Question

1. Explain the computation of, and the relevance of, the following:

1. Marginal Tax Rate

2. Average Tax Rate

3. Effective Tax Rate

Answer 1

1. Marginal Tax rate

The marginal tax rate is the tax rate paid on the next dollar of income. Under the progressive income tax method the marginal tax rate increases as income increases

To calculate the marginal tax rate on the investment, one needs to figure out the additional tax on the new income.

As a simple example, say that one’s income is $500 below the top of the 15% bracket and he is considering an investment that will produce $1,000 in income. If he opts to make that investment and receive that income, then $500 will be taxes in 25% tax bracket.

To calculate the marginal tax rate on the investment, he needs to figure out the additional tax on the new income. In this example, $500 will be taxed at 15% and $500 at 25%. This produces tax of $200, which on income of $1,000 makes the marginal tax from making that investment equal to $200 / $1,000 or 20%.

2. Average tax rate

The average tax rate is the percent of taxes divided by taxable income. Because of the progressive tax system, people pay different percentages of tax the higher their income gets. The average tax rate helps them figure out how much tax was paid overall.

Average tax rate= Total Taxes/Total Income

Example

A earned $70,000 in 2017. According to that year’s tax brackets, he paid 10 percent on the first $9,325, 15 percent on every dollar between $9,325 and $37,950, and 25 percent on every dollar between $37,950 and $70,000. He estimates his total tax liability at $13,238.75, which would make his average tax rate 18.9 percent.

3. Effective tax rate is similar to average tax rate.

The effective tax rate is the average tax rate paid by a corporation or an individual. The effective tax rate for individuals is the average rate at which their earned and unearned income are taxed.

The effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed.

For an individual: ETR = Total Tax ÷ Taxable Income

  For a corporation: ETR = Total Tax ÷ Earnings Before Taxes