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Most Western countries use tax brackets and marginal tax rates as the basis of their tax code. In this lesson, you'll learn the definition of marginal tax rate and its history in the United States.
Marginal Tax Rate
A marginal tax rate is the rate at which your next incremental dollar in taxable earnings is taxed. Marginal tax rates are used when a tax system uses brackets to define different tax rates for different levels of income. The United States has this type of tax system and because there are only seven tax brackets, we can use the 2013 U.S. marginal tax rates, as seen below, in our examples.
Using tax brackets is a popular method of determining tax rates because most governments, and most people, believe that it isn't fair to expect all citizens to pay the same percentage of their income in taxes. If the flat rate was 10%, someone that made $10 million would pay $1 million in taxes, while someone that made $10,000 a year would pay $1,000. That $1,000 is a lot more important to the person making $10,000 than the $1 million is to the person making $10 million.
U.S. Marginal Tax Rates History
There's a saying that states, 'Only two things in life are certain: death and taxes.' Technically, that's not true. The U.S. didn't have personal income tax before the Civil War. In 1861, a temporary tax to help fund the Civil War was passed. There were two brackets in that plan: below $800 per year and above $800 per year. For those making below $800 per year, there was no tax, and for those making above $800 per year, the tax rate was 3% on all income over $800.
After the Civil War, the personal income tax was dropped, at least until 1894. Taxes were still inconsistent after that and depended mostly on what the government expected to spend in the coming year. The big change in U.S. tax history came in 1913 when 42 of the 48 states ratified the 16th Amendment, which increased the taxing authority of the federal government. In case you're curious, the states that didn't ratify the 16th Amendment were Utah, Virginia, Rhode Island, Florida, Pennsylvania, and Connecticut.
If we look again at the 2013 U.S. marginal tax rates table, we can see that the highest tax bracket is 39.6% for any single-filer income above $400,000. Basically, this means if you're single, once you hit $400,000, your marginal tax rate is 39.6%, meaning the next dollar you make will be taxed at 39.6%.
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For many people, 39.6% sounds like a pretty high tax rate, and giving up nearly 40% of a dollar is a pretty big cut. But when compared to historical marginal tax rates in the United States, 39.6% is pretty reasonable. Consider tax rates after President Reagan's tax cuts in 1981: In 1982, the highest marginal tax rate was 50% for anyone making more than $85,600. Looking back, 50% likely seems outrageous, but imagine how that seemed to those that grew up in the 1950s when the highest marginal tax rate was 92%. That's no joke; throughout most of the 1950s, income earned above $200,000 was taxed at 92%. In fact, the highest marginal tax rate in the history of the United States was the post-WWII years when the highest earners had a marginal tax rate of 94% on their top dollars.
Calculating Tax Liabilities
Marginal tax rates apply only to income earned in the bracket with which they are associated. To clarify this point, let's use an example.
The first three tax brackets in the 2013 IRS single-filer tax table starts at 10% for income up to $8,925, 15% for income from $8,925 to $36,250, and 25% for income from $36,250 to $87,850. Let's say the single-filer in our example, we'll call him John, has earnings of $50,000. John's tax liability isn't 25% of $50,000, or $12,500. If all of John's income was taxed at the highest bracket any of income was in, then he would have a $12,500 tax bill. But in the marginal tax bracket system, the first $8,950 of John's income is taxed at 10%. The next $27,324 (John's income between $8,926 and $36,250) is taxed at 15%. The last $13,749 of John's income (from $36,251 to $50,000) is taxed at 25%.
So, instead of the $12,500 tax bill John would have if his entire $50,000 income was taxed at 25%, his tax bill ends up being $8,430. The reason for the difference is because, like most people that pay taxes, John doesn't have a single tax rate. John's marginal tax rate is 25%, but not all of his earnings are taxed at 25%.
The U.S. tax code is incredibly long and complex, but fundamentally, it's based on a simple progressive tax that uses marginal tax rates and tax brackets. A marginal tax rate is the rate at which your next incremental dollar in taxable earnings is taxed, which is based on a series of brackets that are used to define different tax rates for different levels of income. Understanding marginal tax rates as the tax on your next dollar can help as you anticipate the net gain after a bonus or a raise.
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