An important aspect of many taxation systems is what’s referred to as a ‘progressive rate’. When you look at the tax rates, you’ll see that those countries are using a ‘bracket system’. Different categories, or ‘brackets’, are employed, each having its own tax rate. In short, the more income you earn, the more tax you pay. The progressive rate is designed to distribute tax more equitably, so that those with higher incomes pay a larger portion of their income in taxes than those with lower incomes. But how exactly does this work?
The Fundamentals of the Progressive Tax System
Regardless of your income, the portion that falls within the first bracket is taxed at that bracket’s rate (the nominal rate). Only when your income exceeds the upper limit of the first bracket, you pay the higher rate of the next bracket on the exceeding amount. In other words, the higher your income, the more tax you owe.
This concept is based on the principles of solidarity and ability to pay: those who can contribute more, do so. The bracket system is a clear way to put this principle into practice. For each subsequent bracket your income falls into, a higher percentage of that portion of your income is taxed. This ensures a balanced distribution of the tax burden.
The Effective Tax Rate
You may have heard of the ‘effective tax rate’. This is the tax amount you actually pay, divided by your total income. This can be lower than the nominal rate of the highest tax bracket you fall into, because a portion of your income is taxed at a lower rate.
But there’s more to it. The effective tax rate is also influenced by what we call tax credits and deductions: these are discounts on the tax you owe, resulting in you ultimately paying less. The mortgage interest deduction, for example, is a deductible item
The Marginal Tax Rate
It’s a common statement: “If I earn one euro more, I immediately lose half or more to taxes.” This seems to contradict the tax rate of the highest bracket you fall into and the lower effective rate mentioned earlier. So, how is this possible?
Well, this is related to the ‘marginal tax rate’. This rate indicates how much tax you pay on every additional euro earned, and can sometimes be significantly higher than the highest tax rate. The reason for this is that some tax credits depend on income. As your income increases, the discount becomes smaller. If countries have subsidies, they also play a role: due to a higher income, you qualify less for subsidies. In rare cases, the marginal tax rate can even exceed 100% (with very specific incomes, for instance in The Netherlands), which means you ultimately end up with less when your income rises.
This can all sound quite complex, and we haven’t even touched on box 3 or reporting a foreign house on the Dutch tax return. But don’t worry, you don’t have to do everything on your own. Living in The Netherlands? Consider outsourcing your tax matters to us at Taksgemak. It could save you time, money, and a lot of headaches.
About the author: Kelly Hendrikse blends her interest in entrepreneurship with her expertise in tax advice at Taksgemak. She assists both businesses and individuals in understanding tax rules, making complex matters more manageable. Committed to keeping her clients on the right path, she proves to be a valuable ally in any tax-related matter.