Definition
The marginal tax rate refers to the percentage of tax applied on your next dollar of income. It is the tax rate that applies to each additional increment of a taxpayer’s taxable income or earnings. The higher the income, the higher the marginal tax rate, following the progressive tax system.
Key Takeaways
- Marginal Tax Rate refers to the rate at which tax is incurred on an additional dollar of income. As income rises, so does the tax rate.
- It is heavily used within progressive tax systems, where taxpayers are divided into categories or “tax brackets” based on their income levels and are taxed accordingly.
- Understanding one’s marginal tax rate can help with financial planning as it influences financial decisions including investment, savings, or retirement contributions.
Importance
The Marginal Tax Rate is a significant concept in finance as it helps in planning one’s income and investments with better tax efficiency.
It refers to the rate of tax applied on the next additional dollar of income earned.
Unlike the average tax rate, which measures the total taxes paid as a percentage of total income, the marginal tax rate increases progressively with income, under a graduated tax system.
Therefore, understanding it enables individuals and businesses to make sound financial decisions such as forecasting their taxable income, strategizing their investment, retirement planning, and identifying tax-saving opportunities.
It acts as a crucial tool in effective income tax planning and financial management.
Explanation
The purpose of the marginal tax rate, a fundamental concept of the progressive income tax system in many countries including the United States, is to proportionally increase a taxpayer’s fiscal liability as their income rises. This serves to create a ‘tiered’ tax structure, which intends to create a more equitable distribution of the tax burden.
The basic idea is that those who earn more have a stronger ability to bear a larger tax load relative to those with less income. Thus, the marginal tax rate system is designed to serve purposes of both economic efficiency and social justice.
The marginal tax rate is integral for individual and corporate financial planning as it directly affects incomes after taxes and prospective investment decisions. For individuals, understanding one’s marginal tax rate allows for better planning of income and expenses, as it can help individuals anticipate the impact of income changes on their overall tax liability.
On the corporate level, the marginal tax rate is employed in making decisions about capital budgeting and corporate structure. A higher marginal tax rate could serve as an incentive for businesses to pursue certain tax-deductible investments, as these could potentially reduce their overall tax liability.
Examples of Marginal Tax Rate
Income Tax: This refers to the taxation system where people with higher income pay more taxes compared to those with lesser income. For example, in the United states, the federal income tax employs a marginal tax rate system, where incomes over certain thresholds are taxed at progressively higher rates. If a person earns $50,000 in a year, their income might be taxed at 10%, but if they earn $200,000, the portion of their income over the $50,000 threshold might be taxed at 20% or more.
Corporate Tax: This is a tax-based on the profit of a business. If a business earns a profit equivalent to a marginal tax bracket of 21%, an additional dollar of income will be taxed at this rate. For example, a US corporation that earns $100,000 in taxable income pays $21,000 in tax under the 2017 Tax Cuts and Jobs Act. If it earns an additional $1,000, it will pay an additional $210 (21% of $1,000) in tax.
Capital Gains Tax: This tax is applied to the profits made from selling assets like stocks, property, or business. For example, if an individual makes a profit from selling their house above a certain threshold, that additional profit may be subjected to a higher capital gains tax rate. Say, if the long-term capital gains tax rate is 15% for most taxpayers, but jumps to 20% for high earners, if the gain on sale pushes them into the higher income bracket, the portion above the threshold will be taxed at 20%.
FAQs on Marginal Tax Rate
What is a Marginal Tax Rate?
The Marginal Tax Rate refers to the amount of tax paid on an additional dollar of income. The United States employs a progressive income tax system, where the percentage of tax increases as the taxable income increases.
How is Marginal Tax Rate calculated?
The Marginal Tax Rate is calculated based on a person’s tax bracket. The United States Internal Revenue Service (IRS) defines tax brackets which determine your marginal tax rate. For example, if you’re in the 22% tax bracket, you’ll pay about 22 cents in federal taxes per additional dollar earned.
What is the difference between Marginal Tax Rate and Average Tax Rate?
The Marginal Tax Rate applies to the last dollar of income earned, whereas the Average Tax Rate represents the total tax paid divided by total income earned. Sure, the average tax rate is less than the marginal tax rate in a progressive tax system.
How does the Marginal Tax Rate affect investment and saving decisions?
The Marginal Tax Rate can affect investing and saving decisions because it determines how much tax you’ll pay on additional income you earn. For example, if you’re considering taking on more work or investing in a venture that will increase your income, the Marginal Tax Rate can influence your decision since it determines how much of that additional income you’ll keep after taxes.
Related Entrepreneurship Terms
- Progressive Taxation
- Tax Bracket
- Income Tax
- Taxable Income
- Effective Tax Rate
Sources for More Information
- Internal Revenue Service (IRS): The IRS is the U.S. government agency responsible for tax collection and tax law enforcement.
- Investopedia: An extensive source of financial and investing knowledge online offering comprehensive definitions.
- Charles Schwab: A bank and brokerage firm providing everything from standard banking services to retirement and estate planning.
- Kiplinger: A publisher of business forecasts and personal finance advice, Kiplinger’s often covers topics about taxes.
