Before you graduate, understand graduation
By Chris Stiffler
CFI Economist
When I lecture on taxes to college students I’m always surprised by how little students understand taxes, particularly how graduated, or progressive, income tax structures work. To see what I mean, consider the following question: Pretend that somewhere, there is a graduated income tax structure as follows:
So, under this system, if you made $25, how much would you pay in income taxes?
Most students say, “Well, $25 multiplied by 5 percent is $1.25.” And most students are wrong.
This happens because they haven’t learned the distinction between “marginal tax rates” and “effective tax rates.” They generally assume that all income is taxed at the top rate. This makes sense because a lot of people always tell of the story of the individual who earned more this year and got “bumped into a higher tax bracket.” But this doesn’t mean that all income is now taxed at that higher rate.
The correct answer is $0.95. Here’s the math 
They paid 3 percent on the first $10 then 4 percent on the next $10 then 5 percent on the last $5. Yes, that person paid 5 percent on the last dollar earned (the marginal rate), but their effective tax rate was 3.8 percent.
The federal income tax is a graduated structure, and most states also utilize a graduated tax code. But Colorado is one of the few states with a flat income tax rate — a flat 4.63 percent. This means that every taxpayer in Colorado pays the same rate, 4.63 percent, on every dollar they earn. Colorado used to have a graduated income tax structure before 1986.
To teach students about graduated rates, I have them calculate how much extra someone in Colorado would pay if Colorado had the same tax brackets as Montana. Like the majority of states, Montana has a graduated income tax structure. The first $2,900 dollars earned is taxed at 1 percent. Income above $2,900 and below $5,200 is taxed at 2 percent. Income above $5,200 and below $7,900 is taxed at 3 percent. Income above $7,900 and below $10,600 is taxed at 4 percent. Income between $10,600 and $13,600 is taxed at 5 percent, and income between $13,600 and $17,600 at 6 percent. Any income above $17,600 is taxed at 6.9 percent.
Colorado would generate $2.5 billion more in income taxes under Montana’s income tax rates. That would increase income tax collections by a third. The average Colorado family would end up paying $350 more in income taxes annually under Montana’s income tax structure. Such a structure would generate a lot more income from upper income earners and give a tax break to lower income Coloradans, who already pay a significantly greater portion of their earnings in taxes when you account for sales, gasoline and other consumption-based taxes.
For example, a Coloradan whose income puts them in the top 1 percent of earners in the state would end up paying $30,000 more annually while a Colorado household making $30,000 would see its income taxes drop by $60 a year.
If Colorado adopted Montana’s graduated income tax structure, 25 percent of taxpayers would see their income taxes fall while income taxes on upper income Coloradans would increase.
After this exercise, students are normally curious to know what Colorado would buy if the state budget had an additional $2.5 billion. Those students also have suggestions on what the revenue should be used for (higher education and roads are usually on top of the list). If you have the same curiosity, you can build your own state budget here:
https://www.greateducation.org/advocates-corner/mission-possible/
