Difference between average and marginal tax rates

To understand the difference between average tax rate and marginal tax rate, let's break it down with definitions, calculations, and real-world examples using the UK tax system for the 2023/24 tax year.

Definitions

1. Marginal Tax Rate:
   • This is the tax rate applied to the next pound of income you earn. It depends on the income band your earnings fall into.
2. Average Tax Rate:
   • This is the total amount of tax you pay as a percentage of your total income. It's calculated by dividing the total tax paid by your total income.

UK Income Tax Bands for 2023/24

• Personal Allowance: £12,570 (0% tax)
• Basic Rate: 20% on income between £12,571 and £50,270
• Higher Rate: 40% on income between £50,271 and £125,140
• Additional Rate: 45% on income above £125,140

Example 1: A Person Earning £40,000 per Year

Step 1: Calculate Total Tax Paid

1. Personal Allowance (tax-free): £12,570 - Tax = £0
2. Basic Rate (20% on income £12,571 to £40,000):
3. Taxable income = £40,000 - £12,570 = £27,430
4. Tax = £27,430 × 20% = £5,486

Total Tax Paid = £5,486

Step 2: Average tax rate = £5,486 / £40,000 = 0.137 or 13.7%

Step 3: Marginal Tax Rate: The individual’s next pound of income would still fall in the Basic Rate band, so the Marginal Tax Rate = 20%.

Example 2: A Person Earning £60,000 per Year

Step 1: Calculate Total Tax Paid

1. Personal Allowance (tax-free): £12,570, Tax = £0
2. Basic Rate (20% on income £12,571 to £50,270):Taxable income = £50,270 - £12,570 = £37,700, Tax = £37,700 × 20% = £7,540
3. Higher Rate (40% on income £50,271 to £60,000):Taxable income = £60,000 - £50,270 = £9,730, Tax = £9,730 × 40% = £3,892

Total Tax Paid = £7,540 + £3,892 = £11,432

Step 2: Average Tax Rate = (11,432/60,000) × 100 = 19.05%

Step 3: Marginal Tax Rate: The individual’s next pound of income would fall in the Higher Rate band, so the Marginal Tax Rate = 40%.

Key Observations

• Marginal Tax Rate tells you the tax rate on your next pound of income. For high earners, this can rise to 45%.
• Average Tax Rate represents your overall tax burden as a percentage of your total income. It is always lower than your marginal rate due to the tax-free allowance and lower rates on earlier income bands.

Why This Difference Matters

1. Decision-Making:
   • If someone is deciding whether to work overtime or take on additional work, the marginal tax rate is relevant because it tells them how much of their additional income they'll keep after taxes.
2. Understanding Fairness:
   • The average tax rate helps gauge the overall burden of taxation on an individual, giving a sense of progressiveness in the tax system.
3. Policy Analysis:
   • Governments often use marginal rates to influence behaviour (e.g., discourage very high earnings via steep rates) but rely on average rates to determine overall tax revenue and fairness.