What is a marginal tax rate?
How are marginal tax rates and average tax rates different?
Your average tax rate is found by adding up all of the taxes you pay and then dividing by your total income. Your marginal tax rate differs because it only measures the tax you’ll pay on your future income.
It is possible to have a high average tax rate but a low marginal tax rate. For example, let’s say the first $10,000 of any earnings are taxed at 50% and then every dollar after that are taxed at 10%. If you earn $11,000, your average tax rate will be higher than 10%, because you’ll have paid 50% on $10,000 and then 10% of the next $1,000.
When it comes to federal taxes, most people’s average tax rates are lower than their marginal tax rate. That’s because the tax code is progressive, and marginal tax rates get larger as a person’s income increases.
Why are people more likely to work under a lower marginal tax rate than a high marginal tax rate?
In economics it is commonly understood that everyone faces a choice between work and leisure. When working isn’t worth it, we turn to leisure. When leisure gets too expensive, we turn to work.
Lower marginal tax rates make work relatively less expensive, which means people will defer a little more leisure than if marginal rates were higher. And “work” can mean more than just work. It represents saving, investment, hiring, and all sorts of economic activities.