9.2 Income Tax Components

The process of determining taxable income begins with total (gross) income, which is then reduced by adjustments to calculate Adjusted Gross Income (AGI). From AGI, taxable income is derived by subtracting either itemized or standard deductions, as well as personal exemptions (although these are suspended until 2025). The resulting taxable income is then used to calculate the tax liability based on applicable tax rates and tax brackets. At the end, tax credits are directly reduced from the tax liability. AGI serves as a key measure of an individual’s overall tax-bearing capacity, reflecting their financial ability to shoulder tax obligations.

Adjustments: There are a variety of adjustments made to the gross income. First, we have retirement contributions, e.g., Individual Retirement Account (IRA), that are designed to encourage individuals to save for retirement by offering tax advantages. Transfer payments, such as food stamps, are generally not taxed to avoid unnecessary financial transactions. That is, the government wants to avoid providing assistance to low-income households only to tax that same assistance at a later point. However, unemployment benefits are an exceptions since those are fully taxable. Assistance not targeted at low-income households (e.g., Social Security benefits for higher-income individuals) may also be subject to taxation. Other adjustments to taxable income include alimony, expenses related to job-related moves, student loan interest, and self-employed health insurance payments, which are tax-deductible since corporate health benefits are not taxed. Additionally, unrealized capital gains, employer-provided fringe benefits, gifts, and inheritances (to a certain degree) are generally exempt from taxation. Interest received from state and local government bonds is also typically exempt from federal income tax.

Deductions: Certain expenditures that fall outside a household’s control may qualify for tax deductions. These include medical and dental expenses exceeding 7.5% of AGI, losses from casualty or theft above 10% of AGI, and state or local income and property taxes. Other expenditures are encouraged by the federal government through tax incentives that reduce their after-tax cost. Charitable contributions and home mortgage interest on first and second homes are examples of such incentivized actions. Additionally, certain job-related expenses can be deducted, such as costs for education, union dues, work uniforms, and occupational taxes. These deductions help lower the financial burden of maintaining or advancing a career.

Personal Exemptions: Personal exemptions, traditionally a flat amount for each person in a household, provided adjustments based on family size, helping to remove low-income families from the tax system by reducing their taxable income. However, personal exemptions have been suspended until 2025. Deductions and exemptions are designed to adjust taxpayers’ ability to pay based on their specific circumstances. By tailoring tax obligations to individual situations, these provisions enhance both horizontal equity (ensuring those with similar abilities to pay are taxed similarly) and vertical equity (ensuring those with different abilities to pay are taxed at appropriate rates).

Tax Credits: A tax credit serves as a direct deduction from an individual’s tax liability, reducing the amount of tax owed dollar-for-dollar. Tax credits are often used to stimulate private activities and encourage specific behaviors. For example, credits are offered to promote home energy conservation, support child care expenses, and provide financial relief for low-income workers through the Earned Income Tax Credit (EITC). The EITC, in particular, offers a decreasing percentage of earned income as income rises, helping to alleviate the tax burden for those with lower earnings.

Tax Rates: The average tax rate (ATR) is calculated by dividing the total tax by taxable income. It represents the overall percentage of income paid in taxes and is always lower than the marginal tax rate, which applies only to the last dollar of income earned. The effective tax rate (ETR) is calculated by dividing the total tax by Adjusted Gross Income (AGI), providing a broader measure of tax burden relative to all income sources. The effective tax rate is always below the average tax rate, as it includes deductions and adjustments that reduce taxable income.