What is the Difference Between Marginal and Effective Tax Rate?

What is the Difference Between Marginal and Effective Tax Rate?

I am often surprised how many people don’t understand how the United States Income Tax system actually works, but on the surface it is a really simple system.  Like anything else, once we get deeper it becomes a bit LOTS more complicated. However, when someone says, “I don’t want to make more money than $X because my tax rate will go up” you can be assured that they don’t really understand The United States Federal Income Tax System.”

How Does the United States’ Marginal Income Tax System Work?

The federal income tax system in the United States is usually referred to as a graduated or progressive system where the rate increases as your income increases.  Your last dollar is taxed at the highest rate bracket you are in, but that tax bracket isn’t applied to that first dollar.  I think an example really brings the system to light.

The following tax schedule is taken from the IRS Instructions for the 2010 1040.

Tax Schedule 2010 from IRS

If we were to look at a single individual making $85,000:

  • The first $8,375 would be taxed at 10% ($837.50);
  • The dollars between $34,000 and $8,375 would be taxed at 15% (Cumulative: $4,681.25)
  • The dollars between $34,000 and $82,400 would be taxed at 25% (Cumulative $16,781.25)
  • The  dollars above $82,400 (so in our example $2,600) would be taxed at 28%  = $728
  • Cumulative Taxes Owed $17,509.25

As you can see the last dollar is not taxed at 28%, it is still taxed at 10%, it is only those last couple dollars that were taxed at 28%.

What is the Difference between Marginal and Effective Tax Rate?

The effective tax rate is,

the amount of tax an individual or firm pays when all other government tax offsets or payments are applied, divided by the tax base (total income or spending)

In our example our made up person made $85,000, and his marginal tax rate was 28%, but paid $17,500 in total taxes so he effectively paid 20.5%.

This example was overly simplified as deductions come and go with income levels, however, it provides a clear difference between Marginal and Effective Tax Rates

6 Responses to What is the Difference Between Marginal and Effective Tax Rate?

    • Never looked at it that way but you are absolutely right – very few individuals have an effective rate in the 30s

  1. Great explanation.

    Now all we need, in my opinion, is to get rid of all the deductions, credits, exemptions, etc and have only a few brackets. Tax code solved!

    • If they got rid of all the deductions and credits they could probably receive the same net amount with tax rates in the teens for everyone lol

  2. So does the US use an effective tax rate or do they use Marginal?

    Here in Canada we use a marginal tax rate.

    • Marginal as well…what are Canadian tax rates like? You are paying for health care in yours they better be higher lol

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