Marginal Tax Rate

Marginal Tax Rate Economics

The best way to understand the economics of a marginal tax rate is to view a real-world example of them! Below in Table 1 are the 2022 tax brackets for filing classification "single." The US Tax system uses a marginal tax rate that divides your income by brackets. This means that the first $10,275 you make will be taxed at 10%, and the next dollar you make will be charged at 12%. So if you make $15,000, the first $10,275 is taxed 10%, and the other $4,725 is taxed 12%.

Table 1 - 2022 Tax Brackets Filing Status: Single. Source: Kiplinger.com¹

Table 1 above shows taxable income brackets, the marginal tax rate, average tax rate, and total tax possible. The total tax possibly indicates how much taxes will be paid if personal income is exactly at the highest number of any tax bracket.

The average tax rate shows how the marginal tax rate makes even high-income earners pay less than their highest tax bracket. Consider this example below:

What is the goal of a Marginal Tax Rate?

A marginal tax rate, typically implemented in a progressive tax system, is implemented to achieve two main goals, higher revenue, and equity. Does a progressive tax rate bring equity? What are the consequences of equity? It can be easy to determine that a marginal tax rate increases revenue, as the highest income earners are paying a whopping 37% income tax.

Those at the higher end of a progressive tax system pay higher taxes when they earn more. It is reasonable for them to feel it is unfair, as they receive similar utility from government spending as low-income individuals. Some would argue they use even less due to not needing social assistance, which is a part of government spending. All of these are valid concerns.

Advocates for a progressive tax rate would say it can be favorable for increasing demand despite lowering consumer income more than a flat or regressive tax. Consider the example below:

Marginal Tax Rate Formula

The formula to calculate the marginal tax rate is to find the change in taxes paid and divide it by the change in taxable income. This can allow businesses and individuals to understand how they are being charged differently when their income changes.

\(\hbox{Marginal Tax Rate}=\frac{\Delta\hbox{Taxes Paid}}{\Delta\hbox{Taxable Income}}\)

Calculating the marginal tax rate can be useful. However, in most cases, if you are paying a marginal tax rate, it would be publicly available. Understanding this is especially important for the United States, as its one of the few developed nations that require its citizens to file their taxes manually. In many European countries, the government has a system that files them free of charge to its citizens.

Marginal Tax Rate vs. Average Tax Rate

What's the difference between the marginal and average tax rates? They are quite similar and often close together numerically; however, they both serve a specific purpose. As established, the marginal tax rate is the taxes paid on earning $1 more than previous. The average tax rate is a cumulative measure of multiple marginal tax rates.

The marginal tax rate is about how taxes change as taxable income changes; therefore, the formula reflects this.

\(\hbox{Marginal Tax Rate}=\frac{\Delta\hbox{Taxes Paid}}{\Delta\hbox{Taxable Income}}\)

The average tax rate is arguably the real tax rate. However, it can only be calculated after income has been distributed across the qualifying marginal tax brackets.

\(\hbox{Average Tax Rate}=\frac{\hbox{Total Taxes Paid}}{\hbox{Total Taxable Income}}\)

Marginal Tax Rate Example

To better understand the marginal tax rate, check out these examples below!

In the example above, we see Jonas and his brothers attempting to understand how marginal tax brackets work. By isolating the tax change and income proportion, we can determine the marginal rate.

A joke example that actually was used to write policy in America is Laffer's Curve. Proposed to future policymakers by drawing this graph on a napkin, Arthur Laffer claimed that increases in taxes reduce the incentive to work, resulting in less tax revenue. The alternative is that if you lower taxes, the tax base will increase, and you will receive the lost revenue. This was enacted in policy under what is known as Reaganomics.

Fig. 1 - The Laffer Curve

Many in congress who advocate for lower taxes will actively bring up Laffer's curve, citing that a decrease in taxes won't hurt tax revenue as it will grow the economy more. This is still used to persuade tax policy despite its premises being critiqued by many economists for decades.