Average vs. Marginal Tax Rate

Average Tax Rate vs. Marginal Tax Rate

Reviewed by Raphael Zeder | Published Oct 30, 2019

The income tax rate defines what share of a person’s income has to be paid in taxes. However, depending on the tax system, the tax rate may change as the level of income increases or decreases. That means people may have to pay a larger or smaller part of their income, depending on how much they earn. In those cases, it is important to distinguish between two different notions of the tax rate: the average and the marginal rate. Thus, in the following paragraphs, we will look at the differences between the two and learn why it’s important to consider both the average and the marginal tax rate when analyzing the effects of an income tax.

Average Tax Rate

The average tax rate is defined as total taxes paid divided by total income. That means it describes what share of total income ultimately has to be paid in taxes. Thus, the average tax rate is commonly used to measure the actual burden of a tax on taxpayers.

For example, let’s look at two imaginary friends, Ashley and Alex. Ashley works as an attorney and earns USD 100,000 a year. Meanwhile, Alex works as a cashier and makes USD 40,000 a year. Now, suppose the government taxes 10% of the first USD 20,000 of income, 20% of all income between USD 20,000 and USD 50,000, and 40% of all income above USD 50,000.

In this case, Ashley has to pay USD 18,000 in taxes. That is, 10% of the first USD 20,000 (i.e., 20,000 x 0.1 = USD 2,000), 20% of the following USD 30,000 (i.e., 30,000 x 0.2 = USD 6,000), and 40% of the remaining USD 50,000 (i.e., 50,000 x 0.4 = USD 16,000). In other words, Ashley’s average tax rate is 24% (i.e., 24,000 / 100,000). Meanwhile, Alex only pays USD 6,000 in taxes: 10% of the first USD 20,000 (i.e., 20,000 x 0.1 = USD 2,000), and 20% of the remaining USD 20,000 (i.e., 20,000 x 0.2 = USD 4,000). Therefore, Alex’s average tax rate is 15% (i.e., 6,000 / 40,000).

Marginal Tax Rate

The marginal tax rate is defined as the extra taxes paid on an additional unit of income. That means it measures the fraction of extra income that has to be paid in taxes. Therefore, the marginal tax rate can be used to examine how the tax system distorts incentives. Simply put, it determines how much money people get to keep (and how much they have to pay the government) for every additional hour they spend at work. Therefore, we can say that the marginal tax rate determines the deadweight loss of an income tax.

To illustrate this, let’s revisit Ashley and Alex. From the information above, we know that Ashley earns USD 100,000, and Alex earns USD 40,000 a year. Now, assume their employers offer both of them the opportunity to work 10 extra hours for an additional salary of USD 1,000.

In Ashley’s case, the additional USD 1,000 of income would be taxed at a rate of 40% (because she already earns more than USD 50,000), so her marginal tax rate is 40%. Thus, after taxes, Ashley would end up with an additional USD 600 in her pockets (i.e., 1000 x 0.6). Alex’s additional USD 1,000, however, would only be taxed at a rate of 20% (because his income still falls between USD 20,000 and USD 50,000), so his marginal tax rate is 20%. That means Alex would get to keep USD 800 after taxes (i.e., 1000 x 0.8). As a result, he is more likely to accept the offer and work extra time.

In a Nutshell

The income tax rate defines what share of a person’s income has to be paid in taxes. However, the tax rate may change as the level of income increases or decreases. In those cases, we can distinguish between two different notions of the tax rate: the average and the marginal rate. The average tax rate is defined as total taxes paid divided by total income. By contrast, the marginal tax rate is defined as the extra taxes paid on an additional unit of income.

Leave a Reply

Your email address will not be published. Required fields are marked *

I agree that my data may be stored and used as stated in the privacy policy.