Updated July 17, 2023
Definition of Marginal Tax Rate
The marginal tax rate is the tax rate that is levied on the taxpayers for the extra one dollar earned. In many developed countries, the government is following a progressive taxation scheme.
In this method, the taxpayer’s tax liability is cut into pieces. The marginal taxes increases as the taxable amount increases. The decision is entirely on the government of the country. It may differ in other countries as well.
Explanation
It is the tax on the additional dollar the taxpayer earns in the financial year, and the rate may differ from country to country. In a progressive tax scheme, the taxable income is sliced into pieces and is taxed as per the tax rate of the particular tax bracket. It can also be noticed that in the progressive taxation system, the marginal tax rate is always greater than the average tax rate. The taxpayers should know MTR because they have to make certain decisions on the investment in the upcoming year.
Formula
The formula is (Change in Tax /Change in Taxable Income).
If the new taxable income falls within the same tax bracket as the previous one, then the MTR will be equal to the Tax Rate applicable to that tax bracket.
How to Calculate Marginal Tax Rate?
- First of all, the total income of the taxpayer is identified.
- The taxable income is then sliced according to the tax brackets.
- Then the taxes are calculated per the income and the tax rate using the formula (Income of the taxpayer * Tax Rate).
- We can also compare the taxpayer’s average tax rate with that of the MTR, and in the progressive tax system, it is usually higher than the average tax rate.
Examples of Marginal Tax Rate
John is working in a manufacturing company. His total income comes out to be $50000 this year. He requests you calculate the tax liability for him.
Tax Liability of John
| Particulars | Tax Rate | Income ($) | Tax liability |
| Taxable Income | |||
| From 0 to $ 20000 | 0% | 20000 | 0 |
| From $20001 to $40000 | 20% | 20000 | 4000 |
| From $40001 to $60000 | 30% | 10000 | 3000 |
| Above $60001 | 50% | 0 | 0 |
| 50000 | 7000 |
In this example, the marginal tax rate is 30%. The average tax rate will be (Tax Liability/Total Income)*100, i.e., 14%. Therefore this can be concluded that the average tax rate is lower than the marginal tax rate.
Let’s take another example:
Mr. Samuel is a businessman and is also a higher taxpayer. His income for this year comes to $10,00,000. Now we are required to calculate the tax liability of Mr. Samuel.
Tax Liability of Mr. Samuel
| Particulars | Tax Rate | Income ($) | Tax Liability |
| Taxable Income | |||
| From 0 to $ 20000 | 0% | 20000 | 0 |
| From $20001 to $40000 | 20% | 20000 | 4000 |
| From $40001 to $60000 | 30% | 20000 | 6000 |
| Above $60001 | 50% | 940000 | 470000 |
| 1000000 | 480000 |
In this example, we can see that the marginal tax rate is 50%. The average tax rate will be (Tax Liability/Total Income)*100, i.e., 48%. This can be concluded with this example: if the incomes are high, then the average tax rate and the marginal tax rate are almost the same. This is only high when the additional tax component is lower.
Importance of Marginal Tax Rate
- It plays an important role in finding the tax liability of the taxpayer.
- It is a tax levied on the taxpayer for the additional dollar earned.
- The taxpayer can identify the tax and make further investment decisions.
- The marginal tax rate is a part of the progressive taxation system. In this system, the high-income individual is taxed higher, and the lower-income segment will be charged less tax, which is the best taxation method.
- In the marginal taxation system, it has also been seen that the high income tax payable can be benefitted because, in their case, the Average and Marginal Tax rates are mostly the same with very little difference.
Advantages
- The marginal tax system gives a dimension to the progressive tax system, which is useful nowadays.
- The marginal tax system can alert an individual about the tax consequences he will bear if he is willing to show that extra dollar income.
- The taxpayer can get a clear idea of the tax liability he is supposed to pay
- Through the MTR, an individual can assess the investments he is likely to make this year.
- It is very helpful for all types of taxpayers who have that extra income yearly.
Disadvantages
- There are some sentimental values associated with the Marginal tax system. It has been believed that the small taxpayer gets discouraged while earning extra income.
- The extra income brings in the Marginal Tax liability, higher than the Average Tax system. Thus many taxpayers are unwilling to show that income and try to get a deduction.
- Sometimes deduction is also very difficult to claim. Therefore, they have to pay the higher tax for the income earned, and thus is very difficult to implement such a tax system in the country.
Conclusion
The MTR is the tax rate levied on the extra dollar income. There are certain advantages and disadvantages of the system, but the purpose of this tax system is very simple. The higher the income, the lower the tax will be. The individual earning higher incomes will find no difficulty paying the marginal tax because the average tax rate and the marginal tax rate are the same in their case. It is also a fact that for the medium earning individual, the rate is too high compared to the average tax rate.
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