Question

What is the difference between average tax rate and the marginal tax rate? Which one should we use in calculating incremental after-tax cash flows?

Answer 1

Total tax liability or tax paid is calculated on taxable income to arrive at average tax rate.

Average tax rate = Total tax paid / Total taxable income

Average tax rate is non-standard and based on income level of an entity. The taxable income is calculated on basis of tax brackets and each tax brackets has different level of marginal tax. Adding all tax liability basis of each tax brackets leads to a total tax liability and then this total tax is compared with taxable income (refer formula of average tax rate).

Marginal tax rate is a rate of tax which is fixed for different income level which is divided in different tax brackets. The marginal tax of each tax bracket will have different rate applied. The lowest income level will have lower marginal tax and higher marginal tax for higher level of income. Marginal tax cash flow is applied on the last dollar earned.

For calculating incremental cash flows we should use marginal tax rate. Marginal tax will differ at different level of taxable cash flows.