Average Tax Rates and Marginal Rates

When people complain about high tax rates they are usually objecting to marginal tax rates.

When politicians argue that taxes are low they are usually talking about average income tax rates.

A marginal rate is the rate that determines the amount of tax on some increment of taxable income. Most people refer to this as the top tax bracket, but that generally only refers to federal income taxes. The marginal tax rate includes Social Security taxes and state income taxes. People make financial decisions based on the marginal tax rate that will affect the outcome of a particular decision.

A single self employed taxpayer in 2010 with a total income of $75,000 and who uses the standard deduction will be subject to a marginal federal tax rate of 25%. If s/he lives in a high tax state like California, the marginal state income tax rate might be as much as 10%. The tax rate on self employment income is 15.3%, but there is a deduction that is allowed for 50% of that tax, which reduces the federal income tax. That represents a savings of 25% times 15.3% or 3.825%. So the combined marginal tax rate on an additional $100 of self employment income would be about 46.5%.

However, if you compute the actual tax based on the multiple tax brackets for the federal and state taxes, and then add the net self employment tax, the total Federal income tax might be about $11,200. The Self Employment tax would be $11,475 and the state income tax might be $6,000. The total actual tax would be about $28,675. When you divide that by the total income of $75,000, the average tax rate is 38.23%.

For a single taxpayer who makes $50,000 of interest income and has no other income or deductions, his marginal federal income tax rate would be 25% and his state income tax rate in a high tax state might be 7% -- for a total of 32%. (The self employment tax would not apply.) But if you compute the actual tax for this person, the average tax rate would be about 18% instead of 32%.

In addition to distorting the argument with average tax rates, the politicians include the non-paying taxpayers in their calculations. Roughly half of the families in the U.S. do not pay any federal or state income taxes. If the average rate for those who do pay taxes in 20% and only half the families pay income taxes, the politician will tell us that the average income tax per family is only 10%. But the marginal rate for many of the families that do pay taxes and that are also paying the self employment tax may be closer to 50%.

Vern

www.veronjacobs.com