Marginal tax rate and average tax rate explained.
How does a marginal tax rate apply to your taxable income, and how do you calculate your
average tax rate.
Let’s work through those questions with some examples.
Many countries in the world use tax brackets and a progressive tax rate system.
A tax bracket system means that you “slice” your taxable income into pieces, and apply
a different tax rate to each of the tax brackets.
A progressive tax rate system means that the tax rate increases as the taxable amount increases.
The term "progressive" refers to the way the tax rate progresses from low to high.
An example is this table from a fictitious country called Midgard.
0% tax on your first $20,000 of taxable income, then 30% on the next bracket of $20,000 taxable
income, then 40% on the next bracket of $20,000, and 50% on any taxable income above that.
Let’s calculate how much tax John owes.
He has a taxable income of $50,000.
Step one is to split that $50,000 over the tax brackets.
$50,000 fills both of the first two brackets fully, it fills half of the third bracket,
and none of the fourth bracket.
Then we apply the tax rate for each tax bracket.
0% tax on the first $20,000 of taxable income.
30% tax on the next $20,000 of taxable income, which is $6,000 tax owed.
40% on his remaining $10,000 of taxable income, which is $4,000 tax owed.
In total, $10,000 tax is owed on the taxable income of $50,000.
We could say that John makes $50,000 gross, and $40,000 net.
His marginal tax rate is 40%.
The marginal tax rate is the tax rate an individual would pay on one additional dollar of income.
John’s average tax rate is the $10,000 tax owed
divided by his gross income of $50,000, which is 20%.
In a progressive income tax system, the average tax rate is always lower
than the marginal tax rate.
Let’s calculate as well how much tax Jane owes.
She has a taxable income of $70,000.
Same procedure.
Split the taxable income over the various tax brackets.
$70,000 fills all of the first three brackets fully, and places the last $10,000 of income
into the fourth bracket.
Apply the tax rate to each taxable income bracket.
Jane owes $19,000 in taxes on her $70,000 taxable income.
Her gross income is $70,000, her net income is $51,000.
Jane’s marginal tax rate is 50%.
She would pay 50 cents additional tax on one additional dollar of income.
Jane’s average tax rate is the $19,000 tax owed divided by her gross income of $70,000,
which is 27%.
What if both John and Jane get a $10,000 salary increase in their next promotion?
It would take John’s taxable income from $50,000 to $60,000, and Jane’s taxable income
from $70,000 to $80,000.
For John, who has a marginal tax rate of 40%, a $10,000 increase in gross income leads to
an extra $4,000 tax owed, and an increase in net income of $6,000.
For Jane, who has a marginal tax rate of 50%, a $10,000 increase in gross income leads to
an extra $5,000 tax owed, and an increase in net income of $5,000.
On the same increase in gross income, John has a larger increase in net income, due to
the difference in marginal tax rate.
The opposite also holds true.
If we start off with $50,000 taxable income for John and $70,000 taxable income for Jane,
and calculate the impact of each person having a deductible on their taxable income of $10,000,
for example if the government of Midgard promotes investing in renewable energy for home use.
It would take John’s taxable income from $50,000 to $40,000, and Jane’s taxable income
from $70,000 to $60,000.
For John, who has a marginal tax rate of 40%, a $10,000 decrease in gross income leads to
a reduction of $4,000 in tax owed, and a reduction in net income of $6,000.
For Jane, who has a marginal tax rate of 50%, a $10,000 decrease in gross income leads to
a reduction of $5,000 in tax owed, and a decrease in net income of $5,000.
On the same decrease in gross income, John has a larger decrease in net income, due to
the difference in marginal tax rate.
How close can the marginal tax rate and the average tax rate get?
In our example, John has a marginal tax rate of 40% and an average tax rate of 20%, while
Jane had a marginal tax rate of 50% and an average tax rate of 27%.
Your marginal tax rate goes up when additional taxable income
goes into the next-higher tax bracket.
Your average tax rate goes up when the mix between income taxed at low rates versus income
taxed at high rates changes.
Let’s now look at someone with a much higher taxable income:
Jim with $1,000,000 taxable income.
Most of his taxable income is in the highest tax bracket.
Only $60,000 is spread over the first three brackets,
the remaining $940,000 is in the fourth bracket.
His marginal tax rate is 50%, and his average tax rate
is getting very close to that at 48.4%.
Average tax rate is always lower than marginal tax rate in a progressive income tax system,
but if you are a big earner, then they are getting very close.
I hope you enjoyed this discussion of marginal tax rate and average tax rate.
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