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How Does Tax and Tax Basis Work?

Many public services available in our societies are financed through taxes and fees. Here you’ll learn a bit about some of them as they operate in the United States. Your country will have different details, but the basics will be similar.


Income Tax

Income tax is the tax you owe based on how much money you make. If you work for an employer, they will deduct it automatically when they pay you. The amount of income tax you owe is based on an entire year of your income, so it is possible you may owe additional income tax, or be owed an income tax refund, based on how much your employer was deducting throughout the year.


Social Security and Medicare Tax

When you retire, usually at age 65 or later, or if you become permanently disabled, the federal government will pay you a monthly allowance called Social Security. You will also become eligible for a government-funded healthcare program called Medicare. The money the government pays as Social Security, and that it uses to provide you with healthcare, has been collected as a tax on your wages throughout your life. Social Security and Medicare taxes are the amounts the government collects and saves until you retire or are permanently disabled.


Net salary

Net income = Gross income Income tax Social Security and Medicare tax

Net income = Gross income Income tax Social Security and Medicare tax


Summary of taxes and fees

Income tax:

Depends on your income. The percentage of your income taken is graduated, meaning that as your income increases, the tax rate increases on the relevant amount. The combined rate of income tax across your entire income is known as your net average income tax.

Social Security tax (12.4%, paid half by the employee and half by the employer):

Calculated from gross income.

Medicare tax(2.9%, paid half by the employee and half by the employer):

Calculated from gross income.

Net average payroll tax:

This is the combined tax rate you pay for Income, Social Security, and Medicare taxes.

Sales tax (0%13% based on the state and local rate):

A tax on purchases of goods and services.

These rates are set by federal, state, and local governments.

You can see how net salary is calculated in the following examples:

Example 1

Daniel has a gross income of $35000. In addition to income taxes of 27 % he has to pay 6.2 % in Social Security tax and 1.45 % in Medicare tax. What is his net income? The top table shows the numbers calculated. The bottom table shows the formulas i wrote in Excel.

Excel spreadsheet for calculating net income

Example 2

Minnie Mouse has a monthly salary of $3300. How much income tax does she pay if her net average tax rate (including Income tax, Social Security tax, and Medicare tax), is 35%?

First you find out how much Minnie pays in taxes by calculating 35 % of $3300.

Tax deduction in dollars = 3300 0.35 = $1155

Tax deduction in dollars = 3300 0.35 = $1155

Minnie Mouse pays $1155 in taxes.

Then you find out how much she is paid (net monthly income) by subtracting the tax deduction in dollars from the monthly salary.

net monthly income = 3300 1155 = $2145 Minnie Mouse is paid $2145 after taxes when she has a monthly salary of $3300 and a net average tax rate of 35 %.

Alternative method

Alternatively, you can do this easier by using the growth factor. Then you do both calculations at the same time. You use this formula:

net monthly income = 3300 (1 35 100) = 3300 0.65 = $2145 Minnie Mouse is paid $2145 after taxes when she has a monthly salary of $3300 and a net average tax rate of 35 %.

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