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Policy Basics: Marginal and Average Tax Rates

UPDATED
July 9, 2015

Misunderstandings about two different types of tax rates often create confusion in discussions about taxes. A taxpayer’s average tax rate (or effective tax rate) is the share of income that he or she pays in taxes. By contrast, a taxpayer’s marginal tax rate is the tax rate imposed on his or her last dollar of income.

Taxpayers’ average tax rates are lower — usually much lower — than their marginal rates.  People who confuse the two can end up thinking that taxes are much higher than they actually are.Taxpayers’ average tax rates are lower — usually much lower — than their marginal rates. People who confuse the two can end up thinking that taxes are much higher than they actually are.

Under A Progressive Tax System, Marginal Rates Rise With Income

The federal income tax system is progressive, meaning that it imposes a higher average tax rate on higher-income people than on lower-income people.   

It achieves this by applying higher marginal tax rates to higher levels of income. For example, the first portion of any taxpayer’s taxable income is taxed at a 10 percent rate, the next portion is taxed at a 15 percent rate, and so on, up to a top marginal rate of 39.6 percent.

Average Tax Rate Is Generally Much Lower
Than Marginal Rate

As an example, the graph below shows a married couple with two children earning a combined salary of $110,000. They face a top marginal tax rate of 25 percent, so they would commonly be referred to as “being in the 25 percent bracket.” But their average tax rate — the share of their salary that they pay in taxes — is only 9.0 percent, as explained below.

An individual’s average tax rate tends to be much lower than his or her marginal tax rate for three main reasons.

1. Because of exemptions and deductions, not all income is subject to taxation.

In the example above, the couple can claim exemptions and deductions for tax year 2015 totaling $28,600 (a $4,000 personal exemption for each family member and a $12,600 standard deduction). Subtracting that $28,600 from the couple’s $110,000 salary leaves them with $81,400 in taxable income — the amount of income subject to federal income taxes. For further discussion of exemptions and deductions, see “Policy Basics:  Tax Exemptions, Deductions, and Credits.”

 

 

2. The top marginal tax rate applies only to a portion
of taxable income.

As the graph shows, the first $18,450 of the couple’s taxable income is taxed at a 10 percent rate; the next $56,450 is taxed at 15 percent. Only the last $6,500 of their income faces their top marginal rate of 25 percent.

The couple’s resulting tax liability — before credits are taken into account — is $11,938.

3. Credits directly reduce the amount of taxes a filer owes.

Taxpayers subtract their credits from the tax they would otherwise owe to determine their final tax liability. In our example, the couple can claim the Child Tax Credit for both children, further reducing their tax by $2,000.

Our example couple is left with a final tax liability of $9,938. Dividing that amount by the couple’s total income ($110,000) results in an effective tax rate of 9.0 percent. For a more in-depth discussion of these issues, see “Policy Basics:  Tax Exemptions, Deductions, and Credits” or our paper, “Policymakers Often Overstate Marginal Tax Rates for Lower-Income Workers and Gloss Over Tough Trade-Offs in Reducing Them.”