Why Do Governments Have Tax Brackets?

The historical reason is that tax brackets reduce complexity. The tax bracket system is from before everyone had computerized software, so many people were doing tax returns with only the equivalent of a four-function calculator and some people had to do all of the math longhand. A smooth tax function would have increased the number of filing errors substantially. There may be an intellectual appeal to having a smooth tax function now that most of us do prepare our returns using software (or a tax preparer / CPA using software). But it is not without disadvantages. Let me provide an example many people face each year- do I choose the major medical health insurance option or the high deductible with the Health Savings Account? With tax brackets, it is fairly straightforward - in one column, add up medical premiums paid by the employee and then a probability weight on medical expenses for the year. Then add back the tax effect of paying the premiums pre-tax, which is straightforward- the premiums times the usual tax bracket. Then do the same for the second option, but include the tax savings on the HSA in the tax addback as well. Deciding on the likely medical expenses may take a while, but the rest of the math is pretty basic. But with a sliding scale for taxes, all of a sudden the only way to get a really accurate picture is to take into account the entire tax situation every time a decision is made. Since most people won't do this, it encourages a sense of powerlessness as regards income taxes. So to sum up, it is an interesting idea and it has ideological appeal, but practically it would be a real step backward in regular decision making.

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