From the course: Accounting Foundations

Average and marginal tax rates

From the course: Accounting Foundations

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Average and marginal tax rates

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- Remember that under my simple tax system, if you make $100, you pay tax of $10. The first $50 is not taxed. The second $50 is taxed at the rate of 20%. So you will pay a total of $10 tax if your taxable income is $100. Now, this allows us to discuss two important concepts, the average tax rate and the marginal tax rate. The average tax rate is simply the tax that you owe, $10 in this case, divided by how much you made, $100 in this case. $10 divided by $100 is 10%. That's the average tax rate. This is a very intuitive idea. For example, the average federal tax rate for all taxpayers in the United States is between 10% and 15%. Now, note, before you get excited about this relatively low rate, remember that that doesn't include state income tax, sales tax, property tax and Social Security tax. Now, economists say that a more important rate than the average tax rate is the marginal tax rate. The marginal tax rate is the rate you will pay on the next dollar of income that you make. The reason that this is an important concept from an economic standpoint is that this marginal rate is the rate that I have in mind when I'm considering putting in some extra time and effort and risk to make more money, I will pay the marginal tax rate on any extra money from a new business or from working overtime hours. Now, let's say that I'm an entrepreneur with a good business idea. My current income is $100. Should I work hard and devote my time and energy to starting that business and making more money? Well, in the case of my simple tax system, if I start that business and make extra money, I'm going to have to pay the marginal tax rate, 20%, on any new income that I make. The marginal rate, that's the number that people have in mind as they consider whether they should work harder. Look again at my simple tax system. You might be asking yourself, "Why exclude some income from taxation? In this simple system, why let people make that $50 without paying any tax at all?" Well, the concept here is that there is a fixed cost to living. I have to have a certain amount of money to put a roof over my head and put food on the table and clothes on my back. Let's not tax any of that money because those are the essentials of life. But once I've gotten those things taken care of, now the government can start to take some tax from me. The idea of a fixed cost to living is built into all income tax systems around the world. Now, another phrase that you might've heard of is a progressive tax system. A progressive tax system is one in which the average tax rate increases as you make more money. My simple system is a progressive tax system. Let me show you why. As we saw, if you make $50, your tax is zero, so your average tax rate is 0%. If you make $100, your tax is $10, so your average tax rate is 10%. If you make $1,000, you pay a $190 in tax and your average tax rate is 19%. The average tax rate goes up the more money you make. This is a progressive tax system. All income tax systems around the world are designed to be progressive systems. The average tax rate is the overall rate of tax you are paying on all of your income. The marginal tax rate is the rate you will pay on the next dollars you make as your income increases.

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