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Marginal Tax Rate Definition
The definition of a marginal tax rate is the change in taxes for earning one more dollar than the current taxable income. The term marginal in economics refers to the change that occurs with an additional unit. In this case, it's money or dollars.
This occurs on variable taxes rates, which can be progressive or regressive. A progressive tax rate increases as the tax base increases. A regressive tax rate decreases as the tax base increases. With a marginal tax rate, the tax rate usually changes at specific points. When not at those points, the marginal tax rate will likely be the same.
The marginal tax rate is the change in taxes for earning $1 more than the current taxable income.
Marginal tax rates are important to understand because they can diminish the value of additional work or opportunities. Calculating how differing tax rates will affect the outcome is an important step in determining whether it's worth taking.
Imagine a scenario where:
Income under $49,999 is taxed at 10%.Income above $50,000 is taxed at 50%Let's say you work hard at your job and earn $49,999, keeping 90 cents per dollar you make. What is the marginal tax rate if you worked extra to make $1 more? After $50,000, you will only keep 50 cents per extra dollar you make. How much extra work are you willing to work when you keep only 50 cents, which is 40 cents less per dollar?
When it comes to tax, it's important to understand what effect taxes can have on a market system. Any increase in taxes will disincentivize work, as it is less profitable. Additionally, the taxes will take away funds from businesses that will grow their productive output. So, why would we continue a system where taxes exist if that's the case? Well, one of the theories behind government and taxation is that the utility provided to society as a whole is greater than the personal utility lost from the tax.
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%.
For a more specialized explanation of specific tax systems, check out these explanations:
| Taxable Income Brackets(single) | Marginal TaxRate | Average Tax Rate(on highest income) | Total TaxPossible(highest Income) |
| $0 to $10,275 | 10% | 10% | $1,027.50 |
| $10,276 to $41,775 | 12% | 11.5% | $4,807.38 |
| $41,776 to $89,075 | 22% | 17% | $15,213.16 |
| $89,076 to $170,050 | 24% | 20.4% | $34,646.92 |
| $170,051 to $215,950 | 32% | 22.9% | $49,334.60 |
| $215,951 to $539,900 | 35% | 30.1% | $162,716.75 |
| $539,901 or more | 37% | ≤ 37% |
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:
A taxpayer earning $50,000 will fall under the 22% marginal tax rate bracket. However, this doesn't mean they are paying 22% of their income. In reality, they pay less on their first $41,775 made, which brings their average tax rate close to approximately 12%.
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:
A closed economy has 10 households. Nine of the households earn $1,200 monthly, and the tenth household earns $50,000. All households spend $400 on groceries every month, resulting in $4,000 spent on groceries.
The government requires $10,000 in taxes monthly to maintain its operations. A fixed tax charge of $1,000 a month is proposed to reach the required tax revenue. However, nine of the households will have to cut grocery expenditures in half. Resulting in only $2,200 spent on groceries, they decide they need to keep the grocery demand intact.
A progressive tax rate is proposed to charge 10% on the first $2,000 a household makes, charging each household $200 for ten households, generating $2,000 in tax revenue. A 15% tax is charged on any income after, causing the $50,000 household to pay an additional $7,200. This maintains the income for all households to be able to maintain their grocery demand while collecting the required tax revenue.
For more information about other types of taxes and their effects, consider checking out these explanations:
- Lump Sum Tax
- Tax Equity
- Tax Compliance
- Incidence of Tax
- Progressive Tax system
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.
The triangle symbol Δ in the formula below is called delta. It means change, so it indicates that you only use the quantity that is different from the original.
\(\hbox{Marginal Tax Rate}=\frac{\Delta\hbox{Taxes Paid}}{\Delta\hbox{Taxable Income}}\)
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.
Here in the US, we aren't so lucky. Americans, on average, spend 13 hours and $240 filing taxes, according to a survey done by the IRS in 2021.2
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.
\(\hbox{Average Tax Rate}=\frac{\hbox{Total Taxes Paid}}{\hbox{Total Taxable Income}}\)
A CEO at a tobacco company is complaining about having to pay 37% taxes on his business profits, and it's killing the economy. That is a very high tax rate, but you realize that 37% is only the highest marginal tax rate, and the real rate they pay is the average of all the marginal taxes. You find they earn 5 million dollars a week, and from the tax brackets, you know that the average tax rate on the first $539,9001 is 30.1%, which comes to $162,510 in taxes.
\(\hbox{Highest Bracket Income}=\ $5,000,000-\$539,900=\$4,460,100\)
\(\hbox{Taxable Income @37%}=\$4,460,100 \times0.37=\$1,650,237\)
\(\hbox{Total Taxes Paid }=\$1,650,237 +\ $162,510 =\$1,812,747\)
\(\hbox{Average Tax Rate}=\frac{\hbox{1,812,747}}{\hbox{5,000,000}}\)
\(\hbox{Average Tax Rate}=\ \hbox{0.3625 or 36.25%}\)
You check the internet to see if anyone else has done the math to confirm you are correct, only to find you're completely wrong. Due to a tax policy, the company hasn't paid taxes in 5 years.
Marginal Tax Rate Example
To better understand the marginal tax rate, check out these examples below!
Your friend Jonas and his brothers are trying to figure out how to file their taxes. They try to calculate it but get confused about the marginal tax rate brackets. They ask you if they can use the average tax rate to save time.
Unfortunately, you inform them that the average tax rate can only be calculated after summing the marginal taxes paid at the end.
Jonas and his brothers inform you they know they paid 10% taxes on their first $10,275, which is $1,027.5. Jonas says he was charged $2,967 and made $35,000 in total. What did the government tax him?
\(\hbox{Marginal Tax Rate}=\frac{\Delta\hbox{Taxes Paid}}{\Delta\hbox{Taxable Income}}\)
\(\hbox{Average Tax Rate}=\frac{\hbox{Total Taxes Paid}}{\hbox{Total Taxable Income}}\)
\(\hbox{Taxable Income}=$35,000-$10,275=24,725\)
\(\hbox{Taxes Paid}=$2,967\)
\(\hbox{Marginal Tax Rate}=\frac{\hbox{2,967}}{\hbox{24,725}}= 12 \%\)
\(\hbox{Average Tax Rate}=\frac{\hbox{2,967 + 1,027.5}}{\hbox{35,000}}=11.41 \%\)
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
The premise of the Laffer Curve was that a tax rate at point A and point B (in Figure 1 above) generate equal tax revenue. The high tax rate at B discourages work, resulting in less money being taxed. Therefore the economy is better off with more market participants at point A. It was believed that these two tax rates generated the same revenue. Therefore the economy would be better off productively at a lower tax rate.
This logic implies that higher taxes discourage work, so rather than having a high tax rate on a smaller tax base, have a low tax rate on a higher tax base.
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.
Marginal Tax Rate - Key takeaways
- A marginal tax rate is a change in taxes for making one more dollar.
- The United States income tax system uses a progressive marginal tax rate based on fixed income brackets.
- The average tax rate is a cumulative sum of several marginal tax rates. It is calculated by dividing total taxes paid by total income.
- Marginal tax is calculated by the change in taxes divided by the change in income.
References
- Kiplinger, What Are the Income Tax Brackets for 2022 vs. 2021?, https://www.kiplinger.com/taxes/tax-brackets/602222/income-tax-brackets
- lx, Some Countries Do Your Taxes For You. Here's Why the US Doesn't https://www.lx.com/money/some-countries-do-your-taxes-for-you-heres-why-the-us-doesnt/51300/
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Frequently Asked Questions about Marginal Tax Rate
What does marginal tax rate mean?
A marginal tax rate means the change in taxes for receiving $1 more. This occurs in progressive and regressive tax systems.
What is a marginal tax rate example?
A marginal tax rate example is the United States income tax system, where as of 2021, the first $9,950 is taxed at 10%. The subsequent $30,575 is taxed at 12%. Another tax bracket begins, and so on.
Why marginal tax rate is important?
Understanding a marginal tax rate is important because it can help individuals and businesses determine their labor or investment returns. Would you work harder if you knew you were getting rewarded less?
What is the marginal tax rate?
The marginal tax rate varies depending on your personal income. The income you make in the lowest bracket is taxed at 10%. The income you make after 523,600 is taxed at 37%.
What's the difference between marginal tax rate and effective tax rate?
The marginal tax rate varies depending on the income bracket. When all the marginal taxes are added together, it will show the effective tax rate. The effective tax rate is the average tax rate. The marginal tax rate is the tax rate per income bracket.
Does the US use a marginal tax rate?
The U.S uses a marginal tax rate that divides your income by brackets.
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