Question

1. Briefly explain the differences between the following terms:
   1. marginal tax rate;
   2. statutory tax rate;
   3. average tax rate.

Answer 1

The United States's tax system is progressive.

Basically,

this means as your income increases, your income will fall into higher and higher marginal tax brackets.

Average tax rates : it measure tax burden

,

marginal tax rates ; It measure the impact of taxes on incentives to earn, save, invest, or spend.

Marginal tax

  It is the tax you will pay on your next dollar of income. If your next dollar of income falls within the 35% tax bracket, the tax rate that you pay on the next dollar of your earnings is 35%.

  So, the part of your income that falls within each tax bracket is taxed at the rate specified for that tax bracket.

Average tax

It is the total taxes you have paid divided by your total income.

Therefore, your average percentage of your income you pay in taxes will almost always be less than the marginal tax rate of the tax bracket your income falls within.

The average tax rate is the total amount of tax divided by total income.

It can be explained better with following example

For example, if a household has a total income of $100,000 and pays taxes of $15,000, the household’s average tax rate is 15 percent. The marginal tax rate is the incremental tax paid on incremental income. If a household were to earn an additional $10,000 in wages on which they paid $1,530 of payroll tax and $1,500 of income tax, the household’s marginal tax rate would be 30.3 percent.

Average tax rates are a measure of a household’s tax burden; that is, how taxes affect the household’s ability to consume today or (through saving) in the future. Marginal rates measure the degree to which taxes affect household (or business) economic incentives such as whether to work more, save more, accept more risk in investment portfolios, or change what they buy. Higher marginal rates reduce incentives to engage in a particular activity (such as work) or (in the case of sales taxes) consume a particular item.

Statutory Tax Rates

The statutory tax rates are the tax rates that are established by the law. The highest income tax rate a person or business qualifies for is referred to as their “tax bracket”

The statutory personal income tax rates are provided in tax tables. Different tax tables reflect the tax payer’s filing status. For personal taxes this includes single, married filing jointly, filing as a qualifying widower, or married filing separately. There are also tables for businesses. The statutory tax is calculated by using the appropriate tax table. A tax payer’s “tax bracket” is determined by his taxable income. For example, a married couple filing jointly with a taxable income of $152,000 is in the 28 percent tax bracket. This means that additional income would be taxed at 28 percent until the taxable income reaches $231,451, at which time the tax bracket would jump to 33 percent.

Assume you are married and recently graduated from college. You and your spouse both work and have a combined annual income of $55,000 before tax. You have $10,000 in deductions, resulting in a taxable income of $45,000. Taxable income is gross income less deductions. (In the United States, it is found on Line 43 of Tax Form 1040.) The statutory rate is 10 percent for the first $18,550 you earn. You owe $1,855 on this portion of your income. For the remaining $26,450 the statutory rate equals 15 percent, so you would owe $3,967.50 on the taxable income exceeding $18,550. Your total statutory income tax equals $5,822.50.

It is important to distinguish between the statutory rate and the effective rate. Most governments have deductions and tax credits which reduce the tax further. They are enacted to either provide assistance to a group of people or an incentive for a particular behavior. For example, in the United States the Credit for Child and Dependent Care Services (Line 49 of Form 1040) is a tax credit to provide an incentive for parents to work and lower their after-tax expense for day-care. A tax credit is subtracted from the statutory tax derived from the tax tables. The effective rate is an average rate – and is calculated by taking the tax paid and dividing it by the total income. Continuing with our example, assume you have one child. Last year you paid for child care and the government provides you with a $1,000 credit to help you. Your tax liability is reduced by the full amount of the credit to $4,822.50. Your effective tax rate equals your tax liability divided by your total income (Line 22 on Form 1040), or 8.77 percent. (Note that for corporations, the formula would be their tax liability divided by the profit before tax.)

($4,822.50 / $55,000) *100 = 8.77%

Economists also consider the marginal tax rate. The marginal rate is the tax rate charged on the next dollar earned. For individuals it is normally the tax payer’s tax bracket. If you received a $100 bonus it would be taxed at 15 percent, so your marginal tax rate equals 15 percent. This is the most appropriate rate when determining investment decisions such as whether to invest in a tax free municipal bond