Financial Literacy & Independence for Teens - Step 7 - Taxation – The Method Behind the Madness
KEY POINTS
Taxation may not sound thrilling, but trust us, it's more fascinating than you think! Let's dive into the captivating world of major tax systems: progressive, proportional (flat tax), and tax havens.
In our increasingly globalized world, understanding the various tax systems has become essential for individuals. Whether you find yourself considering relocating for work opportunities, pursuing international investments, or simply moving for personal reasons, being well-versed in progressive, flat, and tax haven systems empowers you to make informed financial decisions.
Knowledge of these systems can significantly impact your tax liabilities, investment choices, and overall financial well-being, making it a vital skill in today's interconnected world.
Income Tax Systems
Understanding personal taxation is crucial to obtaining financial literacy.
Teenagers may be surprised to learn that there are several different tax systems implemented by governments throughout the world. We will highlight 3 popular tax systems.
Progressive Tax System
This system is utilized by many countries including, but not limited to,
United States
United Kingdom
Canada
Germany
France
Australia
Sweden
Japan
Italy
Spain
The premise behind a progressive tax system is to create a fair way to distribute the tax burden across the population. Those that can afford to pay more contribute a higher percentage of their income, and those that earn less contribute a lower percentage of their income.
This creates a series of income brackets that are taxed at progressively higher rates. Such leads to the concept of a marginal tax rate.
Marginal tax rates refer to the percentage of tax that applies to an additional increment of income. For example,
|
Income |
Tax Rate |
|
$0-$20,000 |
0% |
|
$20,001 - $50,000 |
20% |
|
$50,001 - $100,000 |
25% |
|
$100,001 – unlimited |
35% |
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.
Tip
Does your employer increase the percentage of taxes withheld related to overtime?
Why does this happen?
Do this mean you earn less net money?
This happens because of your marginal tax explained above. Your earnings for the period are abnormally high due to the overtime. Your employer’s payroll system applies the higher tax rate associated with the higher earnings. Do not despair. You will get these taxes back when you file your annual tax return, and your lower marginal tax rate is applied.
On the downside, you lost use of the incrementally higher taxes paid. On the upside, you have a forced savings with government that will translate into a lump-sum refund or a reduced future tax liability.
The government can offer tax deductions and credits to support specific demographics and initiatives. For example, tax credits could be offered to encourage individuals to obtain a post-secondary education. Another example is the ability of low-income individuals to qualify for refundable tax credits.
It is important to remain informed of domestic tax matters as your tax rates may change over time as the government adjusts the tax system.
Proportional (Flat) Tax System
This system is utilized by many countries including, but not limited to,
Bolivia
Ukraine
Georgia
Hungary
Romania
Kazakhstan
Uzbekistan
Ideally, a flat tax system is fair, easy to understand, efficient, and reduces tax evasion.
The premise behind a flat tax system is that all individuals pay the same tax rate regardless of their respective income levels. Therefore, taxes payable will increase and decrease proportionately with changes in income.
To achieve and maintain tax fairness, flat tax systems typically minimize or eliminate tax exemptions, deductions, and credits.
Proponents will argue that a flat tax system eliminates the disincentive to take risks and earn additional income that is created by the marginal tax rates implicit in a progressive tax system.
Critics will argue that low-income individuals are disadvantaged as they are required to pay a higher percentage of their income on non-discretionary items (i.e., necessities).
Tax Haven
This system is utilized by many countries including, but not limited to,
Cayman Islands
Bermuda
British Virgin Islands
Bahamas
Luxembourg
Netherlands
Ireland
Switzerland
Jersey
Hong Kong
Singapore
Cyprus
Malta
Mauritius
A tax haven is a country or jurisdiction that offers financial and legal benefits for individuals and companies to shield their income from taxation in their home countries
Tax havens are often referred to as tax-free jurisdictions; however, such is not completely accurate. Specific forms of income like employment income, capital gains, dividends, and interest may attract minimal, if any, tax. However, governments of tax haven jurisdictions may raise revenues in the form of payroll taxes, customs duties, land taxes, license fees, and stamp duties.
BOTTOM LINE
Understanding the diverse tax systems is vital in navigating today's complex financial landscape. Progressive, proportional, and tax haven systems each present unique implications for individuals and businesses alike.
The progressive tax systems levy higher taxes on higher incomes, aiming to redistribute wealth and promote economic fairness. In contrast, the proportional tax system applies a constant tax rate to all income levels, providing simplicity but potentially impacting income inequality. On the other hand, tax havens charge little if any taxes and collect fees and duties in other ways.
Being well-informed about these systems empowers individuals to make informed decisions, optimize tax liabilities, and adapt to changing economic conditions.
