Tax Rate vs. Marginal Tax Rate

by Cam Merritt

When you earn money at a job, buy something in a store or engage in most other significant economic activities, you can expect that at least one level of government will be involved by levying taxes. The government's "cut" is determined by the tax rate. There are countless ways to set up tax rates, including using marginal rates, in which different rates apply to different portions of the activity being taxed.

Tax Rates

Governments impose taxes on a wide range of things, but at the most basic level, every tax is simply a charge for conducting economic activity. In the case of income taxes, that economic activity is people and businesses making money. With sales taxes, it's the purchase of goods and services. With property taxes, it's ownership of property. Every tax lays claim to a certain percentage of the economic activity on which it's imposed. That percentage is the tax rate.

Types of Tax Rates

Governments can structure their tax rates in one of three general ways: progressive, regressive and proportional. A progressive rate structure is one in which the tax rate increases as the tax base -- the activity being taxed -- gets larger. The federal income tax system is perhaps the most familiar example of a progressive tax: The more money you make, the higher your tax rate. A regressive rate structure works just the opposite: The tax rate decreases as the tax base grows. The Social Security tax is a commonly cited example of a regressive tax because the tax is assessed on only a certain amount of income. In 2010, for example, workers paid a Social Security tax of 6.2 percent of all income up to $106,800, but no tax on anything in excess of that. So a worker with an income of $50,000 paid 6.2 percent, or $3,100, in Social Security taxes. A worker with $200,000 in income, though, paid a maximum of $6,621.60 -- or 3.3 percent of his income. A worker with $1 million in income paid the same maximum: $6,621.60, or 0.6 percent. Finally, a proportional tax is one in which the same rate applies regardless of the size of the tax base. Most general sales taxes are proportional taxes -- the same rate applies to a $1 purchase as to a $10,000 purchase.

Marginal Tax Rate

Under the federal income tax system, people speak of being in a certain "tax bracket," such as 15 percent, 25 percent or 35 percent. However, being in a particular bracket doesn't mean you pay that percentage of your entire taxable income. Instead, different portions of your income are taxed at different rates. These different rates are called "marginal tax rates." As your income grows, the top portion of your income becomes subject to higher marginal rates, and your tax bracket is the marginal rate you pay on the "last dollar" of your income.

Marginal Rates in Action

Say you were a single person with taxable income of $45,000 in 2010. That put you in the 25 percent bracket. Your tax was figured like this: You paid a rate of 10 percent of the first $8,375 of your taxable income, or $837.50. Then, you paid 15 percent of everything between $8,375 and $34,000, which came out to $3,843.75. Finally, you paid 25 percent of everything from $34,000 to $45,000 -- the "last dollar" of your taxable income. That portion came out to $2,750. Your total tax bill was $7,431.25. Even though you were in the 25 percent bracket, your effective income tax rate was about 16.5 percent, thanks to the marginal rate system. If you'd actually had to pay 25 percent on your entire taxable income, your bill would have been much higher: $11,250.

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