What Is The Difference Between Statutory Average Marginal And Effective Tax Rates

A taxpayer’s statutory tax rate is the legally imposed rate, i.e. the 23% FAIRtax rate.  In the personal income tax this would also be the tax rate schedule as shown in Table 1 (download file for complete details).

A taxpayer’s average tax rate is the ratio of the amount of taxes paid to taxable income.  In 2010, a single individual who took the standard deduction and had an adjusted gross income of $34,001 would be in the 25% tax bracket (statutory rate).  In comparison, his average tax rate would have been only 10.9 percent.

This is because the standard deduction of $5,700 and personal exemption of $3,650 would have made the first $9,350 of his income free of federal income tax.  The next $24,650 of his income would have been subject to the 15% rate or $3,697.50 in taxes.  Therefore, only $1 of his income would have actually been subject to the 25% rate.  His/her total tax would be $3,697.50 plus 0.25 or $3697.75.  Dividing taxes by income yields an average tax rate of 10.9%.

A taxpayer’s marginal tax rate is the tax rate that applies to the taxpayer’s next dollar of taxable income.  In the above example, 25% is the taxpayer’s marginal tax rate.  The tax on an additional $1.00 earned is $0.25.

Effective means the actual rate, i.e. the rate existing in fact.  Both average and marginal tax rates can be expressed as effective tax rates.

An effective marginal tax rate may differ from a marginal tax rate because the taxpayer may be in an income range in which he is subject to a phase-out of some exclusion or deduction.  An effective average tax rate may differ from an average tax rate because some measure of income other than taxable income is used.  For example, the Joint Committee on Taxation typically calculates the effective average tax rate as the ratio of taxes paid to a constructed measure of “economic income”.

In assessing the economic effects of a tax system, the appropriate tax rates are the marginal or the effective marginal tax rates.  Under the current federal income tax system, taxpayers face their highest tax rate, which is their marginal tax rate, at exactly the point at which they are most likely to be influenced by taxes – deciding whether or not it is “worth it” to them to work more.

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