Marginal tax rates

What Are Marginal Tax Rates?

Marginal tax rates refer to the tax rate applied to the last dollar of a taxpayer's taxable income. In a progressive tax system, such as that in the United States, income is divided into segments, or tax brackets, with each subsequent segment taxed at a higher rate. Understanding marginal tax rates is fundamental to personal taxation and financial planning. It clarifies that not all income is taxed at the highest rate an individual faces; rather, only the portion of income that falls into a specific bracket is subject to that bracket's rate.

History and Origin

The concept of a progressive income tax, which underpins marginal tax rates, has roots in the late 19th century amidst calls for a fairer distribution of the tax burden. Prior to the early 20th century, most U.S. federal revenue came from tariffs and excise taxes, which disproportionately affected lower-income individuals.²⁵ The idea of taxing income was introduced during the Civil War with the Revenue Act of 1861, which imposed the first federal income tax, though it was later repealed in 1872.²³, ²⁴

Public sentiment for a progressive income tax grew, driven by Populist and Progressive movements that advocated for wealthier individuals to bear a greater share of the tax burden.²⁰, ²¹, ²² This led to the passage of the Sixteenth Amendment to the United States Constitution. Proposed by Congress in 1909 and ratified on February 3, 1913, the Sixteenth Amendment granted Congress the power to "lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."¹⁸, ¹⁹ This amendment effectively overturned an 1895 Supreme Court ruling that had limited the federal government's ability to levy income taxes.¹⁷ Shortly after ratification, Congress enacted the Revenue Act of 1913, establishing the modern federal income tax with graduated rates, marking the formal adoption of marginal tax rates in the U.S. tax structure.¹⁵, ¹⁶

Key Takeaways

• Marginal tax rates apply to the last dollar earned and increase as income rises within a progressive tax system.
• Taxpayers' entire income is not taxed at their highest marginal rate; instead, different portions of income fall into different tax brackets.
• Understanding marginal tax rates is crucial for effective tax planning and evaluating the impact of additional income.
• These rates are adjusted annually for inflation by the Internal Revenue Service (IRS).
• The U.S. federal income tax system has seven marginal tax brackets.

Formula and Calculation

While there isn't a single formula to calculate "the" marginal tax rate for an individual, it refers to the rate applicable to the next dollar of income earned. To determine the tax liability for a given taxable income, the following calculation structure is used:

Where:

• (\text{Income in Bracket}_i) is the portion of income that falls within tax bracket (i).
• (\text{Marginal Rate}_i) is the tax rate assigned to tax bracket (i).
• (n) is the total number of tax brackets through which the taxpayer's income extends.

For example, if a single filer's taxable income reaches into the 22% tax bracket, only the portion of their income that falls within that specific bracket is taxed at 22%, while lower portions are taxed at 10% and 12%. The IRS annually adjusts federal income tax brackets and rates.¹³, ¹⁴

Interpreting Marginal Tax Rates

Interpreting marginal tax rates means understanding how each additional dollar of income is taxed. For example, if an individual is in the 24% marginal tax bracket, it means that for every additional dollar they earn beyond the lower threshold of that bracket, 24 cents will be paid in federal income tax. This is crucial for making financial decisions, such as considering a raise, taking on a second job, or analyzing investment returns. Knowing the marginal rate helps individuals estimate the true after-tax value of additional earnings. This perspective is vital when evaluating potential deductions or tax credits, as these typically reduce taxable income or tax liability based on the marginal rate.

Hypothetical Example

Consider a single individual in 2025 with a taxable income of $55,000. For illustration, let's use simplified 2025 federal tax brackets for a single filer (actual brackets may vary slightly for inflation adjustments or legislative changes):

• 10% on income from $0 to $11,925
• 12% on income from $11,926 to $48,475
• 22% on income from $48,476 to $103,350

Here's how their federal income tax would be calculated using marginal rates:

1. First bracket (10%): $11,925 (all income in this bracket) * 0.10 = $1,192.50
2. Second bracket (12%): ($48,475 - $11,925) * 0.12 = $36,550 * 0.12 = $4,386.00
3. Third bracket (22%): ($55,000 - $48,475) * 0.22 = $6,525 * 0.22 = $1,435.50

The total federal tax liability would be $1,192.50 + $4,386.00 + $1,435.50 = $7,014.00.

In this example, the individual's highest marginal tax rate is 22%, but their entire $55,000 is not taxed at that rate. Only the portion exceeding $48,475 is subject to the 22% rate.

Practical Applications

Marginal tax rates have several practical applications across various financial domains:

• Investment Decisions: Investors frequently consider marginal tax rates when evaluating the after-tax returns of different investments. For instance, capital gains taxes have their own marginal rates, which can differ for short-term versus long-term gains. Short-term capital gains are taxed at ordinary income marginal rates, while long-term capital gains often qualify for lower preferential rates (0%, 15%, or 20% depending on income).¹² Understanding these distinctions is crucial for maximizing investment income. The IRS provides detailed information on capital gains and losses.¹¹
• Retirement Planning: Individuals use marginal rates to determine the tax implications of contributions to pre-tax retirement accounts, like 401(k)s and traditional IRAs. Contributions to these accounts reduce current taxable income, effectively saving tax at the investor's current marginal rate.
• Compensation and Benefits: Employees considering a raise, bonus, or additional work often think about how much of the extra income they will actually keep after taxes. Their marginal tax rate directly impacts this net gain.
• Government Fiscal Policy: Policymakers use marginal tax rates as a tool to influence economic behavior. Changes to marginal tax rates can affect labor supply, savings, and investment, influencing the overall economy.⁹, ¹⁰

Limitations and Criticisms

While central to progressive tax systems, marginal tax rates also face limitations and criticisms. One common critique is their potential to disincentivize additional work or investment. Critics argue that high marginal tax rates, particularly at higher income levels, can reduce the incentive to earn more because a significant portion of additional income is "taxed away."⁷, ⁸ This can potentially lead to individuals taking on less work or engaging in activities that are less productive but tax-advantaged.

Economists debate the extent of these behavioral responses. Some research suggests that while tax cuts, including reductions in marginal rates, can be associated with increases in economic activity, the overall societal benefits are complex and require considering factors like income inequality and welfare.⁶ Additionally, overly complex tax codes with numerous deductions and credits can make it difficult for individuals to accurately assess their true marginal rate and the impact of financial decisions. The "behavioral elasticity of tax revenue" concept highlights how taxpayers may alter their behavior (e.g., shifting to non-taxable compensation or engaging in tax evasion) in response to tax rate changes, impacting actual revenue collected beyond simple mechanical calculations.⁵

Marginal Tax Rates vs. Effective Tax Rate

The terms "marginal tax rates" and "effective tax rate" are often confused but represent distinct concepts in taxation.

While a taxpayer's marginal tax rate might be 24%, their effective tax rate will almost always be lower. This is because the effective rate accounts for all the income taxed at lower rates in preceding brackets, as well as the impact of deductions (like the standard deduction or itemized deductions) and credits that reduce their overall tax liability.

FAQs

What is my current marginal tax rate?

Your current marginal tax rate depends on your taxable income and your filing status (e.g., single, married filing jointly). The U.S. federal income tax system has seven marginal tax brackets, and your marginal rate is the highest rate applied to any portion of your income. You can find the latest tax brackets on the IRS website or reputable financial news sites.³, ⁴

Does my entire income get taxed at my highest marginal tax rate?

No, your entire income is not taxed at your highest marginal tax rate. In a progressive system, different portions of your income are taxed at different rates according to the predefined tax brackets. Only the portion of your income that falls into the highest bracket you reach is taxed at that specific marginal rate.

How do marginal tax rates affect my savings and investments?

Marginal tax rates influence the after-tax return on your savings and investments. For example, interest earned from a savings account or short-term capital gains from selling investments held for less than a year are typically taxed at your ordinary income marginal rates. Understanding this helps you calculate the true return on your financial activities.

Can marginal tax rates change?

Yes, marginal tax rates and the income thresholds for each tax bracket are adjusted annually by the IRS to account for inflation.¹, ² Additionally, Congress can pass new legislation, like the Tax Cuts and Jobs Act (TCJA), which can significantly alter the tax rates and bracket structures.

Is it always better to be in a lower tax bracket?

While being in a lower tax bracket means a lower percentage of that specific income is taxed, it doesn't necessarily mean you're financially better off overall. A higher income often means you've progressed into higher tax brackets, but your total take-home pay can still be substantially more, even after accounting for the higher marginal rates on the additional income. The goal is often to maximize after-tax income, not just stay in the lowest bracket.