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Average vs. Marginal Tax Rates Revisited

2 min readBy: Gerald Prante

The TaxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. Foundation’s recent fiscal fact showing the top effective marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s 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 surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. 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 incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” 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 inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. for taxable years beginning after December 31, 2011.