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Difference Between Marginal vs Effective Tax Rate

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Different countries follow different tax methods and there is also a difference in the tax brackets. Knowing the differences between these two rates is necessary for effective tax planning. The below table summarizes the difference between both these rates.

What is the Marginal Tax Rate?

The marginal tax rate can be defined as the tax paid on an additional dollar of income earned that is the rate that applies to the additional income earned. The reason it is termed as “marginal” is that when your income moves up the tax bracket the marginal or additional income is taxed at the next highest tax bracket. From the tax payer’s perspective, the tax actually paid on the income differs from the marginal tax rate.

What is an Effective Tax Rate?

The effective tax rate is the actual tax that is due based on your income and provisions. It is calculated as actual taxes divided by pre-tax income. The reason why marginal and effective tax rate differential is because of the difference between the income on the financial statements and total taxable income while calculating tax return.

Head to Head Comparison between Marginal vs Effective Tax Rate (Infographics)

Below are the top 8 differences between Marginal and Effective Tax Rate

Key Differences between Marginal vs Effective Tax Rate

Let us discuss some of the major Difference Between Marginal vs Effective Tax Rate

The marginal tax rate is the percentage of income that will be paid on the next dollar of your income while the effective tax rate is the percentage of the total income that is paid on taxes.

The marginal tax rate can be defined as the tax paid on an additional dollar of income earned that is the rate that applies to the additional income earned. The effective tax rate is the total tax to be paid divided by the total taxable income.

Tax under marginal tax rate is calculated based on multiple tax rates making the computation complex and requiring additional compliance checks. Calculation under the effective tax method is based on one rate which makes computation easier and there is no requirement for additional compliance checks.

Revenue collected by the government under the marginal tax system is higher than under the effective tax rate.

The marginal tax rate is lined with income and hence decreases when income decreases while under the effective tax rate there is not much impact on the taxes when income decreases.

Higher-income attracts higher taxes under the marginal tax rate method and this discourages business expansion on the other hand higher income attracts effective tax rates, therefore, this method of tax calculation promotes business expansion.

Higher-income individuals or institutions pay more taxes under the marginal tax rate method while the tax burden under an effective tax rate mostly falls on the general group level.

Let us understand this by looking at a simple example and how these taxes will be calculated

Marginal Tax Rate

Let us consider an individual Mr. A who is a citizen of the USA and has a total income of $50,000 and let’s assume that will be taxed at 25%. So if Mr. A would get a raise next year and his income increases to $5800 next year the then $800 will be taxed at 25%.

Let us assume that Mr. A’s total tax is $5000 on his income of $50,000 his effective tax rate will be $50,000 / $5000 = 10%

Marginal vs Effective Tax Rate Comparison Table

Let’s discuss the top comparison between Marginal vs Effective Tax Rate:

Basis for Comparison Marginal Tax Rate Effective Tax Rate

Definition The marginal tax rate can be defined as the tax paid on an additional dollar of income earned that is the rate that applies to the additional income earned The effective tax rate is the total tax to be paid divided by the total taxable income

Meaning Percentage of income that will be paid on the next dollar of your income Percentage of the total income that is paid on taxes

Calculation Tax is calculated based on different tax rates Tax rate multiplied by the taxable income

Tax amount The calculated tax amount is generally higher under this method The tax amount is lower as compared to the marginal tax rate

Tax impact Higher-income individuals or institutions pay more taxes under this method Tax, in this case, is diversified and is mostly paid by the general income group

Downside When income decreases taxes also have an impact and goes down with decreasing income There is not much impact on the taxes when income goes down

Economy Higher-income attracts higher taxes under this method and this discourages business expansion Higher-income attracts effective tax rates. Therefore, this method of tax calculation promotes business expansion

Complexity and Checks Multiple tax rates for paying taxes makes this method complicated and checks and compliance are required No checks are required since a single tac rate is involved which makes computation very easy

Conclusion

It is important to know the differences between the marginal tax rate and the effective tax rate to make good tax decisions. You may have heard people say that their effective tax rate is ~30%. This is actually higher than what they actually pay because they mainly focus on the marginal tax rate. Many countries around the world follow the marginal tax rate regime since it is considered to be very logical as it taxes individuals or institutions based on income.