Decoding Tax Rates: Marginal vs. Effective – What Sets Them Apart

What is the difference between marginal and effective tax rates?

Marginal and effective tax rates are two different ways of measuring the impact of taxes on an individual or a business. Understanding the difference between the two will give you a clearer picture of your tax liabilities and help you make informed decisions when it comes to tax planning.

Marginal Tax Rate:

• The marginal tax rate refers to the percentage of tax that is applied to the last dollar of income. It corresponds to the highest tax bracket your income falls under in a progressive tax system. Essentially, it indicates the rate at which your next dollar of income would be taxed.

• An important point to note is that the marginal tax rate does not represent the total tax rate applicable to all your income. In a progressive tax system, lower tax brackets still apply to portions of your income.

Effective Tax Rate:

• The effective tax rate considers the total amount of taxes paid relative to the taxpayer's total taxable income. It provides a more accurate representation of the overall tax burden an individual or business faces. To calculate your effective tax rate, you would divide your total tax liability by your total taxable income and express the result as a percentage.

• The effective tax rate generally offers a more comprehensive picture of your tax-situation as it takes into account your entire income, tax credits, deductions, and other tax-related aspects, giving you the average tax rate that is actually paid on the whole of your income.

In summary, the marginal tax rate illustrates the tax rate on the next dollar of income, while the effective tax rate represents the average tax rate applied to the total taxable income.