Marginal Tax Rate

Published Jan 2, 2023

Definition of Marginal Tax Rate

The marginal tax rate (MTR) is the rate of tax applied to an individual’s next unit of income. That means it is the rate of tax applied to the next dollar of income a person earns. It is important to note that the marginal tax rate may differ from the average tax rate, which is the total amount of taxes paid divided by the total income (e.g., in a progressive tax system).

Example

To illustrate this, let’s look at an example. Let’s say that your friend John is a single taxpayer with an annual income of USD 50,000. Now let’s assume that according to the tax code that applies to John, the MTR for this income level is 25%. That means that for every additional dollar John earns, he will have to pay 25 cents in taxes.

In a progressive tax system, the MTR will increase based on certain tax brackets. So let’s assume that John gets a raise and now earns USD 100,000. Because of his increased ability to pay, his marginal tax rate is now at 35%. That means for every additional dollar John earns now, he will have to pay 35 cents in taxes.

Why Marginal Tax Rates Matter

Marginal tax rates are important because they determine how much of an individual’s income is taxed. Thus, they are critical for understanding the incentives for people to work and invest. If the rate is too high, people may be discouraged from working or investing, as they will not be able to keep as much of their income. By contrast, if the marginal tax rate is too low, people may be encouraged to work and invest more, as they will be able to keep a larger share of their income. Thus, it is important to set the MTR at the right level.