what is the difference between a marginal and an average tax rate 556167

Deep in the Heart of Taxes

Algernon, Inc., has a taxable income of $85,000. What is its tax bill? What is its average tax rate? Its marginal tax rate? We see that the tax rate applied to the first $50,000 is 15 percent; the rate applied to the next $25,000 is 25 percent, and the rate applied after that up to $100,000 is 34 percent. So Algernon must pay .15 × $50,000 + .25 ×25,000 + .34 ×(85,000 75,000) =$17,150. The average tax rate is thus $17,150/85,000= 20.18%. The marginal rate is 34 percent because Algernon’s taxes would rise by 34 cents if it had another dollar in taxable income.

Table 2.4 summarizes some different taxable incomes, marginal tax rates, and average tax rates for corporations. Notice how the average and marginal tax rates come together at 35 percent.

With a flat rate tax, there is only one tax rate, so the rate is the same for all income levels. With such a tax, the marginal tax rate is always the same as the average tax rate. As it stands now, corporate taxation in the United States is based on a modified flat rate tax, which becomes a true flat rate for the highest incomes.

(1)

(2)

(3)

(3)/(1)

Taxable Income

Marginal Tax Rate

Total Tax

Average Tax Rate

$ 45,000

15%

$ 6,750

15.00%

70,000

25

12,500

17.86

95,000

34

20,550

21.63

250,000

39

80,750

32.30

1,000,000

34

340,000

34.00

17,500,000

38

6,100,000

34.86

50,000,000

35

17,500,000

35.00

100,000,000

35

35,000,000

35.00

In looking at Table 2.4, notice that the more a corporation makes, the greater is the percentage of taxable income paid in taxes. Put another way, under current tax law, the average tax rate never goes down, even though the marginal tax rate does. As illustrated, for corporations, average tax rates begin at 15 percent and rise to a maximum of 35 percent. It will normally be the marginal tax rate that is relevant for financial decision making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect of a decision on our tax bill. There is one last thing to notice about the tax code as it affects corporations. It’s easy to verify that the corporate tax bill is just a flat 35 percent of taxable income if our taxable income is more than $18.33 million. Also, for the many midsize corporations with taxable incomes in the range of $335,000 to $10,000,000, the tax rate is a flat 34 percent. Because we will normally be talking about large corporations, you can assume that the average and marginal tax rates are 35 percent unless we explicitly say otherwise. Before moving on, we should note that the tax rates we have discussed in this section relate to federal taxes only. Overall tax rates can be higher once state, local, and any other taxes are considered.

C O N C E P T Q U E S T I O N S

a What is the difference between a marginal and an average tax rate?

b Do the wealthiest corporations receive a tax break in terms of a lower tax rate? Explain.

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