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What Is Incremental Tax?

G. Wiesen
G. Wiesen

Incremental tax is a payment made to a governmental agency by an individual or a business, and is typically based on the amount of income made per year. The rate can increase or decrease over time for one reason or another, usually due to a change in earnings, which can be considered salary or investments. Some countries choose to apply an incremental tax on both individuals and corporations, others only on individuals, and some countries use a different tax method entirely. With this type of system, as a taxpayer's income increases or decreases, then taxes also increase or decrease by an incremental amount, which makes it an incremental tax. This should not be confused with tax increment financing, which is a process by which future revenue can be used to pay for current developments.

Tax Brackets

Man climbing a rope
Man climbing a rope

In many countries, such as the US, India, and Germany, citizens and businesses must pay an incremental income tax each year based on their overall earnings for that year. This rate is determined on a fairly set scale, in which the overall earnings of income earners are used to determine their tax brackets; in some countries, there are a dozen different brackets while in other countries there are only two. Brackets are determined by income — for example, one bracket may include all citizens who earned between $1,000 USD and $150,000 USD, while another includes earnings of more than $150,000 USD. Once the correct bracket is determined, the taxpayer pays the corresponding tax rate to the government. If he has a change in income, he will move up or down accordingly on the scale, most likely changing the amount of money owed in taxes.

Change in Earnings

The division between brackets can have a tremendous impact on the amount of taxes that have to be paid by citizens and businesses. As a result, having an incremental tax system can be beneficial for many people who earn less money, as their rate is generally lower than those who earn more. If a taxpayer is near the upper limit of one bracket and chooses to make an investment that earns revenue, that investment could move him or her up into the next bracket. Most likely this means that the investor now has to pay more in taxes, which may lessen the profit made from an investment or even turn it into an overall loss. On the other hand, many citizens and corporations will pay less taxes if they drop down a bracket after earning less income than they did the previous year.

Tax Increment Financing

It is important that the terms “incremental tax” and “tax increment financing” should not be confused, since they are very different concepts. Tax increment financing is a process by which public financing for community developments and projects, such as renovation of a section of a city, is financed. This system is typically accomplished through investors that are repaid through future profits, usually as government bonds. These bonds are repaid using future revenue, the increment, which is made off of the increased value of the developed area. Such tax increment financing is not always profitable, however, and can result in a loss of finances once investors are repaid.

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