The Difference Between Effective and Marginal Tax Rates

The Difference Between Effective and Marginal Tax Rates

by daranstrom on Mar 1, 2019

Recently, a former state governor and National politician told a 5th-grade class that at a 70% tax rate, if a child earned $10, they would pay $7 in taxes.  This tells me the ex-governor either does not know the difference between effective and marginal tax rates.  This means he is either uneducated or made a false statement which is unethical.  Given the current state of National politics, the individual may have done both.  In fact, both are the likely answer.  

But for him and others who are confused about the difference between effective and marginal tax rates, the following may help.  The effective tax rate is the total federal income tax divided by the total taxable income before deductions. The marginal tax rate is the tax rate on which the last dollar of income is taxed.  With the recent changes in tax laws, federal income tax rates start at 10%.  Marginal tax rates max out at 37% for income exceeding $500,001 for a single tax filer and $600,001 for a joint tax filer.    

Let's look at two examples.

  • The first example is a couple filing a joint return with $60,000 of taxable income in 2018 and takes the standard deduction.  Their total federal income tax would be $3,939 with an effective tax rate of 6.6%.  Their last dollar would be taxed at 12.0% marginal tax rate.
    • Note:  The median household income in the US is about $60,000. 
  • The second example is a couple, also filing a joint return, with taxable income of $500,000 and take the standard deduction.  Their total federal tax would be $117,979 and an effective tax rate of 23.6%.  Their marginal tax rate is 35%.  
    • Note:  Taxable income of $500,000 would place this couple in the top 1% of household incomes in the US.  

Now let's take it a step farther, and bring in FICA [social security and Medicare] taxes.  The first household would pay FICA taxes, 7.65%, on 100% of their earnings.   This changes their effective tax rate to 14.2% and the marginal tax rate to 19.7%.  By comparison, the second household, because in 2018 the OASDI portion of FICA [6.2%] is charged only on the first $128,400 of earned income, their effective tax rate now 25.2% and marginal is now 36.5%. When FICA is taken into consideration, the effective tax rate for the couple at about the median household income is much closer to the couple in the top 1% of household incomes.  

Some will argue that high marginal tax rates reduce GDP [gross domestic production].  I have reviewed a variety of research on the correlation between marginal tax brackets and GDP and have found little that suggests a correlation between the two.  The reason generally cited is GDP is a function of a variety of factors. 

  • For example, from 1941 thru 1943, GDP ranged from 17% to 18.9% and the marginal tax rate ranged from 81%to 88%.  The major factor in this scenario was WWII.  
  • In 2008 and 2009, GDP was negative and marginal tax rates were a historic low of 35%. There were a variety of economic factors causing the negative GDP led by the collapse of the banking industry. 
  • In one study of the 20 highest years of GDP since 1930, only one year was the marginal tax rate less than 60% and in that year, 1984, the marginal tax rate was 50%.  

All of the above illustrate the same point.  GDP is a function of many economic factors and by itself, there is no evidence high marginal tax rates have reduced GDP.  

Years ago, when I first became self-employed, I made mistakes and my earned income was minimal. Years later, I was very fortunate and my business had increased significantly and my income and marginal tax rate were much higher.  Let's be clear, for most of us, It is much much better to have a high income and be in a high marginal tax rate versus very little income and be in a low marginal tax rate.  

It seems to me, the intelligent discussion going forward should not be about marginal tax rates, especially by National politicians who do not understand the difference between marginal and effective tax rates.  Rather, it seems to me the intelligent discussion going forward has to be about the challenges facing the US in this specific time period and how to best meet these challenges.  Two examples of current challenges are a decaying out of date infrastructure and increasing costs from natural disasters.  Again, these are just two examples of current challenges, there are more.  The US has always had challenges and been able to meet them, this time will be no different.  But meeting challenges will start with an informed public on both tax rates and current challenges.   


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