What is average and marginal tax rate?

What is the Difference Between Marginal Tax Rate and Average Tax Rate?

• Assume that apples are priced at $1 each, and each person can buy at most 5,000 apples. The government has devised the follow tax plans: PLAN A: Consumption up to 1,000 apples is taxed at 5%. Consumption higher than 1,000 apples is taxed at 20% PLAN B: Consumption up to 2,000 apples is taxed at 30%. Consumption higher than 2,000 apples is taxed at 10%. Under Plan A, what is the Marginal and Average Tax Rate with consumption level 500 apples, 1,500 apples, and 2,500 apples? Do the same for Plan B. We are in a study group and none of us can figure out the difference between Marginal and Average Tax Rate in this situation. Could you please show the difference and show what type of equation you use to find each? Thank You.

• Answer:

  The difference between marginal and average tax rates is a fairly important concept for all tax payers to better understand the way the government gets paid. You’ve probably heard both terms, but maybe never knew what they were. Well, let’s fix that.Marginal Tax Rate Your marginal tax rate is the highest rate that you are taxed. For many people, a portion of their income is taxed at one rate, and the rest is taxed at another rate. For instance, if you make right around $40,000 a year, you may pay 15% on the first $20,000 or so and 28% on anything over $20,000. So, let’s break that down: 15% of $20,000 is $3,000 28% of $20,000 is $5,600 Total tax liability is $8,600 In this case, your marginal tax rate would be 28%, the highest rate at which your income is taxed. Average Tax Rate The average tax rate is the actual percentage of income going to pay taxes. In the example above we can calculate average tax rate as follows: $8,600 / $40,000 = .215 * 100 = 21.5% So, in this example, your average tax rate is 21.5%, a bit lower than your 28% marginal rate. It’s good to know this because this represents your actual tax liability. Why the Two Tax Rates? In the United States, we have something called a progressive tax system, meaning, the more money you make, the higher your tax rate. If the person in the example above only made $20,000, he’d wouldn’t have had to pay the 28%…instead only the 15% would apply. Our progressive tax system taxes you at a lower rate for the first so many dollars you make, everything over that amount gets taxed at a higher rate, and so on until you reach the cap, which, for 2008, was 35%. So, it all boils down to this, your marginal tax rate is the highest rate at which you’re taxed, but it does not represent the percentage of your income that goes toward paying taxes. That number is the average tax rate.