Difference Between marginal tax rate and effective tax rate

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Permalink Reply by Bill M Wright on March 3, 2010 at 1:16am

The Simple bottom line is your Effective Tax Rate is equal to your total federal/state tax paid divided by your Income. Your Marginal Tax Rate is the highest rate your additional dollars of income must pay in a progressive tax system like the USA's.

Your marginal tax rate -- the figure usually associated with your tax brackets -- is the top rate you're paying on your taxable income, and the rate at which your next dollar of income would be taxed. But it's not your overall tax rate.

The USA tax system has progressively higher rates the more you make. We call them tax brackets, and you do pay an increasing tax rate as your income rises. However, only certain chunks of your income are subjected to each tax (bracket) rate. Consider these tax brackets for single filers in 2006:

For taxable income between:
The tax is:

$0 and $7,550
10% of that sum

$7,551 and $30,650
$755 plus 15% of the amount over $7,550

$30,651 and $74,200
$4,220 plus 25% of the amount over $30,650

$74,201 and $154,800
$15,107.50 plus 28% of the amount over $74,200

$154,801 and $336,550
$37,675.50 plus 33% of the amount over $154,800

$336,551 and up
$97,653 plus 35% of the amount over $336,550.

The marginal rates are -- 10%, 15%, 25%, 28%, 33%, and 35%.

Imagine you make $7,550 a year. That puts you within the 10% bracket, so you'll pay 10% of that income in taxes -- $755 in all. Now, imagine you make just $100 more. Your new income of $7,650 has bumped you into the 15% bracket ( your marginal tax bracket) -- but you won't pay that 15% on everything you've made. Your first $7,550 of income is still taxed at 10%, but the additional $100 will be taxed at 15%, adding another $15 to your previous tax bill, for a total of $770.

Here's where the effective tax rate comes in. To see what your overall tax rate really is, take your total tax due and then divide it by your taxable income. In our example above, earning $7,650 gives you an effective tax rate of 10.1%, because your $770 tax bill is 10.1% of your total income.

This is a simple calculation, of course, so it doesn't include factors such as the alternative minimum tax, self-employment taxes, or thousands of other variables that come into play with 70 years of every increasing USA TAX LAW.

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Permalink Reply by Bill M Wright on March 3, 2010 at 1:20am

I'm responding to the headline question as the Google Ads may be blocking question. Corporate Deferred Tax has nothing to do with Individual Marginal and Effective Tax Rates.

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Permalink Reply by Sachidanand (Sacha) Singh on March 3, 2010 at 9:39am

Deferred tax has been discussed a couple of times. Here are some links:
http://www.finance30.com/forum/topics/deferred-tax-1
http://www.finance30.com/forum/topics/deffered-taxa-dilemma

The first link has one example and an excellent logic sheet.

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Permalink Reply by Amit Puggal on March 3, 2010 at 10:53am

My heartiest thanks to both the renowned scholars for their valuable input

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