Effective vs Marginal Tax Rate

Difference Between Effective vs Marginal Tax Rate

The effective tax rate is the percentage of taxable income that effectively pays in taxes whereas the marginal tax rate is the percentage of tax that will pay on an additional amount of taxable income. In this article, we look at the key differences between Effective vs Marginal Tax rates in detail –

What is Marginal Tax Rate?

• The marginal tax rate is the highest tax rate at which income of individual and non- individual is taxed
• It aims to present a reasonable tax rate among the citizens on the basis of their individual income.
• The government earns more from marginal tax.
• Responsibility to pay tax is moved to the persons who have a higher income.
• This tax rate protects the persons who pay taxes when taxable income decrease tax will also be decreased.
• This tax method discourages business expansion as higher-income would attract higher taxes.
• There are major compliance checks for paying the tax under this method due to multiple tax rate.

Example

Mr. Michel Smith is residing in the USA and earns Annual Income of 15,00,000.00 and pays tax. Calculate his tax Liability. 

In USA, prevailing marginal tax rates are as follows:-

Solution:-

• Upto 500,000 $ =  500,000 *20% =  100,000
• From 5,00,001.00- 10,00,000.00 = 500,000 * 30% = 150,000
• Above 1,000,000 = 500,000* 40% = 100,000

Total Tax would be 450,000 on the basis of Marginal Tax Rate.

What is Effective Tax Rate?

• The effective tax rate is the average rate at which an individual is taxed on earned income.
• The effective tax rate is calculated basis total tax expenses divided by taxable income.
• This tax rate is the percentage of taxable income that effectively pays in taxes.
• This tax amount is calculated basis tax rate multiply with taxable income.
• The government earns less revenue under this tax method
• The tax burden is shifted to the general income group.
• This tax method does not protect the taxpayer when income goes down tax will go down.
• This tax method courage business expansion as higher-income would attract effective taxes.
• There are no major compliance checks for paying the tax under this method due to a single tax rate

Example

Mr. Michel Smith has paid tax of $ 4, 50,000.00 on an annual income of $ 15, 00,000.00. Calculate his effective tax rate.

Solution:

Tax Rate = Total Tax Expenses / Annual Income *100

• =  4.50 Lakhs / 15 Lakhs *100
• =  30% will be Effective Tax Rate

Effective vs Marginal Tax Rate Infographics

Here are the top 7 differences between Effective vs Marginal Tax Rate

Effective vs Marginal Tax Rate Key Differences

The key differences between Effective vs Marginal Tax Rate are as follows –

• The effective tax amount is calculated basis tax rate multiply with taxable income whereas marginal tax amount is calculated basis different type of tax rate.
• The government earns less revenue under the effective tax rate method whereas the marginal tax rate government earns more revenue.
• The tax burden is shifted to the general income group under effective tax rate method whereas under marginal tax rate responsibility to pay tax is moved to the persons which have a higher income.
• Effective tax rate method does not protect the taxpayer when income goes down tax will go down whereas the marginal tax rate protects the persons who pay taxes when taxable income decrease tax will also be decreased.
• Effective tax rate method courage business expansion as higher-income would attract effective taxes whereas marginal tax rate method discourages business expansion as higher-income would attract higher taxes.
• There are no major compliance checks for paying the tax under effective tax rate method due to single tax rate whereas under marginal tax rate method there are major compliance checks for paying the tax due to multiple tax rates.

Effective vs Marginal Tax Rate Head to Head Differences

Now, let’s have a look at the head to head differences between Effective vs Marginal Tax Rate

Basis		Effective Tax Rate		Marginal Tax Rate
Meaning		It is the percentage of taxable income that effectively pays in taxes.		It is the percentage of tax that will pay an additional amount of taxable income.
Calculation		This tax amount is calculated basis tax rate multiply with taxable income.		Under this tax method, the amount is calculated basis different type of tax rate.
Earning		The government earns less revenue under this tax method		The government earns more revenue under this tax method
Tax Burden		The tax burden is shifted to the general income group.		Responsibility to pay tax is moved to the persons who have a higher income.
Protection		It does not protect the taxpayer when income goes down tax will go down.		Protects the persons who pay taxes, when taxable income decrease tax will also be decreased.
Business Expansion		It courage business expansion as higher-income would attract effective taxes.		It discourages business expansion as higher-income would attract higher taxes.
Compliance Checks		There are no major compliance checks for paying the tax under this method due to a single tax rate		There are major compliance checks for paying the tax under this method due to Multiple tax rates.

Conclusion

The marginal tax rate is increased with the increase in taxable income, unlike the effective tax rate which applies a fixed rate on all taxpayers. Under this tax method, the amount is calculated basis different type of tax rate. The effective tax rate is flat tax and under this method, every person will pay tax whether it has lower income or higher income.

Maximum countries have tax system of marginal tax rate system which is very logical. This tax system will help the government for identification of people basis their income. On the basis of above countries should have a marginal tax rate system for balancing the economy.

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