In a tax system and in economics, the tax rate describes the ratio at which a
business or person is taxed. There are several methods used to present a tax
rate: statutory, average, marginal, and effective. These rates can also be
presented using different definitions applied to a tax base: inclusive and
exclusive. Statutory
A statutory tax rate is the legally imposed rate. An income tax could have
multiple statutory rates for different income levels, where a sales tax may
have a flat statutory rate. Average
An average tax rate is the ratio of the total amount of taxes paid to the total
tax base, expressed as a percentage. Let be the total tax liability.
Let be the total tax base. In a proportional tax, the tax rate is
fixed and the average tax rate equals this tax rate. In case of tax brackets,
commonly used for progressive taxes, the average tax rate increases as taxable
income increases through tax brackets, asymptoting to the top tax rate. For
example, consider a system with three tax brackets, 10%, 20%, and 30%, where
the 10% rate applies to income from $1 to $10,000, the 20% rate applies to
income from $10,001 to $20,000, and the 30% rate applies to all income above
$20,000. Under this system, someone earning $25,000 would pay $1,000 for the
first $10,000 of income; $2,000 for the second $10,000 of income; and $1,500 for
the last $5,000 of income. In total, they would pay $4,500, or an 18% average
tax rate. Marginal
A marginal tax rate refers to the tax rate an individual would pay on one
additional dollar of income. Thus, the marginal tax rate is the tax percentage
on the last dollar earned. In the United States in 2013, for example, the highest
marginal tax rate was 39.6%, applying to earnings over $400,000. Earnings under
$400,000 that year had a lower tax rate of 33% or less.
The marginal tax rate on income can be expressed mathematically as follows:
where t is the total tax liability and i is total income, and ∆ refers to a
numerical change. In accounting practice, the tax denominator in the
above equation usually includes taxes at federal, state, provincial, and
municipal levels. Marginal tax rates are applied to income in countries with
progressive taxation schemes, with incremental increases in income taxed in
progressively higher tax brackets. In economics, marginal tax rates are
important because they impact the incentive of increased income. With
higher marginal tax rates, individuals have less incentive to earn more. This
is the basis of the Laffer curve, which theorizes that population-wide taxable
income decreases as a function of the marginal tax rate, making net
governmental tax revenues decrease beyond a certain taxation point.
With a flat tax, by comparison, all income is taxed at the same percentage,
regardless of amount. An example is a sales tax where all purchases are taxed
equally. A poll tax is a flat tax of a set dollar amount per person. The
marginal tax in these scenarios would be zero.
= Implicit marginal tax rate = For individuals that receive means
tested benefits, benefits are decreased as more income is earned. This is
sometimes described as an implicit tax. These implicit marginal tax rates can
exceed 90% or even greater than 100%. Some economists argue that these issues
create a disincentive for work or promotion and may result in a structural
income inequality. Effective
The term effective tax rate has different meanings in different
contexts. Generally its calculation attempts to adjust a nominal tax rate to
make it more meaningful. It may incorporate econometric, estimated, or
assumed adjustments to actual data, or may be based entirely on assumptions or
simulations. The term is used in financial reporting
to measure the total tax paid as a percentage of the company's accounting
income, instead of as a percentage of the taxable income. International
Accounting Standard 12, define it as income tax expense or benefit for
accounting purposes divided by accounting profit. In Generally Accepted
Accounting Principles, the term is used in official guidance only with respect
to determining income tax expense for interim periods by multiplying
accounting income by an "estimated annual effective tax rate," the
definition of which rate varies depending on the reporting entity's
circumstances. In U.S. income tax law, the term is used
in relation to determining whether a foreign income tax on specific types of
income exceeds a certain percentage of U.S. tax that would apply on such income
if U.S. tax had been applicable to the income.
The popular press, Congressional Budget Office, and various think tanks have
used the term to mean varying measures of tax divided by varying measures of
income, with little consistency in definition.
Investors usually modify a statutory marginal tax rate to create the
effective tax rate appropriate for their decision.
For example: If capital gains are only taxed when realized by a sale, the
effective tax rate is the yearly rate that would have applied to the average
yearly gain so that the resulting after-tax profit is the same as when all
taxed at statutory rates on sale. It will be lower than the statutory rate
because unrealized profits are reinvested without tax.
For example: When dividends are both taxed as income, and also generate a tax
credit in the UK and Canadian system, the effective tax rate is the net effect
of both - the net tax divided by the actual dividend's value.
For example: When contributions are made to Tax Deferred Accounts the reduced tax
base will result in reduced taxes calculated at the statutory marginal
rate. But the reduction in the tax base may also affect qualification for other
government benefits. The difference in those benefits is added to the numerator
to increase the effective marginal rate due to the contribution.
Inclusive and exclusive Tax rates can be presented differently
due to differing definitions of tax base, which can make comparisons between
tax systems confusing. Some tax systems include the taxes owed
in the tax base, while other tax systems do not include taxes owed as part of the
base. In the United States, sales taxes are usually quoted exclusively and
income taxes are quoted inclusively. The majority of Europe, value added tax
countries, include the tax amount when quoting merchandise prices, including
Goods and Services Tax countries, such as Australia and New Zealand. However,
those countries still define their tax rates on a tax exclusive basis.
For direct rate comparisons between exclusive and inclusive taxes, one rate
must be manipulated to look like the other. When a tax system imposes taxes
primarily on income, the tax base is a household's pre-tax income. The
appropriate income tax rate is applied to the tax base to calculate taxes owed.
Under this formula, taxes to be paid are included in the base on which the tax
rate is imposed. If an individual's gross income is $100 and income tax rate
is 20%, taxes owed equals $20. The income tax is taken "off the top",
so the individual is left with $80 in after-tax money. Some tax laws impose
taxes on a tax base equal to the pre-tax portion of a good's price. Unlike the
income tax example above, these taxes do not include actual taxes owed as part of
the base. A good priced at $80 with a 25% exclusive sales tax rate yields $20
in taxes owed. Since the sales tax is added "on the top", the individual pays
$20 of tax on $80 of pre-tax goods for a total cost of $100. In either case, the
tax base of $100 can be treated as two parts—$80 of after-tax spending money
and $20 of taxes owed. A 25% exclusive tax rate approximates a 20% inclusive
tax rate after adjustment. By including taxes owed in the tax base, an exclusive
tax rate can be directly compared to an inclusive tax rate.
Inclusive income tax rate comparison to an exclusive sales tax rate:
Let be the income tax rate. For a 20% rate, then
Let be the rate in terms of a sales tax.
Let be the price of the good. The revenue that would go to the
government: The revenue remaining for the seller of
the good: To convert the tax, divide the money
going to the government by the money the company nets:
Therefore, to adjust any inclusive tax rate to that of an exclusive tax rate,
divide the given rate by 1 minus that rate.
15% inclusive = 18% exclusive 20% inclusive = 25% exclusive
25% inclusive = 33% exclusive 33% inclusive = 50% exclusive
50% inclusive = 100% exclusive See also
Progressive tax Proportional tax
Regressive tax Tax incidence
List of countries by tax rates List of countries by tax revenue as
percentage of GDP Tax rates of Europe
Tax exporting Capital flight
References External links