Marginal Tax Rates Versus Average Tax Rates

To help understand how a tax structure could be more efficient, it may be useful to distinguish between average and marginal tax rates.


Marginal Tax Rates Versus Average Tax Rates

The average tax rate is the total taxes paid divided by total income.

The marginal tax rate is the tax paid on an additional dollar of income.

The average tax rate measures the sacrifice made by a taxpayer. The marginal tax rate measures how much the tax system discourages people from working.


An Example to Illustrate the Difference Between Marginal and Average Tax Rates

According to the table at the top of page 258, if a single worker had $30,000 of taxable income in 2005, the worker would owe $4,165 in federal income tax.

· 10% federal income tax on the first $7,300 of taxable income

· 15% federal income tax on income earned above $7,300 but less than $29,700

· 25% federal income tax on income earned above $29,700 but less than $71,950

The worker owes $730 on the first $7,300 of taxable income.

(.10)($7,300) = $730

The worker owes $3,360 on the taxable income above $7,300 but less than $29,700.
$29,700 - $7,300 = $22, 400
Thus, the worker pays 15% tax on $22,400 of his or her income.
(.15)($22,400) = $3,360

The worker owes $75 on the taxable income above $29,700 but less than $71,950.

$30,000 - $29,700 = $300
Since the worker’s taxable income is $30,000, the worker pays 25% tax on $300 of his or her income.
(.25)($300) = $75

Thus, the total federal income tax owed is $4,165.

Federal income tax owed = (.10)($7,300) + (.15)($22,400) + (.25)($300)
. = $730 + $3,360 + $75
= $4,165

The average income tax rate is the tax paid divided by income. If the workers total income is $30,000, then this worker’s average tax rate is:

average tax rate = $4,165 / $30,000 = 0.138 or 13.8%

The marginal tax rate is the tax paid on an additional dollar of income. If this worker earns additional income above the current $30,000, it will be taxed at 25%. (See the table for 2005 on page 258.)

Thus, this worker’s average tax rate is 13.8% and the marginal tax rate is 25%. The worker is paying 13.8% of his or her income in federal income tax. This represents the sacrifice the worker is making to financially support the federal government. The marginal tax rate is significantly higher in this case. If this person chooses to work more (and increase his or her income above $30,000 per year), the government will be owed 25 cents of each additional dollar earned. This may reduce the person’s incentive to do the additional work. If the person works enough to earn an additional $1,000, the federal government will collect $250. Thus, the worker’s disposable income increases by only $750.