What is a Marginal Tax Rate?

In many countries, percentage of tax is assessed by income bracket. People will pay a higher percentage as they move up the income scale. This is called a progressive tax system, which shifts burden of higher taxes on those with higher income. Taxation gets a little more complicated, since tax may increase incrementally by bracket, and people are not always paying the same amount of tax on all of their earnings. Instead they can pay different percentages on different parts of their earnings, and the tax rate that applies to top earnings is called a marginal tax rate.

Marginal tax rate may really be defined as the amount a person or business is taxed on the last dollar or highest dollar made. This should not be confused with total tax rate. When people hear of tax increases, especially for those exceeding a certain amount of money, they may feel understandable panic. Yet, in a lot of countries these tax rates will only apply to a certain amount of income, and don’t affect taxation rates for the rest of income made. Marginal tax rate is not average tax for total profits or earnings.

One thing that is commonly misunderstood about marginal tax rate is that it will dramatically shift entire income. People may think that climbing into a different tax bracket translates to losing more of their money to taxes. Most may not understand that only the portion that exceeds present tax bracket is taxed at a higher rate. The total tax may be a slightly greater percentage of earnings when calculated against income, but where tax brackets exist, any additional tax percentages in the higher brackets only come out of the higher earnings.

Many people understand this better with an example. Say tax rate is 30% for income made between $200,000-$250,000 US Dollars (USD). It increases to 35% for any income over $250,000 USD. For the employee who makes $250,001 USD, total tax rate doesn’t jump to 35%. Only the last dollar made, or the money over $250,000 is taxed at the 35% level.

Nevertheless, higher marginal tax can be painted as dramatically changing the income of some, and it certainly changes tax rates for those who make huge amounts of money in the highest tax bracket. It’s been argued that high marginal taxes punish those who make more and discourage people from being better earners, getting more training, or from ever investing or inventing. This is a strongly debated issue, and others point out that many people are motivated by far more than profit, and are not going to be greatly discouraged if the last few dollars they make are worth a little less than the rest of the income they derive from various activities.

Some economists reject this system of climbing percentages that result in a final marginal tax rate. Instead they propose a flat tax. Argument against this tax include that it frequently would be a hardship for those people who make the least, and even in this system, people would still have a marginal rate or tax percentage they paid on the highest dollar earned. It’s just that everyone would share the same marginal rate. Many argue though that even a low marginal rate can be difficult for those with little income to lose, and true progression is fairer.