Marginal Tax Rate Definition
Marginal tax rate can be defined as a progressive tax structure where the tax liability of an individual increase with the increase in the amount of income earned during a financial year.
It 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. It 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 U.S. Example
In the U.S., taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws.read more 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.
The 7 income tax brackets and their bifurcations:
Marginal Tax Rate Formula
The mathematically driven marginal tax rate formula is as follows:
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For eg:
Source: Marginal Tax Rate (wallstreetmojo.com)
Alternatively, the Marginal Tax Rate Formula is as follows:
Total Income Tax = Taxable Income(n) x Tax Rate under a Tax Bracket(m) + Taxable Income(n+1) x Tax Rate under a Tax Bracket(m+1)… So on
Marginal Tax Rate Calculation Examples
Example 1
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-taxPre-taxPretax income is a company's net earnings calculated after deducting all the expenses, including cash expenses like salary expense, interest expense, and non-cash expenses like depreciation and other charges from the total revenue generated before deducting the income tax expense.read more 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 that would eventually bring down his taxable income.
Example #2
Marc, an individual aged 28, earns $1,00,000 during the financial year 2018. Calculate Mark’s Income Tax liability if the following is the given taxation system in the U.S.
Will Marc be taxed at the highest rate of tax, i.e., 30%?
What is Marc’s effective tax rateEffective Tax RateEffective tax rate determines the average taxation rate for a corporation or an individual. For both, there is a similar formula only with variation in considering variables. The effective tax rate formula for corporation = Total tax expense / EBTread more?
Sol – No, Even if Marc has earned $10,00,000, his entire income will not be taxed at the highest tax rate but will be calculated as given below,
Therefore, the calculation of this formula will be as follows
Marc’s effective tax rate= (Total Tax Payable/ Total Taxable Income)
= ($2,47,500/$10,00,000) x 100
Marc’s Effective Tax Rate will be –
- Marc’s Effective Tax Rate = 24.75%
Example #3
Louis and Emma married assesses disclosed taxable income of $ 1,50,000 during F.Y. 2018. With the help of given below tax brackets, calculate the tax payable by them if they are filing a joint return as married filing jointly.
Sol – Since Louis and Emma opted for Married Filing Jointly, the tax will be calculated according to tax brackets given for this category and tax liability will be calculated as follows:
Total Tax Payable
- Total Tax Payable = 24,879
Therefore, the calculation of this formula will be as follows
= Tax Payable/ Total Taxable Income
=($24,879/$1,50,000)
Marc’s Effective Tax Rate will be –
- Marc’s Effective Tax Rate = 16.59%
Example #4
Calculate tax liability of Mr. Marc (unmarried) supporting more than half of family expenditure for full F.Y. 2018 having a total taxable income of $12,00,000 with the help of given tax brackets.
Sol. Since Mr. Marc is unmarried and is supporting more than half of his family expenditure, he is eligible to file an Income Tax return as head of household. Tax brackets applicable will be as follows:
Total Tax Payable
- Total Tax Payable = 408,912.00
Therefore, the calculation of this formula will be as follows
= Tax Payable/ Total Taxable Income
= ($4,08,912/$12,00,000) x100
Marc’s Effective Tax Rate will be –
- Marc’s Effective Tax Rate = 34.08%
Advantages
- The tax burden is shifted to the higher income group.
- Protects the taxpayer; when income goes down, the 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 taxProgressive TaxProgressive tax refers to the increase in the average rate of tax with the increase in the amount of taxable income so that the liability of paying heavy taxes passes to those who earn a higher income and those with lower income can have a relaxation from the heavy income tax obligations.read more rate, which increases with the increase in taxable income, unlike the flat tax Flat Tax The flat tax system is a mechanism in which the same tax rate is applied to every individual irrespective of their income. Also, no deductions or exemptions are allowed. In this tax system, the person earning higher wages does not fall into a tax higher bracket.read morerate, 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.
- The marginal tax rate allows a number of adjustments to taxable income, like deductions and exemptions.
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