Personal Tax 101 - A Beginner’s Guide
KEY POINTS
Overview of three common tax systems: progressive, proportional, and tax haven
Bring clarity to the concept of marginal tax rates
Uncover the various forms of government taxation
Taxation can be daunting, frustrating, and expensive. We aim to minimize all of these issues and leave you with a clear path towards your retirement and legacy goals.
In this post, we will skip over the purpose of taxation and focus on identifying the various ways you are taxed and how that impacts you on a day-to-day basis.
Types of Tax Systems
First, we need to describe the nature of taxation as it varies by jurisdiction. The three main tax systems we will highlight are progressive, proportional, and tax haven.
A progressive tax system imposes higher tax rates on individuals and/or households as their income rises. The resulting marginal tax rate is the amount of additional tax paid for every additional taxable dollar earned. The following is a fictitious example:
To clarify, the tax rates above are not retroactive causing a taxpayer to pay $35,000 of taxes on $100,000 of income. The tax rates are tiered. Therefore, such taxpayer would pay tax equal to the income multiplied by the tax rate for each segment above for a total tax bill of 18,500 on $100,000 of income.
The progressive tax system can co-exist with certain regressive taxes that by definition disproportionately impact the lower income segments. Regressive taxes are imbedded throughout society and can be applied to, but not limited to: retail sales, cigarettes, alcohol, gasoline, and residential property. The progressive tax system may promote income equality while mitigating some of the effects of regressive taxes. However, the tiered nature of the progressive tax system creates a potential disincentive for taxpayers to increase their education, productivity, and take risks in order to earn incrementally less after-tax income.
A proportional tax system, also known as a flat tax, refers to one tax rate applied to all taxpayers regardless of the amount of income earned. Such creates a less complicated tax system and removes the potential disincentive imposed by a progressive tax related to earning incrementally less after-tax income. However, a flat tax does not address income inequality within a society.
Tax havens are very different than progressive and proportional tax systems. Such jurisdictions have many unique legal and privacy considerations that are beyond the scope of this article. We will focus on the basic tax aspects of such jurisdictions. Tax havens are jurisdictions with very low overall tax rates. They are often referred to as tax-free jurisdictions; however, such is not completely accurate. For example, employment income may be tax exempt; however, taxes may take the form of: payroll tax, customs duties, land tax, license fees, and stamp duty. Although many tax havens are located in tropical destinations, the chart below shows a diverse geographical dispersion from which to choose.
The following table highlights selected countries that utilize the three tax systems discussed.
Sources of Taxation
Next, let’s look at the various types of taxes you likely pay (will vary based on jurisdiction). Generally, governments will tax their citizens based on the income they earn, the products and services they consume, and the property they own. The following table illustrates how the governments (federal, state/provincial, municipal) capture your taxable activities (unfortunately, this summary is not exhaustive).
The Income column above highlights several sources of personal income that are common across most progressive tax systems. Unfortunately, the commonalities end there in many respects. For example, the United States, United Kingdom, and Canada all have different marginal tax rates. They will also impose different taxable income inclusion rates based on the nature of the income. Not only that, but some types of income may not even be taxed depending on the jurisdiction: lottery winnings are tax-free in the United Kingdom and Canada, however, such are taxable in the United States.
The Property column also exhibits differences amongst the three countries. The United States and United Kingdom impose an estate tax (subject to varying exemption limits and inflation indexing) upon a taxpayer’s death; whereas, Canada imposes a deemed disposition and taxes payable on the resulting crystallization of unrealized gains, if any. The Property column also references two regressive taxes: municipal property taxes and land transfer taxes. Such taxes may be earmarked by governments to fund specified services (e.g., education, police, fire departments).
Last, but not least: consumption taxes. These taxes impact your routine daily spending and are not always transparent at the point of sale. Retail sales taxes are the most transparent as such are applied to your purchase at the time of sale. Value added taxes are added to the cost of a product throughout the production process and the transparency of such taxes vary by jurisdiction. Excise taxes such as those applied to cigarettes and alcohol can be less transparent, but are often discernable with some effort. Import duties are typically the least transparent of the consumption taxes noted as the costs are built into the price paid by the ultimate consumer.
There is a lot to unpack in the above overview. We will tackle many of these topics in future posts. It suffices to say, your legacy depends on tax mitigation (not to be mistaken with tax avoidance which is illegal). Let this phrase form a key part of your legacy mantra:
Taxation mitigation
Before you go …
Quick Tip - Marginal Tax
Have you ever been excited to earn time and a half or double time while working overtime on a statutory holiday, only to be disappointed when your employer deducts a higher rate of tax on your paystub? It probably made you feel like sacrificing a statutory holiday was not worth it. Do not despair, the sacrifice was totally worth it.
Let me explain.
Remember the marginal tax system we discussed: it just effectively deferred part of your overtime compensation. Your income for the period is abnormally large compared to your previous pay periods. Therefore, your employer’s payroll system automatically calculated the current tax deductions as if you were now in a higher tax bracket. Your net pay will increase, but you will have paid a proportionately higher percentage of taxes to the government. Do not worry, you will get these taxes back when you file your annual tax return when your lower marginal tax rate is applied. On the downside, you lost potential interest on the excess taxes paid to the government. On the potential upside, you have a forced savings with the government that will translate into a lump-sum refund or a reduced future tax liability.
Click to learn more about taxes in your jurisdiction:
Organization for Economic Co-operation and Development (OECD)
