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Hey, it's Sony. We're dropping a bonus episode into your feed today because today is tax day and we thought you might want to better understand what you're paying and why. Enjoy and tell us what you think@podcastsoinfortin40.com. Almost everyone has a moment like this. You're staring at a tax form, second guessing every box and wondering if you're about to make a mistake. You don't understand filing your taxes isn't just paperwork. You One of the only times millions of Americans actually confront how the system works. And on the surface, it seems straightforward. You make money, the government takes some of it. But once you look closer, things get confusing fast. What actually counts as your income? What does it mean to be in a tax bracket? And why do some taxes hit the very first dollar you earn while others don't? And perhaps the biggest question of all, why do some of the wealthiest Americans end up paying so much less than taxes? When you file your income taxes, your stepping into a system that didn't always exist. In fact, did you know that the Constitution actually forbade the income tax as it exists today? An actual amendment was needed to make it legal. Who, you might be thinking, could rile up enough Americans to pass an amendment that says they should all pay income taxes? I'm Soni Kassam. Today on 1440 Explorers, we're breaking down the history of the income tax, how brackets actually work, and the other major tax hiding on your pay stub. And finally, why? For the people at the very top, the rules can look very different. Our guide is Michael Linden, a former White House budget official and someone who has spent years thinking about how the system actually works. Stay with us.
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Listen. Learning has never been harder. The Internet is overwhelmed with low quality content, clickbait with little substance, AI generated slop and opinions masquerading as facts. Curious people like you are left sifting through noise instead of finding what matters. Enter 1440 topics we've curated the highest quality resources from across the Internet. Think data, visualizations, captivating videos, long form journalism and paired them with staff written overviews to make every subject easy to understand and explore. Want to learn about venture capital or how new weight loss drugs work? Do you keep reading about CRISPR but are missing the best 101 on the breakthrough technology? Find all of this and so Much more at join140.com 1440Topics separating what's worth your time from the rest of the Internet.
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The Purpose of a Tax System the core purpose of a tax system in Any government in any country is to raise revenue to finance the operations of the public sector.
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That's our guide, Michael Linden. He spent 20 years in tax policy, including stints at the White House Office of Management and Budget under President Joe Biden and the Senate Budget Committee. Today, he's trying to tell me why I shouldn't be so annoyed with filling out my taxes. Michael says taxes are how a society turns your paycheck into things like schools
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and fire departments to Social Security, Medicare, national defense, investments in science, investments in research. It could be things that help people afford houses, to help people afford healthcare. All of the interventions that the public sector does in our daily lives.
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Basically, taxes fund the state. Sometimes that means things you rely on and barely notice. Sometimes it means things you strongly disagree with. Either way, for most working Americans, the tax that feels most painful and most personal is the income tax. The income tax feels inevitable, almost baked into American life. But Michael's point is it isn't.
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If you think about original, original America, we didn't have income taxation.
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For much of early American history, taxing income was not straightforward. The Constitution required direct taxes to be divided among the states according to population. That meant the federal government couldn't just say, you earned more, so you pay more. Then came the Gilded Age and the barons,
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the Carnegies, the Rockefellers. These massive titans of industry had accumulated so much wealth and power, and that prompted the institution of the income tax, and that was the 16th amendment.
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Such was the fervor to get people to pay up their fair share that Americans ratified a constitutional amendment to make a federal income tax possible. So when you get angry on tax day, it's worth remembering this system didn't just appear from above the country. People like you and me actually asked for it. Before we go any further, it helps to know that in America, taxes come in three federal, state, and local. Federal taxes go to the national government and fund things like Social Security and national defense. While state and local taxes, which include property, sales, and income taxes, help pay for schools, roads, and the services closer to home. Today, we're focused on federal taxes because they are the biggest piece of the overall tax bill. About 2/3 of all taxes Americans pay go to Washington, with the remainder going to state and local governments. And more specifically, we're focused on the taxes most working Americans feel directly the taxes on labor, the ones tied to your paycheck. There's a whole other world of taxes on investments, corporate profits, and property. But today, we're sticking with the federal taxes most likely to show up on your Pay stub the income tax. All right, so let's dive in. What is the income tax?
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It is a tax on the income that an individual or a household, if you're married and you're filing jointly, that you earn in a year, Imagine a
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pile of cash on the table. That's everything you've earned this year. Every paycheck, every freelance check, every tip, every extra dollar that came in. The income tax starts with the full pile and asks a deceptively simple question. How much of this actually counts?
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The other thing that you have to understand about the income tax is that there are a lot of deductions and exemptions. There's income that everyday people make that doesn't count towards your taxable income and effectively has a 0% tax rate on your income. So, for example, if you put some money away in a tax exempt retirement account, even though that's money you made, the tax system treats that as zero.
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So picture that pile of cash again, you earned the money, it hit the pile. But if, say, $5,000 of that went into a tax deferred 401k, that $5,000 gets pulled out of the pile before taxes are calculated. It still counts as money you made. It just doesn't count as money the government is taxing right now. But there are others.
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For many Americans, they'll take what's known as the standard deduction, which basically just says we're just going to treat the first $20,000 of earnings is zero tax. You don't pay taxes until after that first 20,000.
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For many households, though not everyone, the government simply ignores a first chunk of income altogether. That's the standard deduction, a built in amount of money that is effectively taken off the table before taxes are calculated and your taxable pile shrinks again. So before the income tax ever applies, the pile is already smaller than it looked at first glance.
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So we have all of these deductions that people can use to reduce their taxable income.
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That's the key idea. The income tax doesn't apply to every dollar you earn. First, the tax code sorts through your pile, removes certain dollars, and arrives at a smaller number. That smaller number, after the deductions and exemptions, is your taxable income. The tax code actually has a few versions of that number for different purposes, with names like Adjusted gross Income and Modified AGI. But for our purposes, the important one is taxable income, which means we are finally ready to enter the most misunderstood part of the American tax code. Drum roll. Tax brackets.
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Do you think that you could give me my 20,000 in cash. My concern is, and I've got to check it with my accountant, but that this might bump me up into a higher tax grant.
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Maybe you've heard of these. Maybe you've even announced yours with a kind of pride. I'm in the 24% bracket. To me, this sometimes sounds like the government has picked you up by the ankles and dropped your entire remaining pile of cash into one giant bucket labeled 24%. But that is not what happens. Instead, I want you to take your remaining bundle of taxable income and imagine a row of buckets in front of you, very official looking IRS buckets. And each bucket has a label on it. 10%, 12%, 22%. Then eventually all the way up to 37%. Those are the federal income tax brackets. Now bring over that pile of taxable income you have left and start pouring it in. The first chunk of cash goes into the 10% bucket.
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Everybody, no matter how wealthy you are, no matter how much money you make, everybody pays the same rate on the first chunk of money that they make. No matter how wealthy, or if you're Elon Musk or if you're, you know, me or you, you're paying 10% on the first 10 or $15,000.
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That first bucket has a fixed capacity before it starts to overflow. Think of it like a measuring cup for 20, 25. The 10% bucket holds just about $12,000 of taxable income if you're single. Once that bucket is full, your money spills into the next bucket, the 12% one. That fills up around $48,000. And once you hit that limit, your cash spills into the next bucket, which is labeled 24%. And on and on it goes, so long as you make enough money to keep filling buckets all the way to 37%, the top bracket as of today.
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So just to be very clear, if you're in the top rate, they don't pay 37% on all of that income. They only pay 37% on income over that threshold. So sometimes people think, oh, my God, 37%. That's a lot of an entire chunk that you get taken out to pay taxes on. But that's not how it works.
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Hitting the top bracket doesn't suddenly turn all of your income into 37% taxed income. It just means the last dollars at the very top are taxed at that rate. Everything below that was taxed in the lower brackets first. That's the big idea. The tax code doesn't treat all of your income the Same. It moves through your money in layers. Starting small, then stepping up. Your bracket is not your whole story. It's just the tax rate on the top bucket. But the brackets are not just a math trick. They reflect a deeper idea at the heart of the income tax.
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The income tax is progressive. And I don't mean progressive in the political sense. Progressive versus conservative. It's a technical term that we use that just means the more money you make, the higher rate you pay as a share of your income. So a progressive system is one in which richer people pay a larger share of their income in taxes than middle income people, and then poorer people do.
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And because the system starts by carving out deductions and exemptions, there are people at the lower end of the income scale who, by the time all that is applied, simply don't have taxable income left over. They earned money. They worked. But there may be nothing left in the pile for the federal income tax to reach.
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A lot of Americans don't pay income tax. Many Americans make less than these thresholds. They make less than these basic deductions or exemptions, so they don't have taxable income. At the end, it's about 50% of households don't pay income tax.
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To be fair, Michael says a lot of these are retired people and students. But it's still a large number. And this is where it gets tricky. Even if your income is low enough that exemptions wipe out your income tax bill, that doesn't mean you go untaxed. For pretty much all Americans with a paycheck, there's still another tax coming out of each pay stub. It's one you can't really get away from because it starts hitting you from the very first dollar you earn.
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It generates about a third of all federal revenue. And that is what's known as payroll taxes. Most Americans might know these as FICA taxes. These are the taxes that if you look at your paycheck every two weeks or month or whenever you get paid, you see FICA taken out. This is not income taxes. It's a different system. Payroll taxes are dedicated to Social Security, Medicare, and to a lesser extent, unemployment insurance.
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Unlike the income tax, which helps fund all kinds of things, this is a dedicated payroll tax. That means the money it collects from your paychecks is set aside for very specific programssocial security, Medicare, and some unemployment insurance that can't be used for general spending. The basic idea here is what's called social insurance. While people are working, they pay in, and that money helps support retirees. People with disabilities and older Americans. And even if you only make $10,000 a year, this tax can still apply. That's the big difference. The income tax can disappear after deductions and exemptions, while payroll taxes start with the very first dollar of wages you earn. Sounds super fair and protective of the poor, right? Well, it's complicated because one big piece of the payroll tax, the part that funds Social Security, only applies to a certain income ceiling, around $160,000 to $180,000 a year, depending on the year. Once you earn more than that, that tax stops. So lower wage workers pay it all year long, while higher earners eventually stop paying it.
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That's why payroll taxes are what's known as regressive. The more you make, the lower your effective tax rate becomes.
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All right, one more note before we move on. April 15 can feel like a stressful date, like the government suddenly showed up at your door all at once on this terrible day. But for most working Americans, that's not actually what's happening. If you have a regular job, you've probably been paying these taxes all year long. On every paycheck you get, a little bit of federal income tax gets withheld. Same for Social Security and Medicare. By the time the dreaded tax day rolls around, your money has mostly already left the building. So April 15th is usually not the exact moment you file and pay your taxes. It's the moment you find out whether you paid too much, too little, or somehow landed exactly right. The IRS calls this a pay as you go system, which is a sweet way of describing something that is more like, we'll just be taking this as we go. And if you're self employed, it's the same basic idea. Instead of withholding from each paycheck, you're generally supposed to send in estimated taxes every quarter, which means tax day is less like a giant annual mugging and more of a final settling up. For some, that means a refund. For others, it's a bill. Either way, it's the dramatic season finale to a process that has actually been running in the background the whole year. And finally, there's one more wrinkle that we need to talk about before we wrap up. Because everything we just walked through the brackets. The paycheck withholdings mostly describes how taxes work for people who live on wages. And for most Americans, that is still the basic story. Wages and salaries are the biggest piece of income, and taxes are something that show up through labor, through a paycheck. But at the very top, think of the infamous 1%. There is another world.
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If you are super, super wealthy in this country as an individual, by and large, you don't make most of your money that way. You're making your money by having the assets that you own appreciate in value.
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That could mean stock, real estate, art, things you own becoming more valuable over time. And that increase in value is treated very differently from a paycheck. For one thing, it's often taxed at a lower rate. The top federal tax rate on ordinary income is 37%, while the top federal rate on long term capital gains is roughly 24%. But the second advantage may be even more important. Timing.
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And what that means is that very wealthy people get to decide when they pay their taxes. They can time their sales of their assets to when they want to pay taxes.
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Think about it. If you never sell the stock or the painting or a property, you don't trigger the tax on that gain. On paper, your wealth may have surged, but for tax purposes, that gain usually doesn't count until you turn it into a sale. So what happens if these very wealthy people need cash, but they don't want to sell? This is where people invoke the spooky Buy, borrow, die. First, they buy these assets and hold them while they rise in value. Then, instead of selling them and triggering
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a tax, they can borrow against the value of their assets for very, very low interest rates.
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Did you get that? If you're sitting on a huge stock portfolio, a bank will be very happy to lend you money because your portfolio becomes perfect collateral. You'll still need to repay your loan eventually, of course, but a loan is not considered income, so you've essentially received spending money without triggering a taxable event. And if you want more cash later, you can often take out a new loan, pay off the old one, and keep borrowing against assets that are still rising in value. As long as your underlying fortune keeps growing, the strategy doesn't necessarily spiral. It can just keep going. Okay, and then comes the last step in Buy, borrow, die. The die part. This is where the tax code gets especially strange. Normally, if you buy an asset at one price and sell it at a much higher one later, you owe taxes on the gain. That's the gains in capital gains. But when a person dies and passes that asset to an heir, and the tax code essentially resets the starting line.
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Normally, like if you buy a stock at $1 and you sell it at $100, you pay taxes on the gain. $99, right? You buy an asset at $1, it goes up to $100 you die. You give it to your heir who sells it at $100. He pays zero taxes on it. Cause no gain, no taxes. But of course, that's crazy because that person, your heir, got a hundred new dollars.
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The gains built up over a lifetime can disappear when the asset passes to the next generation. In tax language, that's called a step up in basis.
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That's why very wealthy people pay a very different kind of income tax than everybody else. The tax system with which they interact is very different than a normal person.
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So if this seems so lopsided, why is it so hard to change?
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Well, it's hard to reform because wealthy people have a lot of money and they have a lot of political power. They really don't want to reform the system. If we snapped our fingers today and just said we are going to tax capital income exactly the same as we tax labor income, you know, it would be trillions of dollars of new revenue, most of which comes from the top 1% of Americans, richest 1% of Americans.
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Michael's clear about where he comes down, but he says there are many economists who see this differently. Their argument is that taxing capital gains at lower rates encourages investment, business formation and risk taking and that those things can help grow the economy. So the system we've walked through in this episode, Paychecks Withholding, April 15, is real, but it's mostly the tax system for people who earn money by working. If you're someone whose money comes from owning capital, the system can look pretty different. And while that may bum the rest of us out, Michael ended our conversation with something like a pep talk, a reminder of what all of this is actually for.
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Taxes are the way we solve problems together. We tried to do individual fire department protection, and that didn't really work that well. And ultimately we need citywide or community wide fire protection. And the way that we finance that is that we all pay a little bit in taxes to make that work. That doesn't work otherwise. Right. That doesn't make them any less painful on April 15. But I do think that they are indispensable. Every war we've ever won was partly because of taxation. Every major scientific breakthrough, the Internet, space flight, cell phones, all cancer research, you know, the list goes on and on.
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Many thanks to Michael Linden for joining us in today's episode and thanks to all of you for listening to 1440 explores. I'm Sony Kassam. Make sure to follow the show and leave a review on Spotify and Apple or wherever you listen to your podcasts and let us know what you think of this episode@podcastsoin1440.com 1440 Explorers is a production of Rime Media for 1440 Media. This episode was produced by Niccolo Minoni and edited by Dan Bobkoff. Our sound designer is Jay Cowett. The executive producer at Rime is Dan Bobkoff, and the executive producers at 1440 are me and Drew Scheigerwald.
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Sam.