- Remember that under my simple tax system,
if you make $100, you pay tax of $25.
The first $50 is not taxed.
The second $50 is taxed at the rate of 50%.
So you'll pay a total of $25 tax,
if your taxable income is $100.
Now, this allows us to discuss two important concepts,
the average tax rate and the marginal tax rate.
The average tax rate is simply the tax that you owe,
$25 in this case, divided by how much you make,
$100 in this case.
$25 divided by $100 is 25%.
That's the average tax rate.
This is a very intuitive idea.
For example, the average federal tax rate
for all taxpayers in the United States
is between 10% and 15%.
Now note, before you get excited
about this relatively low rate,
remember that this doesn't include state income tax,
sales tax, property tax, and social security tax.
Now, economists say that a more important rate
than the average tax rate is the marginal tax rate.
The marginal tax rate is the rate you'll pay
on the next dollar of income that you'll make.
The reason that this is an important concept
from an economics standpoint
is that this marginal rate is the rate that I have in mind
when I'm considering in some extra time and effort
and risk to make more money.
I will pay the marginal tax rate
on any extra money from a new business,
or from working overtime hours.
Let's say that I'm an entrepreneur
with a good business idea, my current income is $100.
Should I work hard and devote my time and energy
to starting the business and making more money?
Well, in the case of my simple tax system,
if I start that business and make extra money,
I'm going to have to pay the marginal tax rate, 50%,
on any new income that I make.
The marginal rate, that's the number
that people have in mind as they consider
whether they should work harder.
Now look again at my simple tax system.
You may be asking yourself,
why exclude some income from taxation?
In this simple system, why let people make $50
without paying any tax at all?
Well, the concept here is that
there's a fixed cost to living.
I have to have a certain amount of money
to put a roof over my head and put food on the table
and clothes on my back.
Let's not tax any of that money,
because those are the essentials of life.
Only after I've got those things taken care of,
now the government can start to take some tax from me.
This idea of a fixed cost of living
is built into all income tax systems around the world.
Another phrase that you might have heard
is a progressive tax system.
A progressive tax system is one in which
the average tax rate increases as you make more money.
My simple system is a progressive tax system,
let me show you why.
As we saw, if you make $50, your tax is zero,
so your average tax rate is 0%.
If you make $100, your tax is $25,
so your average tax rate is 25%.
And if you make $1,000, you pay $475 in tax,
and your average tax rate is 47.5%.
The average tax rate goes up the more money you make.
This is a progressive tax system.
All income tax systems around the world
are designed to be progressive systems.
Now remember, the average tax rate
is the overall rate of tax
you are paying on all of your income.
The marginal rate is the rate you will pay
on the next dollars you make as your income increases.