The Terms: Marginal tax rates and average tax rates
What it Means: A marginal tax rate is the amount paid on an additional dollar of income. The average tax rate is the total paid divided by taxable 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 that we have a progressive system of taxation on income—and most of us don’t fully grasp the difference between marginal tax rates and average tax rates.
Fortunately, the concept is easy to understand once you move past the confusing jargon. Let’s unpack what it means.
First, we need to understand “tax rate.” This is simply the ratio of tax to the amount being taxed. This ratio is almost always expressed as a percentage, so instead of saying the tax rate ratio is 1:10 we say the tax rate is 10 percent. That means for every dollar I am taxed 10 cents (1:10 or 10 percent). Since taxpayers receive deductions and credits, what we owe often differs from what we pay. But for now we’ll assume they are the same.
In the United States we have a progressive income tax, meaning the tax rate increases as the taxable amount increases. For our federal 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 “marginal,” just think of it as “additional.” For example, the marginal 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 will focus solely on 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 grow confused about income 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 bucket on the second step says “$101-200—Tax at 20 percent”; and so on up the staircase. Once you fill the first bucket, the additional (marginal) dollar (e.g., the 101st dollar) progresses into the next bucket, and so on up the staircase. This illustration provides us with 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 an unmarried worker named Becky. Here are the 2020 income tax brackets for single individuals:
- 10 percent for $0 to $9,875
- 12 percent for $9,876 to $40,125
- 22 percent for $40,126 to $85,525
- 24 percent for $85,526 to $163,300
- 32 percent for $163,301 to $207,350
- 35 percent for $207,351 to $518,400
- 37 percent for $518,401 or more
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, to find the answer we have to calculate her average tax rate.
Let’s use our bucket-on-the-stairs illustration again. The first $9,875 Becky earned goes into the first bucket (the 10 percent bracket) while the next $125 goes into the second bucket (the 12 percent bracket). On the first $9,875 she paid $987.50 in taxes and on the $125 she paid $15 ($987.50 x 12% = $15). Altogether she paid $1,002.50 in taxes. The ratio of 1,002.50:10,000 equals an average tax rate of about 10 percent.
And this is why people grow confused. If you ask Becky what her marginal tax rate is, she’ll look at the chart and answer (correctly) that it’s 12 percent. She may therefore assume that she pays an income tax rate of 12 percent. In reality, she only pays the 12 percent rate on the additional income over $9,875 that she’s earned—the $125. But if you ask Becky our original question—“What is the tax rate you pay on your current income?”—she will likely say 12 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 (i.e., the tax we pay on the last few dollars of our income) and does not reveal the average rate (i.e., the tax we pay, on average, on all our income).
Calculating our average tax rate isn’t difficult—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, let’s divide his $100,000 income into each of the buckets (tax brackets). Imagine we have his entire income in cash. We write a number on each dollar, from 1 to 100,000, and then place the dollars in their separate buckets:
- 10 percent bucket: $9,875 (1 to 9,875)
- 12 percent bucket: $30,249 (9,876 to 40,125)
- 22 percent bucket: $45,399 (40,126 to 85,525)
- 24 percent bucket: $14,474 (85,526 to 100,000)
Now we multiply the amount in each bucket by the tax rate for that bracket:
- 10 percent x $9,875 = $987.50
- 12 percent x $30,249 = $3,629.88
- 22 percent x $45,399 = $9,987.78
- 24 percent x $14,474 = $3,473.76
Finally, we add all these amounts together:
- $987.50
- $3,629.88
- $9,987.78
- $3,473.76
- = $18,078.92
Bob owes a total tax of $18,078.92, which means his average tax rate is 18.1 percent (total tax paid: $18,078.92/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 Christian leaders to know?
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 related to the additional time they spend on their work.
All employees must 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. Too often, a misunderstanding of how marginal tax rates works leads people to assume additional work is not worth the effort.
To understand why they have this perception, let’s consider one last example. Becky and Bob have a colleague named Barney who earns $40,000. He assumes (erroneously) that since his marginal tax rate is 12 percent, he’s paying a total tax rate of 12 percent, which would be a tax of $4,800 (in reality he’s only paying $4,602.38).
Barney’s boss tells him that by taking on an extra three hours each month he can earn $42,000 per year. Barney looks at the IRS chart and notices the raise would make his marginal tax rate 22 percent. He assumes (again, erroneously) that the raise would force him to pay taxes of $9,240 (22 percent x $42,000).
Since he thinks he was paying $4,800, he believes the raise would require him to pay $4,440 in additional taxes. He thinks he’d have to pay more than twice as much in taxes as he’d earn from the $2,000 raise.
This may seem far-fetched, but calculating taxes is not intuitive and even highly intelligent people can make this mistake. If you are a church leader who helps people steward their finances, you’ll likely come across someone who has this misperception about taxes.
The reality is that Barney only pays the higher rate on his additional (marginal) income ($1,875). So instead of paying $4,400 more after the raise, he only pays $412.50 more. What Barney doesn’t understand is that moving to a higher tax bracket never causes a lower net income.
Knowing how marginal tax rates affect Barney’s pay doesn’t settle whether he should work more, but it can help him make a better-informed decision how he should steward God’s resources.
Other Details:
- 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. A helpful rule of thumb is that whatever your highest marginal tax bracket is, your average tax rate will be at least several percentage points lower than that.
- Tax deductions are valuable because they lower your taxable income. But tax credits are even better. Tax credits provide a dollar-for-dollar reduction of your income tax liability. If your marginal tax rate is 22 percent and you have a $100 deduction, you save $22. 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.
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