386 Chapter 9 Taxes
the discussion and examples included in this chapter are intended to illustrate the income
tax system in general terms, but there are so many exceptions, details, and special cases
that it would be impossible to cover them all in detail here. It should be understood that,
in any particular situation, there may be facts that would cause taxes to be determined in
a way that differs—possibly significantly—from what is discussed here. In addition, it
should be noted that income tax rates are rules that can and do change from one year to the
next, and so the rates that are in effect when you read this will probably not be exactly the
same as the ones given here.Calculating Personal Income Taxes
The first step to calculate the amount of income tax to be paid is to determine just how
much income is subject to tax! While income from almost any source is potentially taxable,
not every dollar of income is actually taxed. An individual’s (or married couple’s) taxable
income, the income upon which income tax is actually paid, is found by making certain
subtractions from actual income.
Tax exemptions and deductions are subtracted from income before the tax is calculated.
Taxpayers are generally allowed to exempt a certain amount of income ($3,300 in 2006,
though the amount generally increases from year to year) for themselves and for each person
they can claim as a dependent. You may not take an exemption for yourself if someone else
(typically a parent) claims you as a dependent; your ability to claim exemptions may also
be limited if your income is high.
In addition, many expenses are tax deductible, meaning that they can be subtracted
from income before calculation of the amount of tax owed. Tax deductible expenses
include mortgage and some student loan interest, many state and local taxes, charitable
contributions, medical expenses (above a certain threshold), some educational expenses,
and many, many others, though each of these categories is subject to certain limitations.
Taxpayers with significant tax deductible expenses file a form with their tax returns where
they itemize these deductions, listing the expenses of each type so that they can be deducted.
Taxpayers who choose not to itemize usually may take a standard deduction instead. The
standard deduction amount in 2006 was $5,150 for a single taxpayer; a married couple
filing their taxes jointly could take a $10,300 standard deduction (again, these amounts
generally increase from one year to the next).
There are other adjustments that may be made to someone’s taxable income, though
since these other adjustments would apply only in special situations we will not address
them here.Example 9.2.1 Luisa and Alfonso are a married couple who had a joint income of
$68,579 in 2006. They have two dependent children. They paid $3,450 in state and
local taxes in 2006, and gave $3,700 to charity. They have no other tax deductible
expenses, and no other special adjustments to their taxable income. What was their
taxable income for 2006?Luisa and Alfonso can claim four exemptions: two for themselves and two for their depen-
dent children. At $3,300 that works out to 4($3,300) $13,200. Also, they could deduct
$3,450 $3,700 $7,150 for their state and local taxes and charitable contributions;
however, since the standard deduction for a married couple is $10,300 they are better off
taking the standard deduction instead of itemizing. Their total taxable income therefore was
$68,579 $13,200 $10,300 $45,079.The rates used to calculate income taxes vary, depending on the taxpayer’s income level.
Lower incomes pay lower rates; higher incomes are subject to higher rates. Tax rates set
up in this way are known as progressive tax rates. (While there are many advocates for
a single flat tax rate that would apply to all levels of income, progressive rates are likely
to remain in use for the foreseeable future.) The specific rates used can be, and often are,
changed by Congress, and do in fact vary over time. Nonetheless, the 2006 tax rate sched-
ules for a married couple filing their taxes jointly, given below, are typical.