Note: This is the latest entry in the Acton blog series, “What Christians Should Know About Economics.” For other entries in the series see this post.
What it means: A marginal tax rate is the amount of tax paid on an additional dollar of income.
The Explanation: What is the tax rate you pay on your current income?
For most Americans, the question is surprisingly difficult to answer. The reason we don’t know our tax rate is because we have a progressive system of taxation on income — and most of us don’t fully grasp the concept of marginal tax rates.
Fortunately, the concept is easy to understand once you get past the confusing jargon. So let’s unpack what it means.
First, we need to understand the term “tax rate.” This is simply the ratio of tax to the amount being taxed. The ratio is almost always expressed as a percentage, so instead of saying the tax rate ratio is 1:10 we just say the tax rate is 10 percent. That means for every dollar I’d be taxed 10 cents (1:10 or 10%).
In American we have a progressive tax rate system. To say our system of taxation is “progressive” does not mean that political progressives (i.e., liberals) designed it or prefer it (though it mostly was and they generally do). A progressive tax merely means that the tax rate increases as the taxable amount increases. So for income tax, the tax rate progresses from low to high as a person’s income increases.
The third thing we need to know is the meaning of “marginal” in marginal tax rates. Marginal is a key concept in economics, but for now when you hear the term “marginal” just think of it as “additional.” For example, the marginal (additional) tax rate is the additional tax on the marginal (additional) income you earn.
Now we have only one more concept to add: tax brackets. (For our purposes we’ll focus solely on the federal tax brackets.) The federal system of taxation on income is progressive and marginal, which means we do not pay the same tax rate on every dollar of our income. (Read that sentence again, because failure to understand that point is the reason most people get confused about tax rates.)
Think of tax brackets as buckets sitting on a staircase that hold specific amounts of your income. The first bucket on the bottom step says “$0-$100 – Tax at 10 percent”, the second bucket on the second step says “$101-200 – Tax at 20 percent”, and so on up the staircase. Once you fill up the first bucket the additional (marginal) dollar (the 101st dollar) progresses into the next bucket, and so on up the staircase. This is an image of a progressive system of marginal tax rates that includes several tax brackets.
Now let’s move to a real-world example by looking at the marginal tax rates for Becky, an unmarried worker.
10% for income $0 to $9,275
15% for income $9,275 to $37,650
25% for income $37,650 to $91,150
28% for income $91,150 to $190,150
33% for income $190,150 to $413,350
35% for income $413,350 to $415,050
39.6% for income $415,050+
What is Becky’s tax rate if she earns $8,000 a year? That one is easy: 10 percent. But what is Becky’s tax rate if she earns $10,000 a year? That is trickier. Since Becky has two tax rates we have to calculate her average tax rate.
The first $9,275 Becky earned goes into the first bucket (the 10% bracket) while the next $725 dollars goes into the second bucket (the 15% bracket). So on the first $9,275 she paid $927.50 in taxes and on the $725 she paid $108.75. Altogether she paid $1,036.25 in taxes. The ratio of 1,036.25:10,000 equals an average tax rate of 10.4 percent.
And this is why people get confused. If you ask Becky what her marginal tax rate is she’ll look at the chart and answer (correctly) that it’s 15 percent. She may therefore assume that she pays an income tax rate of 15 percent. In reality, she only pays the 15 percent rate on the additional income over $9,275 that she’s earned — the $725. But if you ask Becky our original question — “What is the tax rate you pay on your current income?” — she will likely say 15 percent.
In a way, that makes sense. We assume that we should be able to look at the IRS’s tax bracket chart and determine our tax rate. But the chart only tells us about our marginal rate (the tax we pay on our last few dollars of our income) and does not reveal the average rate (the tax we pay, on average, on all our income).
Calculating our average tax rate isn’t complicated — it just requires some multiplication and addition. Let’s look at one more example, Becky’s unmarried boss Bob, who earned $100,000 in income. To calculate Bob’s average tax rate we must divide up his $100,000 income into each of the buckets (i.e., tax brackets). Let’s start by putting a number on each dollar, from 1 to 100,000.
In the 10% bucket we put $9,275 (dollars #1 to #9,275); in the 15% bucket we put $28,375 (dollars #9,276 to #37,650); in the 25% bucket we put $53,500 (dollars #37,651 to #91,950); and in the 28 percent bucket we put $8,850 (dollars #91,951 to #100,000). Now we just need to multiply the amount in each bucket by the tax rate for that bracket and add up each column:
10% x $9,275 = $927.5
15% x $28,375 = $4,256.25
25% x $53,500 = $13,375
28% x $8,850 = $2,478
$927.5 + $4,256.25 + $13,375 + $2,478 = $21,036.75
Bob owes a total tax of $21,036.74, which means his average tax rate is 21 percent (total tax paid ($21,036.74) / total income ($100,000)).
Why it Matters: We now understand how to use marginal tax rates to calculate the average tax rate we pay on our income. But why is this important for Christians to know? There are at least two reasons.
The first reason is that all of our income belongs to God — and we are called to be good stewards of his resources. While God doesn’t require us to know the exact percentage of how much we are paying in taxes, knowing our average tax rate can give us a clearer picture of how many resources we have — after “rendering to Caesar” (Mark 12:17) — to use for God’s other purposes.
The second reason is that all of our time belongs to God — and we are called to be good stewards of his resources. For many workers, whether they are salaried or paid hourly, the level of additional income they earn is correlated with the additional time they spend on their work. Every individual has to decide for themselves how much of this resource God wants them to spend on additional work. But they should make the decision based on accurate assessment of the facts. Often, a misunderstanding of how marginal tax rates works leads them to assume additional work is not worth the effort.
Let’s look at one last example. Barney earns $37,650 and assumes (erroneously) that since his marginal tax rate is 15 percent, that he’s paying a total tax rate of 15 percent, which would be a tax of $5,647.50. Barney’s boss tells him that by taking on an extra shift each month he can earn $40,000 per year. Barney looks at the IRS chart and notices the raise would make his marginal tax rate 25 percent. He assumes (again, erroneously) that the raise would force him to pay taxes of $10,000 (25% x $40,000).
Since he thinks he was paying $5,647.50 he believe the raise would require him to pay $4,352.50 in additional taxes. He thinks he’d have to pay more in taxes than he’d earn from the $2,350 raise! (This may seem far-fetched but I assure you someone you know thinks this way about taxes.)
The reality is that Barney only pays the higher rate on his additional (marginal) income ($2,350). So instead of paying $4,352.50 more after the raise, he only pays $587.50 more. What Barney doesn’t understand is that moving to a higher tax bracket never causes you to have a lower net income.
Knowing how marginal tax rates affect Barney’s pay doesn’t tell us whether he should work more, but it can help him make a better informed decision.
Other Stuff You Might Want to Know:
• Your marginal tax rate will always be higher than your average tax rate, unless you are in the lowest tax bracket — then the marginal rate (since there is only one) is equal to the average rate. So a good rule of thumb is that whatever your highest marginal tax bracket is, you’re average tax rate will be at least several percentage points lower than that.
• Just as the marginal tax rate applies to your marginal (additional) income — the income you put in the last few buckets (brackets) — so too do tax deductions. As economist Jodi Beggs explains:
The same principle holds in reverse for tax deductions- if you make $50,000 and have a $100 tax-deductible expenditure (ignore the standard deduction for now), your taxable income decreases by $100 and your taxes owed decrease by $25, in effect giving you a discount on your expenditure equal to your marginal tax rate. Note again that it was only this last tax bracket, or your marginal tax rate, that was relevant in calculating the effect of the tax deduction.
• Tax deductions are valuable because they lower your taxable income. But even better are tax credits. Tax credits provide a dollar-for dollar reduction of your income tax liability. If your marginal tax rate is 25 percent and you get a $100 deduction, you save $25. In contrast, a $100 tax credit saves you $100. As the IRS says, “A tax credit is always worth more than a dollar-equivalent tax deduction, because deductions are calculated using percentages.”