Average and Marginal Tax Rates

* This is a post which has been posted on gunther goes tax’ish on August 9, 2009 by the author *

Welcome to the second Noob-Out post on Gunther goes Tax’ish. I have thought about the last Noob-Out post and thought that it might have been a bit too geeky. Thus, this post will be more basic. Hope you enjoy it.

I have thought about some misconceptions in tax issues. One is certainly the misunderstanding of the difference between average tax rates and marginal tax rates. Let’s say you are told that the marginal tax rate in Germany is 42% if you earn more than 52.882 € and less than 250.000 €. That does not mean that your income, let’s say 60.000 €, is taxed at 42%. The income tax you pay is not 42% * 60.000 € = 25.200 €. The good news is: it is less than that. I found this excellent video and article by Gerald Prante, explaining the difference between these two.

Average vs. Marginal Tax Rates explained by Gerald Prante

So, in out example it would mean that the 42% tax rate only applies to the amount earned more than 52.882 €, i.e. 7.118 €. The average tax rate is somewhere around 30%, while the marginal tax rate is at 42%. So, statements like “They are taking away 42% of my income!” are not really true. In Gerald’s example, the progression of the tax rates was flat (i.e. 10%, 20% and 30%). Thus, someone who earns 100.000 $ might have an incentive to reduce the income to 99.999 $, because that person pays now 0.30 $ tax on that additional dollar earned. Thus, people in the lower part of that income bracket (let’s say 100k -110k) have an incentive to trade that additional income with something else. For example, a manager would rather like to have a company car instead of earning that amount, which kicks him into the next tax bracket. But as you can imagine it’s not possible to reduce the income to the tax exempted amount in that way. In the German example below, you also see that the benefit of reducing the income in order to be in different tax brackets, does not yield so much benefits. This is because there is a gradual progression in the [13.470 € - 52.882 €] tax bracket (i.e. not flat).  I hope this helps to develop your geek-skills in tax related matters. Thanks for reading!

For all German readers:

The average tax rate is in German the “Durchschnittssteuersatz” (or effektiver Steuersatz) and the marginal tax rate is “Grenzsteuersatz“. The tax brackets in Germany are as follows:

The graph is from the FAZ. You can also visit the website of the German Finance Ministry to calculate your average and marginal tax rate. There is also a more detailed description of the tax brackets on the Wikipedia Site on income tax.