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What is the difference between marginal and average tax rates?



The marginal and average tax rate distinction/calculation is secondary in terms of importance for the CFA Level 3 exam. Nevertheless, we have seen multiple choice problems in the past asking you to either (1) calculate one or the other, (2) distinguish between them, or (3) identify how a tax regime will change the rate. 

Calculating the marginal and average tax rate for the CFA exam

The marginal tax rate is the tax rate on the last dollar of income earned.

So, if your income is $105,000 and the tax rate for the $100,000 to $150,000 bracket is 30% then your marginal tax rate is 30%. Simple right? 

The average tax rate on the other hand is the total taxes you’ve paid divided by your income.

In a progressive tax regime the average tax rate should always be lower than your marginal tax rate because as your income increases each tranche of income gets taxed at a progressively higher rate. In other words, under a progressive system not all income is taxed at the same rate. Instead each dollar you earn is taxed at a different rate depending on the marginal tax rate schedule in your tax jurisdiction.

This graphic illustrates the concept:

Marginal vs. Average Tax Calculation - CFA Exam

As you can see, the first $27,800 of the families income is not taxed. The next $17,850 (or dollars $27,801 - $45,650) is taxed at 10%, then dollars $45,651 - $100,300 are taxed at 15% and so on. The marginal tax rate, or tax rate on the last dollar of income earned is 25%.

To get the average tax rate we take the blended or weighted average of each tranche and sum them together.  In this case the average tax rate of 9.5% is calculated as:

  • Dollars paid in taxes: ($27,800 * 0) + ($17,850 * .10) + ($54,650 * .15) + ($9,700*0.25) = $12,407.50
  • Average tax rate: ($12,407.50 / $110,000) = 11.28%

If the regime was a flat one, the average and marginal tax rates would be the same.

Summary

For the CFA Level 3 exam marginal and average tax rates are (1) straightforward and (2) much less important than other material related to taxes. Still it's worth practicing a few problems and internalizing this lesson so that you earn any points where this comes up.