What Is Marginal Tax Rate - Why Is It Important?

The marginal tax rate is the tax rate paid on the last dollar of earned income.  The marginal tax rate is higher than the stated tax rate that the IRS publishes.  It is important because it is the marginal tax rate that reflects the true total amount of taxes that you pay.  The average tax rate is the total taxes paid on income as a percentage of your income.

Tax Table Example

As an example, in 2008 the IRS published tax rates for individual income was as follows:

$0 to $8,025, your tax bracket is 10 percent;
$8,025 to $32,550, your bracket is 15 percent;
$32,550 to $78,850, your bracket is 25 percent;
$78,850 to $164,550, your bracket is 28 percent;
$164,550 to $357,700, your bracket is 33 percent; and,
$357,700 and above, your bracket is 35 percent.

If your earned income in 2008 was $100,000, you would be in the 28 percent tax bracket.  Does this mean that you paid $28,000 in taxes? No.  Your actual tax rate for 2008 would have been 21.98 percent, determined as follows:

($8,025 less $0) $8,025 × .10 = $802.50
($32,550 less $8,025) $24,525 × .15 = $3,678.75
($78,850 less $32,550) $46,300 × .25 = $11,575.00
($100,000 less $78,850) $21,150 × .28 = $5,922.00
$802.50 + $3,678.75 + $11,575.00 + $5,922.00 = $21,978.25 (21.98 percent)

Marginal Tax Rates

A marginal tax rate affects taxpayers on every dollar earned that pushes them over their maximum bracket.  A person earning $100,000 in 2008 had a tax rate of 21.98 percent but if that same earner made $150,000, their tax rate increases to 35.98 percent:

($8,025 less $0) $8,025 × .10 = $802.50
($32,550 less $8,025) $24,525 × .15 = $3,678.75
($78,850 less $32,550) $46,300 × .25 = $11,575.00
($150,000 less $78,850) $71,150 × .28 = $19,922.00
$802.50 + $3,678.75 + $11,575.00 + $19,922.00 = $35,978.25 (35.98 percent)

Marginal Tax Rate Effect on Income Activities

This is presuming that the taxpayer had no deductions or credits to reduce their taxable income.  A marginal tax rate creates a disincentive for additional effort, investment, education or other activities that may cause your personal tax rate to increase, without a corresponding reduction to your taxes through deductions and other incentives.

There are arguments that countries that maintain a high marginal tax rate do so at the peril of their future economic growth.  High earners will look for places to shelter their marginal or additional income in order to avoid paying a higher tax rate.  This effectively moves those dollars out of the economy where they can be used to increase the investment rate in order to fund innovation or create jobs. The opposite side to this argument is that individuals who make more should shoulder a greater responsibility for those who are not as economically fortunate.

Understanding Marginal Tax Rates

Understanding the marginal tax rate helps taxpayers understand how to make good decisions regarding the savings and investment of their money.  It can also help a taxpayer ask more questions about any tax credits or deductions that may be available in order to reduce their tax rate and create incentives to earn more.
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