Basic Tax Rate Concepts

Learning to compute a marginal tax rate (MTR) provides an analytical, value-added skill that facilitates decision-making in a variety of contexts. These decision settings may involve multiple years, multiple jurisdictions, and multiple persons; separate lessons discuss each of these areas and a final tutorial examines more complex situations. This initial lesson explains statutory, effective, and marginal tax rates and provides background information you need to understand and calculate MTRs.


Statutory Tax Rates

Statutory tax rates are those percentages appearing in the tax law. For example, §11 in the Internal Revenue Code contains statutory rates for taxing C corporations under U.S. law. In summary, these rates apply to taxable income as follows:

Congress formulated the 39% and 38% “bubble” rates to take back advantages of lower rates otherwise applicable. For instance, the 39% bracket acts as a five-percentage-point addition to the 34% rate, neutralizing the advantage of the 15% and 25% brackets. When a corporation’s taxable income reaches $335,000, the 39% bracket begins taking back the advantages of the lower 15% and 25% tax rates and completes the process once taxable income reaches $10 million. Thus, you can obtain the tax attributable to taxable income ranging from $335,000 to $10 million by applying all the rates in the above schedule to taxable income or, more simply, by multiplying taxable income by 34%. Similarly, when a corporation’s taxable income reaches $15 million, the 38% acts as a three-percentage-point addition to the 35% rate and starts taking back the advantages of the 34% tax rate, completing the process after taxable income reaches $18,333,333. To calculate the tax on taxable income of $18,333,333 or more, you can multiply taxable income by 35%.

Example 1:

Axel Corporation derives $200,000 and $400,000 taxable income during its past two years. You can compute the federal tax liability for each year using statutory tax rates as follows:


Year 1:

($50,000 x 15%) + ($25,000 x 25%) + ($25,000 x 34%) + ($100,000 x 39%) = $61,250

Year 2:

($50,000 x 15%) + ($25,000 x 25%) + ($25,000 x 34%) + ($235,000 x 39%) + ($65,000 x 34%) or

$400,000 x 34% = $136,000

Understanding the function and application of statutory tax rates (including bubbles) helps in selecting the correct federal tax rate as input for the MTR calculation discussed later. Most examples appearing on this site assume the applicable corporate tax rate is 34% (i.e., that taxable income equals or exceeds $335,000 but is less than $10 million) or 35% (i.e., that taxable income exceeds $18,333,333).

In contrast to corporate rates, the U.S. statutory tax rates applicable to individuals appear in §1 of the Internal Revenue Code and vary by filing status. Though Congress often nudges these percentages up or down, the highest rate for most ordinary income stands at 35%. However, the Code taxes net capital gain and qualified dividend income at a maximum 15% rate. Also, individuals subject to the alternative minimum tax may be subject to the 26% and 28% rates found in §55.

As temporary means of raising tax revenue, some countries impose surtaxes (or surcharges) in addition to their national income taxes. Foreign laws can express surtaxes as percentages of either: (1) taxable income or (2) regular tax. Careful reading identifies which of these two serve as the surtax's base.

Example 2:

As a Kazanbiquen resident, Bevel Corporation derives K$150,000 taxable income. Kazanbiquen law taxes the first K$100,000 at 20% and any additional income at 30%. In addition, Kazanbique imposes a 5% surtax for the next two years. If the 5% applies to taxable income, Bevel Corporation incurs tax of:

 

 

(.2) (K$100,000) + (.3) (K$50,000) + (.05)(K$150,000) or

(.25) (K$100,000) + (.35) (K$50,000) = K$42,500

  If instead the 5% applies to the regular tax, Bevel Corporation owes:
    (1.05) [(.2) (K$100,000) + (.3) (K$50,000)] = K$36,750


Average and Effective Tax Rates

You can compute the average tax rate (ATR) from tax return information as follows:

(1)

Since the ATR relates to overall activities for a taxable year rather than specific decisions, it provides little assistance when evaluating economic choices. Further, reducing the ATR, per se, is not a laudable objective. In fact, any company placing all its capital in tax-exempt securities can reduce ATR to zero. However, the resulting low rate of return may not impress shareholders.

Similarly, the effective tax rate (ETR) relates to a time period, such as a taxable year, rather than to a specific project, asset, or activity. It reflects the average rate of tax over the period from all a firm’s activities. Put simply, the ETR is computed as follows:

(2)

The numerator may include state, federal, and foreign income tax liabilities. Depending on the user, only the current tax payable may appear in the numerator; other times, the numerator includes both current and deferred tax, though the latter amount is not adjusted to its present value.

The dollar amounts for calculating ETRs generally come directly from financial statement disclosures. Thus, ETRs may differ significantly from average tax rates based on information taken from tax returns.

Example 3:

Axel Corporation’s first income statement shows $500,000 net income before taxes and income tax expense of $180,000. Income tax payable of $150,000 and deferred income tax liability of $30,000 appear in the liability section of Axel’s balance sheet. If based only on current taxes, the ETR equals:

 

 

  Including deferred taxes increases the ETR as follows:
   

As an average, the ETR attempts to measure a taxpayer’s income tax burden from all activities over a limited period such as one year. Depending on the user, ETRs may reflect (1) policy decisions at a macroeconomic level or (2) overall tax planning at the firm level. From a macro perspective, the tax burden may reflect past policy decisions or suggest changes to existing policy. For instance, economists and policy wonks look at ETRs to determine if similarly situated taxpayers bear commensurate tax burdens. If not, they may suggest changes to existing law to align ETRs and, thus, move the tax system closer to horizontal equity.

Example 4:

Prior to the Tax Reform Act of 1986, sizeable investment tax credits and generous depreciation methods provided significant tax preferences to capital-intensive firms. As a result, such firms often had lower ETRs than labor-intensive companies with similar risk-adjusted, before-tax rates of return. To reduce variability in ETRs, the 1986 Act repealed the investment tax credit, lowered the top statutory rate of corporations from 46% to 34% (reducing the tax advantages attributable to depreciation), and raised the alternative minimum tax rate to 21%. By narrowing differences in ETRs, Congress hoped to allocate economic resources more optimally and improve the overall efficiency of the U.S. economy.

In addition to its policy uses, some corporate officers and financial statement analysts view ETRs as measures of overall tax planning. Lower ETRs may be attributed to more effective tax planning. Thus, corporations sometimes use ETRs to mark progress in their tax planning efforts over time or benchmark themselves against other corporations engaged in similar business activities.

Example 5:

Five years ago, Cardwell Corporation’s ETR equaled 39.3%, a rate at the top end for its industry. To bring the ETR down, the CEO hired a new tax director who developed and implemented specific tax planning approaches to many of the firm’s financing and investment activities. This year, Cardwell Corporation's ETR is 35.6%, which compares favorably with those of similar companies.

This website deals with step 5 in the tax research process and emphasizes decision-making.   Since ETRs depend on financial statement disclosures, reflect all transactions and events over a fixed period, and receive no present value adjustments, you should not depend on them for making decisions or tax planning. Similarly, average tax rates (ATRs) computed from tax return information (i.e., income tax before prepayments divided by taxable income) provides little assistance when making economic decisions.

So, this site focuses on MTR calculations rather than the ETR or ATR. Nonetheless, distinguishing between these concepts and their uses can help you understand when MTRs are appropriate measures and the reasons not to rely on ETRs or ATRs for tax planning.

Marginal Tax Rates

In contrast to ETRs, the MTR computation focuses on the tax rate attributable to a specific project, asset, activity, or venture. Some use the ETR to measure tax planning effectiveness for all a firm’s activities over a given period (usually a year), but the MTR relates to specific decisions that may involve tax paid (or saved) and income received (or expenses paid) over several years. Also, unlike the ETR, the MTR calculation converts all amounts to their present values, explicitly taking into account the timing of income, expenditures, and tax payments. Thus, this site defines the MTR related to a given decision as follows:

(3)

Example 6:

Devon Corporation expects taxable income of $14 million and federal tax liability of $4.8 million (i.e., $10 million times 34% plus $4 million times 35%) before considering a new contract that, if signed, will add $3 million to this year's taxable income. The $3 million incremental income falls partly in two different tax brackets and results in an additional $1,110,000 of tax. So, the MTR related to the specific decision of signing the contract can be computed as follows:

 

 


  You also might determine the MTR in this simple situation by noting that one-third of the incremental income falls in the 35% bracket and two-thirds falls in the 38% bracket and simply interpolating between these two rates (i.e., 35% plus two-thirds of the three percentage point difference between brackets).

In the case of individual taxpayers, determining the MTR for incremental income (or expenditures) over certain ranges can be a more complex undertaking than it is for corporations because of the many phase-out rules applicable to individuals. Some phase-outs impact low-income taxpayers, while others affect the middle and upper classes. Further, phase-out rules often apply to individuals setting aside funds for future educational needs, contributors to individual retirement accounts, and retirees.

Example 7:

Eric and Erica are retirees who together receive $38,000 pension income and $10,000 Social Security benefits. Erica would like to accept a recent offer to earn $1,000 income as a sales associate during the last two weeks of December. Based on the statutory rates for married individuals filing jointly, Erica might conclude that her incremental earnings will be taxable at only 15%. However, the §86 phase-out rules cause gross income to increase $1,850 (i.e., $1,000 compensation plus $850 due to the §86 exclusion phase-out of Social Security benefits). In effect, the increased income causes more of her $10,000 Social Security benefits to be taxable. Thus, the MTR attributable to her decision to accept this short-term employment offer equals 27.8%, determined as follows:

 

 


  For simplicity, this example ignores FICA tax.

Examples on this website involving individual taxpayers generally specify the applicable individual tax rate to use in determining MTRs, ignoring the complexities of phase-out rules to emphasize more fundamental concepts. However, Example 7 alerts the reader to the difficulty calculating MTRs when considering taxes at the individual level. For yearend planning, taxpayers might use tax return software to assist with MTR computations. After inputting the year's estimated tax data, software users can observe changes in tax liability as they make incremental changes to income or expense items.

Excluded or nontaxable income results in a zero MTR. However, income items that the Code excludes only partially results in a positive but perhaps low MTR. Many such situations involve employees receiving employer-provided benefits. For instance, §79 allows employees to exclude group-term life insurance premiums, but only to the extent of premiums buying the first $50,000 of coverage. Similarly, §132 excludes qualified transportation fringes and employee discounts, but only up to statutory percentages or dollar amounts.

Example 8:

As employee of the year, Freddy must choose between a $1,500 bonus or $1,500 discount on store merchandise. If he takes the discount, he wants to pay $1,000 for a new entertainment center that sells to the public for $2,500. The employer's applicable gross profit rate is 35%. Thus, §132 allows Freddy to exclude his employee discount only to the extent of the $875 gross profit component (i.e., 35% x $2,500). Assuming Freddy would be taxed at 10% on a $1,500 bonus, the MTR related to the discount equals:

 

 


  Of course, Freddy would have the flexibility to spend a bonus anyway he wanted, but the relatively low MTR applicable to the employee discount makes that choice attractive.

The MTR facilitates decision-making often occurring at step 5 of the tax research process. Though helpful, the MTR may be only an input for the decision rather than the final yardstick. For instance, comparing after-tax cash flow may be appropriate when before-tax cash flows differ. Similarly, when choices involve how to invest funds, decision makers may face alternatives differing in before-tax rates of return. Selecting the alternative with the lowest MTR does not always maximize wealth. A more appropriate touchstone examines the combined effect of MTRs and before-tax cash flow or rate of return. The following equations emphasize this point, establishing the proper touchstone as after-tax cash flow or rate of return:

c = C (1 - MTR)

r = R (1 - MTR)

(4)

(5)


where c = after-tax cash flow,
  C = before-tax cash flow,
  r = after-tax rate of return, and
  R = before-tax rate of return.
Example 9: Georgette inherited $10,000 from her great grandfather and wishes to invest the entire amount in taxable bonds yielding 6% or nontaxable bonds yielding 4%. Assume the taxable and nontaxable bonds bear the same risk. Also, she lives in a state that does not impose income taxes, so only federal taxes affect her choice. The MTRs on the taxable and nontaxable bonds are 25% and zero, respectively. The after-tax rates of return per Equation 5 equal:
 

 

Taxable bonds:    

Nontaxable bonds:

r = .06 (1 - .25) = 4.5%

r = .04 (1 - 0) = 4.0%

  So, if she chooses based solely on the MTR, she would invest the $10,000 in nontaxable bonds. However, the taxable bonds yield 4.5% after taxes and, thus, represent the better choice.

Like choices involving additional income, the MTR assists in making decisions about incremental expenditures too.

Example 10:

It is the last week in December, and Harold wants to make a contribution to his church. However, a recent business setback left him with limited cash, and he wishes to know his after-tax cost of making a $1,000 contribution. His filing status and income level place him near the middle of the 25% tax bracket. Assuming Harold can deduct the entire contribution, his MTR applicable to this decision is computed as follows:

 

 


  Thus, the after-tax cost of a $1,000 charitable contribution equals $750.

This lesson explains how to calculate MTRs when only one jurisdiction imposes a single tax on a person receiving or paying all incremental income, expenses, and taxes in the current year. Other lessons explain how to combine MTRs for multiple years, jurisdictions, and persons into an overall MTR. For instance, the next lesson uses present value concepts to determine MTRs when a person receives income or pays tax over two or more years. However, before proceeding to the “Multiple Years” lesson, please take the self-tests covering basic concepts to assure your understanding. Also, please complete the “Short Exit Questionnaire” before leaving the site.