The marginal tax rate refers to the rate of taxation on the basis of which the tax on each of the additional dollar of the income earned by the person is calculated and in case of the individual the marginal tax rate increases with the increase in the income of the person.
Marginal Tax Rate Definition
Marginal Tax Rate simply means that as there is an increase in the income earned, there will be a corresponding increase in the tax rate that has to be paid. The marginal tax rate aims to conduct a fair tax rate among the citizens on the basis of their individual income.
To explain it in simple words, the individuals that have an income that falls in the lower section will have to pay a lower tax rate on the taxable income whereas, an individual with a higher income will have to pay a higher tax rate on the taxable income.
Marginal Tax Rate US Example
In the U.S., taxpayers are bifurcated into seven brackets on the basis of their taxable income – 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Since the U.S. follows a progressive income tax pattern, as the income increases so do the income tax. But this doesn’t mean that the people in the highest bracket pay the highest rate on all of their income.
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The 7 income tax brackets and their bifurcations:
Marginal Tax Rate Formula
Below is the formula for Marginal Tax Rate –
Where
- t is the tax liability
- i is the taxable income
- Δ is the numerical change
In the above marginal tax rate formula includes all taxes such as federal, state, provincial, and municipal taxes.
Marginal Tax Rate Calculation Example
Different countries have different rates pertaining to their income range but the crux of the matter remains the same. If a person falls in a higher tax bracket, he will need to pay the tax rate applicable to all the lower brackets along with the tax bracket in which he falls in. The marginal tax rate calculation example below would give a better understanding.
The taxable income for John, a single resident of the U.S., is $82,000 for the year 2018-2019, the marginal tax rate for his income, according to the tax brackets mentioned above, will be 22%. If he were to earn an extra $501 of taxable income, he would be upgraded to the next tax bracket, which in this case would be 32%.
So, for $82,000 his tax would be:
Tax for income range $0-$9,525 @10%
- =$952.50
Tax for income range $9,526-$38,700 @12%
- = $38,700 – $9525
- = $29,175 x 12%
- = $3501
Tax for income range $38,701-$82,500 @22%
- = $82,000 x 22%
- = $18,040
Total tax = $952.50 + $3501 + $18,040
- = $22,493.50
If John were to receive a bonus of say $15,000 by the end of the tax year his marginal tax would be 24%. In this case, he would need to make arrangements for deduction so that his taxable income is reduced and the pre-tax contributions are increased. Sounds confusing?
In simple words, he will need to look for alternative investment options like life insurance cover, taking a car/home loan or making charitable contributions which would eventually bring down his taxable income.
Advantages
- The tax burden is shifted to the higher income group.
- Protects the taxpayer, when income goes down tax will go down.
- Governments earn more from Marginal tax.
Disadvantages
- Discourages business expansion as higher income would attract higher taxes.
- It is unconstitutional as it does not treat the citizens of the same country equally.
- The highest earning citizens of the country may leave to avoid paying higher taxes.
Conclusion
- The marginal tax rate is a progressive tax rate which increases with the increase in taxable income, unlike the flat tax rate which applies a flat rate on all income groups across.
- It is calculated on the basis of the income bracket in which the individual or the organization falls in.
- Marginal tax rate allows a number of adjustments to taxable income, like deductions and exemptions.
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