Marginal Tax Rate

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Definition of the Marginal Tax Rate:

The marginal tax rate is the tax rate charged on the next dollar of income. For example, if an employee is given a $1.00 raise and pays $0.15 in added taxes, her marginal tax rate equals 15 percent.

Detailed Explanation:

Economists use the word “margin” to refer to the next. Marginal cost is a supplier’s cost to provide one more unit of a good or service. The marginal tax rate is the tax rate charged for the next dollar earned. The marginal tax rate determines how much of added income is kept and how much is paid in tax. 

Most countries, including the United States, have a progressive income tax. This means as a person’s income increases, a higher percentage of their income is taxed. The 2016 tax brackets for a single person in the United States are:

marginal tax rate chart
Source: IRS Publication

It is important to distinguish between the statutory rate, effective rate, and marginal rate. Statutory rates are set by the statutes and do not consider tax benefits from tax credits that are subtracted directly from taxable income. For example, assume you are a recent college graduate and your taxable income equals $30,000. You would owe $4,036.25 in income taxes. The statutory rates are 10 percent for the first $9,275, and 15 percent for between $9,276 and $30,000.    

First $9,275 at 10%    $927.50
Remaining $20,725 at 15% $3,108.75
Total Statutory Tax $4,036.25

A marginal tax rate is frequently confused with an average or effective tax rate, but it is very different. Your effective tax rate is 13.45 percent, ($4,036.25/$30,000), but your marginal tax rate equals 15 percent because if you earn $100 more you would owe $15 more in taxes. The effective tax is a historical tax rate because it is determined by past activities. The marginal tax rate is the tax rate that would be paid on the next dollar earned, so it is forward looking. For this reason, economists favor the marginal tax rate when making financial decisions such as investing in a tax free municipal bond. For individuals it is normally the tax payer’s tax bracket.

Supply-side economists believe a low marginal tax rate is important in maintaining a healthy economy. High marginal tax rates stifle the incentive to work. A high capital gains tax would discourage entrepreneurs from taking risks needed to cultivate new technologies and businesses. President Reagan, a leading proponent of supply-side economics, told the story of how a high tax bracket discouraged him and other actors from working. (Many refer to supply-side economics as “Reagomics”.) He said he would only act in two movies a year. His income for the third movie would have been taxed at 95 percent, so he and the other actors favored leisure to working on a third movie. His marginal tax rate would have jumped to 95 percent had he chosen to act in a third movie. 

To view the US tax brackets for 2016 visit IRS Tax Brackets.

Dig Deeper With These Free Lessons:

Marginal Analysis - How Decisions Are Made
Fiscal Policy - Managing an Economy by Taxing and Spending 

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