A:

The marginal tax rate is the rate of tax that income earners incur on each additional dollar of income. As the marginal tax rate increases, the taxpayer ends up with less money per dollar earned than he or she had retained on previous earned dollars. Tax systems that employ marginal tax rates apply different tax rates to different levels of income; as income rises, it is taxed at a higher rate. It is important to note, however, that the income is not all taxed at one rate but at many rates as it moves across the marginal tax rate schedule.

marginal1.gif

The above is a simple example of a marginal tax rate schedule. It illustrates the rate at which various levels of income are taxed. As income rises, each dollar of income above the previous level is taxed at a higher rate. If a taxpayer earns more money and moves into a higher income level, marginal tax rates can significantly diminish the benefit of the additional income because it will be taxed at a higher rate. As a result, some believe that marginal tax rates are harmful to the economy because they discourage people from working harder to earn more money. However, it is important to note that although earning more money may increase income tax rate, a larger income will still be taxed at more than one level. The chart below illustrates how marginal tax rate works.

marginal3.gif

As the graph shows, it may be best to think of the example in terms of income that is growing from $0 to $120,000. As it moves towards $120,000 it incurs different tax rates. Therefore, income between $0 and $20,000 is taxed at 10%, so the tax owed is $2,000 ($20.000 x 10%). Then income moves into a new marginal tax rate (20%). As it grows above $20,000, the $120,000 income earner owes $4,000 in tax ($20,000 x 20%) for this portion of income in addition to the $2,000 of tax incurred on the first $20,000. This is done at each income level up to the taxpayer's total income, in this case, $120,000. Based on the tax rate schedule above, the $120,000 income earner pays a total of $38,000 in taxes based on the marginal tax rate system. This example also illustrates that not all of this taxpayer's income is taxed at the same rate. Therefore, only $2,000 of tax is owed at the lowest income level, while $6,000 of tax is incurred at the third level on the same amount of money ($20,000). Many people are confused by marginal tax rates, believing that the rate at which they will be taxed is a flat rate based on the income level into which they fall. According to this incorrect assumption, therefore, a $120,000 income would be taxed at a 50% rate, making the amount of tax owed $60,000.

For additional reading, see Tax Tips For The Individual Investor and Using Tax Lots: A Way To Minimize Taxes.

RELATED FAQS

  1. Is the marginal tax rate a progressive tax?

    Learn how the marginal tax rate is a progressive tax that takes a higher percentage of income tax from high-income earners ...
  2. What should you consider before taking a loan on your Registered Retirement Savings ...

    Learn about the primary factors you should consider before deciding to take out a loan from your Registered Retirement Savings ...
  3. What is affected by the interest rate risk?

    Find out more about interest rate risk, how bond prices are affected by interest rate fluctuations and how interest rate ...
  4. How can I lower my effective tax rate without lowering my income?

    Discover how to reduce your effective tax rate without losing income by maximizing adjustments and deductions, earning tax-free ...
RELATED TERMS
  1. Tax Deductible Interest

    A borrowing expense that a taxpayer can claim on a federal or ...
  2. Nordic Model

    The social welfare and economic systems adopted by Nordic countries.
  3. Deferred Tax Asset

    A deferred tax asset is an asset on a company's balance sheet ...
  4. Welfare Capitalism

    Definition of welfare capitalism.
  5. LIBOR

    LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate ...
  6. Global Recession

    An extended period of economic decline around the world. The ...

You May Also Like

Related Articles
  1. Taxes

    Is the marginal tax rate a progressive ...

  2. Retirement

    What should you consider before taking ...

  3. Economics

    Venezuela: Portrait of a Country in ...

  4. Economics

    How the UK Makes Money

  5. Economics

    Gambling on Macau: Too Risky?

Trading Center