Average vs. Marginal Tax Rates Revisited

The Tax Foundation’s recent fiscal fact showing the top effective marginal tax rates by state under the proposed House Democrats’ health care plan has generated quite a bit of attention thus far.

Unfortunately, many are misinterpreting the effective marginal tax rate. For example, in our analysis, the effective marginal tax rate in Hawaii in 2011 would be 57.22 percent. If a person is making $5 million in Hawaii, that DOES NOT mean that his total tax bill would be .5722 * $5,000,000. It merely means that on each additional dollar of income beyond a certain level (where that top rate kicks in), the person would only get to keep 42.78 cents of that additional dollar.

The 57.22 percent rate means that if the person made $6,000,000 instead of $5,000,000, his tax bill would INCREASE by .5722 * (6 million – 5 million) = 572,200 as a result of that increase.

Note also that the surtax would not apply from the first dollar of income. It would apply to income beyond the surtax threshold. So if some single tax return is making $300,000, putting him into the first surtax rate bracket (1%), his tax bill would not go up by $3,000 as a result of the surtax. It would go up by $200. To have a policy where he was taxed on that entire amount would create large cliffs in certain ranges where it would never be in a person’s interest to earn an additional dollar (i.e. effective marginal tax rate > 100%).

For the lawyers out there, here’s JCT’s description:

The proposal imposes a tax at the rates of 1 percent, 1.5 percent, and 5.4 percent on certain income of high-income individuals. In the case of a joint return or return of a surviving spouse, the 1 percent rate applies to so much of the taxpayer’s modified adjusted gross income as exceeds $350,000 but does not exceed $500,000; the 1.5 percent rate applies to so much of the taxpayer’s modified adjusted gross income as exceeds $500,000 but does not exceed 1,000,000; and the 5.4 percent rate applies to so much of the modified adjusted gross income as exceeds $1,000.000. In the case of a married individual filing a separate return, the dollar amounts are 50 percent of the above dollar amounts. In the case of unmarried individuals, heads of households and trusts and estates, the dollar amounts are 80 percent of the above dollar amounts. The dollar amounts are indexed for inflation for taxable years beginning after December 31, 2011.