additional effort to get a higher paying job. Why? Because regardless of whether your income is $50K over $200K, you’ll still only take home $50K. A salary of $50K is more valuable than a salary of $40K in this system, but a salary greater than $50K is no more valuable than a $50K salary. This just gives you an idea of how the marginal tax rate can affect economic incentives. For an interesting introduction to more general incentive systems, you should definitely read Freakonomics.

One of the anomalies of the US tax system is the social security tax in that it is a regressive tax where the marginal rate actually decreases as your income increases. In 2005, you effectively payed 6.2% of your salary on the first $90K of your income and zero percent for each dollar above $90K (actually, your rate as a function of your cost to your employer is 12.4% instead of 6.2%). This is a strong incentive to increase your earnings in this case. Medicare, by contrast, in a flat rate of 1.45% (actually, 2.9% to your employer) regardless of your income.

In practice, one of the major effects of marginal rates concerns deductions. Basically, a deduction is money on which you don’t have to pay taxes. Some well-known tax deductions in the US system include having dependents, paying interest on a mortgage, and charitable giving. With a basic understanding of marginal rates, we can now see that deductions are worth more as your income increases.

As an example, let’s say that Bob and Alice still make $50K and $150K, respectively. Now, let’s say that each gives $1000 to their favorite tax-deductible charity. Essentially, this is $1000 on which they don’t have to pay taxes. So, for Bob, this means his tax bill is reduced by $250 since his marginal rate is 25%. Alice, by contrast, has her tax bill reduced by $333 for the same contribution. So, we can see that the deduction is 33% more valuable (333/250) to Alice than it is to Bob. You can extrapolate to see that large contributions to charity and large mortgages become very valuable as you get richer. Thus, our current tax system provides potentially significant incentives for the rich to give to charity, which is probably a positive, but also to buy very expensive houses with large interest payments, which is probably bad.

<stepping on soapbox> Personally, I would prefer that our tax system didn’t allow any deductions or credits since I’m not a big fan of the government doing social engineering any trying to influence people’s behavior. In my mind, any expense should be decided by the consumer without the government trying to prod them in a certain direction. And, in practice, tax deductions and credits end up being a huge lobbying target where they get passed not based on their intended effects so much as who can lobby the best. For example, the mortgage interest deduction is, indirectly, a huge windfall to the real estate industry. This also causes our tax system to become extremely burdensome with so many lobbying interests and greatly complicates our ability to make financial decisions. <stepping off soapbox>

So, the purpose of this post has been to give you an idea of how our tax system can have a significant effect on your financial decisions. This is important for retirement savings, in particular, since there are some potentially large deductions available for this.

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