Lessons · Accounting · the rate on your next pound, and the rate on all of it
The rate on your next pound, and the rate on all of it
The marginal rate is the rate on the next unit of income you earn. The effective rate is the total tax divided by total income. Under a banded system the effective rate is always lower than the marginal rate, and the two answer different questions.
Hone is a place to practise a career, one idea a day. This is one of its lessons, written out in full and free to read without an account.
In beta. This lesson was written for Hone and has not yet been checked by a qualified accountant. Practice material, not professional advice. What that means.
What it is for
Every decision about whether to take extra work, a raise or a second job is a marginal question, and every statement about what somebody actually pays is an effective one. Using the marginal rate to describe the burden overstates it badly, and using the effective rate to evaluate extra work understates what the extra will cost.
How to think about it
For a decision about doing more, use the marginal rate. For a description of what is being paid, compute total tax over total income. Say which one you are quoting, because the two are far apart and people assume the smaller one.
Worked example
Total tax over total income is the effective rateWhat is actually being paid overall.
The rate on the next unit earned is the marginal rateWhat extra work is taxed at.
The effective rate is always the lower of the twoBecause lower bands are included in it.
Which one to quote depends on the questionA decision is marginal; a description is effective.
Your turn
Name the rate that applies to the next unit of income earned.
The rate on the next unit earned is the rate
Solve one, graded on the server
The trap
Quoting a marginal rate as what somebody pays. It is the rate on their last slice, never on their income, and repeating it as the burden is how a tax system acquires a reputation it has not earned.