Most people have recently completed their income tax filing, so it’s a good time to review some tax concepts. At the top of the list is tax rate, which may sound simple. But is it? NC State University economist Mike Walden responds.
“There are really two different and distinct tax rates that taxpayers need to be aware of. One is the average tax rate, and actually this is the rate that most people think of. The average tax rate simply says, add up all the taxes you pay (or if you are focused on federal taxes only, look at your federal tax, whatever), take your aggregate amount paid in taxes, divide it by your income — your gross income — and that gives you the actual percentage of each dollar that you earn that you will pay in taxes.
“The other rate, though — and many economists would say this other rate is more important — is the marginal tax rate. This says if your income changes, either up or down, for each dollar of change, how much will your income tax owed change (or you want to broaden it to all taxes)?
“And the difference between the two is, we have several tax rates, especially applied to income, based on how much you earn. The official tax rates at the federal level, for example, vary from 10 percent to 40 percent. So when you earn extra money, it depends on where you are in that range as to how much additional tax you will pay. That’s the concept behind the marginal tax rate.
:Now another use of the marginal tax rate is, How much do you save in taxes if you make a deduction or if you have a tax credit for something? If you something that you donate to charity, for example, or solar panels on your home where you get a tax credit, that saves you dollar for dollar with the amount spent. But if you make a deduction, it only saves you the amount that you spend times your marginal tax rate, so for example if you have a $1,000 deduction, you would get a reduction in your taxes of $250.”