Average vs. Marginal – Explanation of Tax Rate Calculations

A common misunderstanding in tax terminology involves the distinction between marginal tax rates and average (or “effective”) tax rates. Both terms relate to the same IRS-imposed income tax rates but there is a key difference that makes each rate useful depending on particular considerations. A marginal tax rate is simply the tax bracket within which a taxpayer’s last dollar earned (of his taxable income) falls into. Under marginal rate analysis, each taxpayer-earned dollar is taxed within its relative bracket as you move up the progressive tax rate schedule. A taxpayer’s average rate, on the other hand, is represented by the ratio of a taxpayer’s final income tax amount paid to his taxable income.

Imagine Joe, a single taxpayer, earns $50,000 taxable income in 2013. Using the income tax rate schedules found in Revenue Procedure 2013-15, Joe has the following income tax base, liability, and rates:

Tax Base: $50,000
Tax Liability (Taxes Owed): $8,428.75 [$4,991.25 + 25% of $13,750 ($50,000-$36,250)]
Marginal Tax Rate: 25% [rate which last dollar earned is taxed at]
Average Tax Rate: 16.86% [$8,428.75 /$50,000]

Each of these two tax rate calculations is helpful for different scenarios. Average tax rate is most relevant when determining how much of each dollar earned is collected by the federal government. Marginal tax rate, however, is more useful for a taxpayer looking to determine whether attempting to earn additional income the following year is worth performing the excess work. Put another way, a taxpayer who earns income on a per-project basis may not choose to take on an additional project is he determines those additional dollars will be taxed at a 25% marginal rate. In the above scenario, Joe relinquishes 16.86 cents per dollar earned to the federal government as taxed income (average tax rate). Contrarily, if Joe would have earned $50,001 in 2013, his additional $1 earned would have been taxed at 25% (marginal tax rate).

Photo by: Norbert Lov