Effective vs Marginal Tax Rate

Difference Between Effective and 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 critical differences between Effective vs. Marginal Tax rates in detail –

What is Effective Tax Rate?

• The effective tax rate is the average rate at which an individual is taxed on earned income.
• It is calculated basis total tax expenses divided by taxable income.
• It 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 encourages business expansion as higher-income would attract effective taxes.
• There are no significant 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:

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

What is the Marginal Tax Rate?

• The marginal tax rate is the highest tax rate at which the income of individual and non- individual is taxed.
• It aims to present a reasonable tax rate among the citizens based on their 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 decreases tax will also reduce.
• This tax method discourages business expansion as higher-income would attract higher taxes.
• There are significant compliance checks for paying the tax under this method due to multiple tax rates.

Example

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

In the 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

The total tax would be 450,000 based on the Marginal Tax Rate.

Effective vs. Marginal Tax Rate Infographics

Let’s see the top differences between the effective vs. marginal tax rates.

Critical Differences Between Effective and Marginal Tax Rate

• The effective tax amount is calculated basis tax rate multiply with taxable income. In comparison, the marginal tax amount is calculated basis different types of tax rates.
• The government earns less revenue under the effective tax rate method. In comparison, in the marginal tax rate government earns more revenue.
• The tax burden is shifted to the general income group under an effective tax rate method. Whereas under marginal tax rate responsibility to pay tax is moved to the persons who have a higher income.
• The effective tax rate method does not protect the taxpayer; when income goes down, the tax will go down. Whereas, the marginal tax rate protects the persons who pay taxes; when taxable income decreases, the tax also decreases.
• The effective tax rate method encourages business expansion as higher-income would attract effective taxes. In comparison, the marginal tax rate method discourages business expansion as higher-income would attract higher taxes.
• There are no significant compliance checks for paying the tax under the effective tax rate method due to a single tax rate. Whereas under the marginal tax rate method, there are significant compliance checks for paying the tax due to multiple tax rates.

Comparative Table

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 types of tax rates.
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 decreases tax will also be decreased.
Business Expansion		It encourages 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 significant 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 types of tax rates. The effective tax rate is a flat tax, and under this method, every person will pay tax, whether it has a lower income or higher income.

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

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