The Difference Between Average and Marginal Tax Rates

The United States individual income tax system is a progressive tax system. This means that households with higher incomes pay a higher percentage in tax. Because of the recently passed tax reform, the tax brackets for individuals and married couples have changed (see tables below).

For persons filing “single”, the marginal tax rates are as follows:

New Rate New Income Bracket Old Rate Old Income Bracket
10% Up to $9,525 10% Up to $9,525
12% $9,525-$38,700 15% $9,525-$38,700
22% $38,700-$82,500 25% $38,700-$93,700
24% $82,500 – $157,500 28% $93,700-$195,450
32% $157,500-$200,000 33% $195,450-$424,950
35% $200,000-$500,000 35% $424,950-$426,700
37% $500,000+ 39.6% $426,700+

In the new system, an individual who earns, for example, $100,000 is in the 24% marginal tax bracket. This means that for every additional dollar earned over $100,000 (and up to $157,500), this person pays $24 in federal income tax for every $100 dollars earned. Note that this person still only pays 10% over the first $9,525 earned; 12% of the amount in the next bracket, 22% of the amount in the next bracket, etc. Therefore the average tax paid for this person will be less than 24% (see video at the bottom of this page for a sample calculation).

For married couples filing jointly, the marginal tax rates are as follows:

New Rate New Income Bracket Old Rate Old Income Bracket
10% Up to $19,050 10% Up to $19,050
12% $19,050-$77,400 15% $19,050-$77,400
22% $77,400-$165,000 25% $77,400-$156,150
24% $165,000-$315,000 28% $156,150-$237,950
32% $315,000-$400,000 33% $237,950-$424,950
35% $400,000-$600,000 35% $424,950-$480,050
37% $600,000+ 39.6% $480,050+

Source: Internal Revenue Service (www.irs.gov)

For most tax payers the marginal tax rate is lower in the new tax system. In addition, there is a higher standard deduction ($12,000 for single filers and $24,000 for joint filers). However, there are fewer deductions for persons who itemize. For example, the limit on deducting state and local taxes is $10,000 (these include state and local income, sales, real estate, or property taxes). Mortgage interest deductions are limited to the interest on the first $750,000 of mortgage debt. In addition, interest on home equity loans will not be deductible (even those taken out before December 31, 2017). The marginal tax rate on long-term capital gains (earnings from selling stocks, bonds and other financial assets) continues to range from 0% to 20% (0, 15, or 20%, depending on your income). High-income tax payers pay an additional 3.8% net investment tax. Short-term (one year or shorter) capital gains are taxed at regular individual income tax rates. For a summary of all of the 2018 tax reform changes, see https://turbotax.intuit.com/tax-tips/irs-tax-return/tax-reform-changes-that-impact-your-2017-taxes/L9kree6l2.

Tax Calculations

An individual who earns, for example, $100,000 is in the 24% marginal tax bracket. However, this person still only pays 10% over the first $9,525 earned; 12% over the amount in the next bracket, etc.

To illustrate the total amount of tax paid and the difference between average and marginal tax rates, consider the following three individuals filing as a single person:

Individual 1
This person has taxable income of $6,000. Her marginal tax rate is 10%, and the total amount of tax paid equals $6,000 times 10%, or $600. The average tax is the total amount of tax paid divided by the total income. This equals $600 divided by $6,000, or .10, or 10%. This person’s average and marginal tax rates are the same.

Individual 2
This person has a taxable income of $25,000. His marginal tax rate is 12%. However, he pays only 10% over the first $9,525. Then he pays 12% over the remaining $15,475. The total tax equals:
(.10 x $9,525) + (.12 x $15,475) = $952.50 + $1,857 = $2,809.50. So his average tax rate is $2,809.50 divided by $25,000, or .11238, or 11.238%. Thus, his average tax rate (11.238%) is lower than his marginal tax rate (12%).

Individual 3
Let’s say that this person has a taxable income of $100,000. Her marginal tax rate is 24%. She pays 10% over the first $9,525. Then she pays 12% over the amount in the next bracket ($29,175), 22% over the amount in the following bracket (43,800), plus 24% over the remaining amount in the following bracket ($17,500). This person’s total tax equals:
(.10 x $9,525) + (.12 x $29,175) + (.22 x $43,800) + (.24 x $17,500) = $952.50 + $3,501 + $9,636 + $4,200 = $18,289.50. So her average tax rate is $18,289.50 divided by $100,000, which equals .182895, or 18.2895%. Thus, her average tax rate (18.2895%) is lower than her marginal tax rate (24%).

In general, for every person in the 12% or higher marginal tax bracket, the marginal tax rate is higher than the average tax rate (in a progressive tax system).

Tax Deductions

Our current federal, state and local income tax systems allow households to deduct a variety of expenses from their gross income. Gross income minus tax deductions equals taxable income. For example, the mortgage interest a person pays each year on her/his house is deductible (up to a $750,000 mortgage). Other deductions include (up to a $10,000 limit) state and local taxes, real estate taxes and loan points, certain retirement contributions, capital gains losses, health care expenses, dependent care expenses, self-employment expenses, and charitable expenses. If the person’s income is $100,000, and has $40,000 in deductible expenses, then her/his taxable income (adjusted gross income, or AGI) is $60,000. Because of deductions, this person will only have to pay taxes on $60,000, instead of on $100,000.

Tax Systems

The Federal individual income tax system described above is an example of a progressive tax. Taxes can also be proportional or regressive. These systems are explained below.

1. Progressive tax.

In a progressive tax system, higher income earners pay a higher marginal tax rate than lower income earners. In the table at the top of this page, federal marginal tax rates range from 10% to 37%. For example, a single individual who earns $20,000 in taxable income is in the 12% tax bracket. This means that each additional dollar earned by this person (until he reaches the next higher bracket) is subject to a 12% federal tax.

 

From the examples above we can see that it does not mean that (s)he pays 12% of her/his total income in taxes. The first $9,525 is subject to only 10%. The remaining amount up to $20,000 is subject to 12%.

2. Proportional tax.
In a proportional tax system, high- and low-income earners pay the same tax rate. Most United States state and local individual income tax systems are proportional. For example, a person who earns $10,000 pays 5% in state income taxes, and a person who earns $500,000 also pays 5%. Some economists support a proportional, or flat tax for our federal income tax system. Most flat tax proposals do not allow many deductions, except for an exemption to pay any tax for lower income households. Therefore, it is very simple.

In the United States, everyone pays the same percentage of Social Security tax up to a certain threshold level ($127,200 in 2017). Up to this threshold, the Social Security tax is proportional. After the threshold, it becomes regressive, because an income earner pays 0% in Social Security tax on income of more than $127,200.

3. Regressive tax

In a regressive tax system, low-income earners pay a higher rate than higher-income earners. For example, a person who earns $10,000 pays 20% in tax, and a person who earns $100,000 pays 10%. Most state sales tax systems are regressive. Lower income households usually spend their entire income on consumer products. Therefore, if all products are subject to a sales tax of 5%, then they pay 5% of their income on sales tax. Higher income households usually spend only a portion of their income on consumer products. Therefore, as a percentage of their income, they pay less than 5%. Some states try to avoid the regressive nature of the sales tax by exempting essential consumer products such as food and clothing.

The Alternative Minimum Tax

If a person applies a large number of deductions, so that the total amount of taxes falls below a certain level, then (s)he may be subject to the alternative minimum tax. The alternative minimum tax was passed in the United States to ensure that everyone pays at least some minimum amount of tax.

Other Common Taxes

In addition to the various taxes mentioned in the examples above, there are numerous other taxes. Corporations pay income taxes (maximum rate of 21%). Most local governments collect property taxes. There are also various other federal taxes, including excise taxes, capital gains taxes, and estate taxes. An excise tax is similar to a sales tax, but it is usually levied by the federal government on products such as tobacco, cigarettes, spray cans, and gasoline. A capital gains tax is a tax paid over an asset, which has gained value. For example, if someone purchases stock worth $10,000 on January 1, and then sells the same stock for $14,000 two years later, the $4,000 in gained income is subject to a capital gains tax. Estate taxes are paid when someone dies and leaves a valuable estate. The heirs will have to pay an estate tax if the value of the estate exceeds a certain amount.