In: Accounting
Define and Discuss Average and Marginal Tax rates
Average tax rate:- Average tax rate, as the name itself suggests, is calculated by dividing the total tax with total taxable income.
In formula terms, Average tax rate = Total tax / Taxable income x 100
Suppose following is the income tax slab table
Taxable Income Tax rate
$0 - 10,000 5%
$10,000 - 20,000 10%
$20,000-30,000 15%
and if individual earn $25,000 then his tax liability will be 10,000 x 5% +10000 x 10% + 5000 x 15% = $2,250. Therefore Average tax rate = 2250/25000 x 100 = 9%
Marginal tax rate:- Marginal tax rate, on the other hand, means the tax rate which is calculated on additional income earned. For example, suppose a indiviual earns $25,000 and his tax liability is $2,250 but if he earn $5,000 then his tax liability will be $3,000.
Therefore Marginal tax rate = Additional tax liability/ Additional taxable income x 100
= (3000-2250)/(30000-25000) x 100 = 15%
Marginal tax rate help us to assess whether we should earn more or not and if we earn more then what its impact on our taxes. Higher marginal tax rate reduces the motivation to engage in Particular activity.