Home Income News

by Tyler Kron

Taxes are an integral part of everyone’s life. We have corporate tax, sales tax, income tax, property tax, payroll tax, along with numerous other taxes. All taxes have a component called the Marginal Tax Rate. The marginal tax rate is simply the rate at which the tax changes as additional money is spent. In other words, it is the derivative of the tax function (dF/dT). The average tax rate is the average of the taxes paid divided by the sum of taxable income ((Taxes Paid)/(Taxable Income)). These two tax entities differ as the marginal tax rate is an instantaneous rate, while the average tax rate is just that, an overall average tax on the total amount of money spent. On a progressive tax scale, the average tax takes into consideration a wide range of tax rates and is unable to quantify the tax on each additional dollar spent. Thus, when it comes to making marginal decisions, it is the marginal tax rate which is analyzed, not the average tax rate. Generally speaking the average tax rate is lower than the marginal tax rate. The only case in which an individual’s marginal tax is lower than its average tax would be on a regressive tax system.

Alan Reynolds, from the Cato Institute, suggests that real marginal tax rates are higher than statutory rates, but what does that mean? The real marginal tax rate, often called the effective marginal tax rate, is the rate which the person pays in reality. The statutory rate is the hypothetical rate. How could the actual tax be higher than the published rates? It is actually quite simple and intuitive. As a person becomes more successful and thus increases their income, they start to lose tax deductions. For example, as one climbs up the progressive tax hierarchy, the amount of money ones receives for claiming dependencies drops off. So in effect, a person is not only getting taxed at a higher rate, but they are also loosing the amount of deductions they can claim towards their taxes.

It is difficult to compare the marginal tax rates of the US with those of other countries as the marginal tax rates are scattered from a range of 59% to 13% and each country has a slightly different ideology about how taxes should be implemented. If one were to analyze the table, it is evident that the average marginal tax rate for 2002 was 38.34%. For the same year, the United States had a marginal tax rate of 39%, which is essentially the average. Consequently, when compared to some countries the US has a relatively high marginal tax rate while compared to other countries, the US has a relatively low marginal tax rate. Thus comparing the marginal tax rate with other countries would vary greatly depending on the specific country.

When correlating the tax rate to the GDP, the full story is hidden and to discover the actual effects takes further analysis. The ratio is given by tax revenue divided by the GDP. However, such a ratio does not take into effect the opportunity cost of the taxes. This simple ration doesn’t account for the damage the tax has done. When it measures the tax revenue generate, it only accounts for the accounting profits, not the economic profits, which are usually much lower. If there were such a way to counter in the opportunity costs and benefits of the tax, then such a ratio would be more useful when analyzing the effects of a tax.

A higher marginal tax rate acts as a negative incentive towards progress and growth. Why would a company or individual decide to invest with the intention of making a profit if their profit is going to be taxed at a higher and higher rate depending on how much they make? Why would they try to further their profit when the tax deductions start to deteriorate? It is as if the company or individual is being punished for making good decisions which increased their revenue. Such an ideology is counterproductive to progress. The lower the marginal tax rate, the more willing people are to make investments.

The government is inefficient and wasteful when it comes to taxes. The sole purpose of taxes is to provide public services which the private market cannot provide. However, as with all taxes, a dead weight loss is created. This means mutually beneficial transactions that would have normally occurred will no longer occur because of the increased marginal cost. Thus it is important to minimize the marginal tax rate. This will encourage growth and enable more mutually beneficial transactions to occur. The higher the marginal tax rate, the higher the detrimental effects of the tax.

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