In a tax system, the tax rate is the ratio (usually expressed as a percentage) at which a business or person is taxed. The tax rate that is applied to an individual's or corporation's income is determined by tax laws of the country and can be influenced by many factors such as income level, type of income, and so on.[1] There are several methods used to present a tax rate: statutory, average, marginal, flat, and effective. These rates can also be presented using different definitions applied to a tax base: inclusive and exclusive.
A statutory tax rate is the legally imposed rate. An income tax could have multiple statutory rates for different income levels, where a sales tax may have a flat statutory rate.[2]
The statutory tax rate is expressed as a percentage and will always be higher than the effective tax rate.[3]
Average
An average tax rate is the ratio of the total amount of taxes paid to the total tax base (taxable income or spending), expressed as a percentage.[2] Average tax rates is used to measure tax burden of individuals and corporations and how taxes affect the individuals and corporations ability to consum.[4]
Let be the total tax liability.
Let be the total tax base.
In a proportional tax, the tax rate is fixed and the average tax rate equals this tax rate. In case of tax brackets, commonly used for progressive taxes, the average tax rate increases as taxable income increases through tax brackets, asymptoting to the top tax rate. For example, consider a system with three tax brackets, 10%, 20%, and 30%, where the 10% rate applies to income from $1 to $10,000, the 20% rate applies to income from $10,001 to $20,000, and the 30% rate applies to all income above $20,000. Under this system, someone earning $25,000 would pay $1,000 for the first $10,000 of income (10%); $2,000 for the second $10,000 of income (20%); and $1,500 for the last $5,000 of income (30%). In total, they would pay $4,500, or an 18% average tax rate.
Flat
Flat tax rate also known as single-rate is one of the simplest taxations. For flat is a single tax rate (same percentage) on the whole taxable amount. A flat tax rate is used because of its simplicity, transparency, neutrality, and stability. Flat tax rates are quite transparent because it makes it easier for taxpayer to estimate their tax liability and for policymakers to estimate how changes would impact tax revenue. [5]
Let’s show a simplified example of a flat tax rate in Colorado. There is a flat tax rate determined at 4.4%. We will assume that annual taxable income is $ 100,000. Then income tax is equal to $ 4,400.[6]
In practice, a flat tax rate on income is used in many states of USA, like Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah or internationally for example in many post-soviet countries like Hungary, Serbia, Estonia or Ukraine, and also in Iceland or Bolivia.[5][7]
On the other hand, it must be said that, in practice, no state has a perfectly flat income tax rate, and every state makes certain distinctions between types of income and has several discounts and reductions.[5]
A poll tax, also known as a head tax, is a flat tax of a set dollar amount per person. As an example, we can look at the history of the USA, where poll tax was introduced in 1870, which was a fee paid for the right to vote.[8]
The marginal tax in these scenarios would be constant (in case of a poll tax—zero), however, these are both forms of regressive taxation and place a higher tax burden on those who are least able to cope with it, and often results in an underfunded government leading to increased deficits.
Marginal
A marginal tax rate is the tax rate on income set at a higher rate for incomes above a designated higher bracket, which in 2016 in the United States was $415,050. For annual income that was above the cut-off point in that higher bracket, the marginal tax rate in 2016 was 39.6%. For income below the $415,050 cut off, the lower tax rate was 35% or less.[9][10]
The marginal tax rate on income can be expressed mathematically as follows:
where t is the total tax liability and i is total income, and ∆ refers to a numerical change. In accounting practice, the tax numerator in the above equation usually includes taxes at federal, state, provincial, and municipal levels. Marginal tax rates are applied to income in countries with progressive taxation schemes, with incremental increases in income taxed in progressively higher tax brackets, resulting in the tax burden being distributed amongst those who can most easily afford it.
An example of the usage of marginal tax rates and tax brackets used in the USA in 2023 can be seen below. The layout can be seen in the following table.
Layout of tax brackets
Tax rate
from...
up to…
10%
$0
$11,000
12%
$11,001
$44,375
22%
$44,726
$95,375
24%
$95,376
$182,100
32%
$182,101
$231,250
35%
$231,251
$578,125
37%
$578,126
And up
If we have income equal to $58,000 per year then $11,000 is taxed by 10%, $33,725 by 12%, and $13,275 by 22%. Marginal tax of this individual is equal to 22%. This is also an example of how progressive taxation works in practice.[11]
Marginal taxes are valuable as they allow governments to generate revenue to fund social services in a way that only affects those who will be the least negatively affected.
Specific
A specific tax rate, or per unit tax rate, is a fixed amount of tax on a specific good or service. It means that the tax rate is not in the form of percentages but in the form of single units which does not depend on the price of goods but on the amount of units. Specific tax is used in tobacco taxation because it has been proved that a high specific tax significantly enlarges the price of cigarettes and it is an effective way to reduce the consumption of goods like cigarettes.[12]
For example, we can have a pack of cigarettes containing 20 cigarettes in California. The California tax rate is $ 0.1435 per cigarette stick and $ 2.87 per pack of 20 cigarettes. [13] So if a pack costs $ 10 or $ 12, the tax rate for both is $ 2.87.
Mixed tax rate
For some goods exists a combination of two tax rates. The commonly known mixed tax rate is specific and flat at once. Usually, it is used for excise taxation or sin taxation used on tobacco, alcohol, or fuel.[14]
For example, we can again have a pack of cigarettes containing 20 cigarettes but in the United Kingdom. In the United Kingdom, the flat tax rate is at 16.5% of the retail price and also £ 6.33 per pack of 20.[15] Let’s say that the price of the pack of cigarettes before tax is £10.00. Then specific tax is £ 6.33 and flat tax rate is £10.00 * 16.5% = £1.65. Then a pack of 20 cigarettes costs £17.98 and the tax expense is £7.98.
Effective
The effective tax rate is the percent of their income that an individual or a corporation pays in taxes.[16]
The term is used in financial reporting to measure the total tax paid as a percentage of the company's accounting income, instead of as a percentage of the taxable income. International Accounting Standard 12,[17] define it as income tax expense or benefit for accounting purposes divided by accounting profit. In Generally Accepted Accounting Principles (United States), the term is used in official guidance only with respect to determining income tax expense for interim (e.g. quarterly) periods by multiplying accounting income by an "estimated annual effective tax rate", the definition of which rate varies depending on the reporting entity's circumstances.[18]
In U.S. income tax law, the term can be used in relation to determining whether a foreign income tax on specific types of income exceeds a certain percentage of U.S. tax that would apply on such income if U.S. tax had been applicable to the income.[19]
An interesting phenomenon connected with effective tax rate is its negativity called negative effective tax rate, which occurs when the tax benefits received by an individual or corporation exceed the taxable income. A negative tax rate can happen because of factors such as tax credits, deductions, or incentives, for example, if a corporation has a pre-tax income of $100k and tax benefits of $110k, then the corporation has a negative effective tax rate. It also works with individuals and in this system government pays individuals.[20]
Inclusive and exclusive
Mathematically, 25% income tax out of $100 income yields the same as 33% sales tax on a $75 purchase.
Tax rates can be presented differently due to differing definitions of tax base, which can make comparisons between tax systems confusing.
Some tax systems include the taxes owed in the tax base (tax-inclusive, Before Tax), while other tax systems do not include taxes owed as part of the base (tax-exclusive, After Tax).[21] In the United States, sales taxes are usually quoted exclusively and income taxes are quoted inclusively. The majority of Europe, value added tax (VAT) countries, include the tax amount when quoting merchandise prices, including Goods and Services Tax (GST) countries, such as Australia and New Zealand. However, those countries still define their tax rates on a tax exclusive basis.
For direct rate comparisons between exclusive and inclusive taxes, one rate must be manipulated to look like the other. When a tax system imposes taxes primarily on income, the tax base is a household's pre-tax income. The appropriate income tax rate is applied to the tax base to calculate taxes owed. Under this formula, taxes to be paid are included in the base on which the tax rate is imposed. If an individual's gross income is $100 and income tax rate is 20%, taxes owed equals $20.
The income tax is taken "off the top", so the individual is left with $80 in after-tax money. Some tax laws impose taxes on a tax base equal to the pre-tax portion of a good's price. Unlike the income tax example above, these taxes do not include actual taxes owed as part of the base. A good priced at $80 with a 25% exclusive sales tax rate yields $20 in taxes owed. Since the sales tax is added "on the top", the individual pays $20 of tax on $80 of pre-tax goods for a total cost of $100. In either case, the tax base of $100 can be treated as two parts—$80 of after-tax spending money and $20 of taxes owed. A 25% exclusive tax rate approximates a 20% inclusive tax rate after adjustment.[21] By including taxes owed in the tax base, an exclusive tax rate can be directly compared to an inclusive tax rate.
Inclusive income tax rate comparison to an exclusive sales tax rate:
Let be the inclusive tax rate (like an income tax). For a 20% rate, then
Let be the exclusive rate (like a sales tax).
Let be the total price of the good (including the tax).
The revenue that would go to the government:
The revenue remaining for the seller of the good:
To convert the inclusive rate to the exclusive rate, divide the money going to the government by the money the company nets:
Therefore, to convert any inclusive tax rate to an exclusive tax rate, divide the inclusive rate by 1 minus that rate.
15% inclusive = 18% exclusive
20% inclusive = 25% exclusive
25% inclusive = 33% exclusive
33% inclusive = 50% exclusive
50% inclusive = 100% exclusive
Tax deductions and tax credits
Tax deductions and tax credits are two ways how to decrease taxpayer’s liability. Individuals can claim credits and deductions when they file their tax returns to lower their taxes, which is connected with marginal and average tax rates.[22]
Deductions
A tax deduction is an amount you can subtract from your taxable income, so you do not have to pay tax on it. By lowering individual taxes, taxable income is also lowered, and the average tax rate decreases too. Their value depends highly on the top marginal tax bracket. For example, if we have an individual whose top marginal tax bracket is 10% then the maximum deductions from $2000 is $200. On the other hand, if we have an individual whose top marginal tax rate is 37% then the maximum deduction from $2000 is $740.[23]
Credits
A tax credit is an amount that can be subtracted directly from an individual tax bill, which means that credits increase an individual's refund or reduce the amount of taxes that an individual owes. Tax credits again lower the average tax rate but tax credits are not influenced by the marginal tax rate. If an individual has $2000 of tax credits then his taxes are directly smaller by $2000. [24]
Optimal
The standard theory of optimal tax rate aims to design the tax to maximize social welfare while collecting a certain level of revenue.[25]
Laffer curve
One of the theories on how to find optimal tax rates is called the Laffer curve (named after economist Arthur Laffer). Laffer curve is a hump-shaped curve, that compares the relationship between tax rate and tax revenue. The Laffer curve tells us that raising tax rates beyond some level may reduce incentives enough to reduce output and tax revenues. There is, then, a tax rate at which tax revenues are maximized.[26]
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer by a governmental organization in order to collectively fund government spending, public expenditures, or as a way to regulate and reduce negative externalities. Tax compliance refers to policy actions and individual behaviour aimed at ensuring that taxpayers are paying the right amount of tax at the right time and securing the correct tax allowances and tax relief. The first known taxation took place in Ancient Egypt around 3000–2800 BC. Taxes consist of direct or indirect taxes and may be paid in money or as its labor equivalent.
The United States has separate federal, state, and local governments with taxes imposed at each of these levels. Taxes are levied on income, payroll, property, sales, capital gains, dividends, imports, estates and gifts, as well as various fees. In 2020, taxes collected by federal, state, and local governments amounted to 25.5% of GDP, below the OECD average of 33.5% of GDP.
A flat tax is a tax with a single rate on the taxable amount, after accounting for any deductions or exemptions from the tax base. It is not necessarily a fully proportional tax. Implementations are often progressive due to exemptions, or regressive in case of a maximum taxable amount. There are various tax systems that are labeled "flat tax" even though they are significantly different. The defining characteristic is the existence of only one tax rate other than zero, as opposed to multiple non-zero rates that vary depending on the amount subject to taxation.
A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, so that the average tax rate exceeds the marginal tax rate.
A progressive tax is a tax in which the tax rate increases as the taxable amount increases. The term progressive refers to the way the tax rate progresses from low to high, with the result that a taxpayer's average tax rate is less than the person's marginal tax rate. The term can be applied to individual taxes or to a tax system as a whole. Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a lower ability to pay, as such taxes shift the incidence increasingly to those with a higher ability-to-pay. The opposite of a progressive tax is a regressive tax, such as a sales tax, where the poor pay a larger proportion of their income compared to the rich
FairTax is a single rate tax proposal which has been proposed as a bill in the United States Congress regularly since 2005 that includes complete dismantling of the Internal Revenue Service. The proposal would eliminate all federal income taxes, payroll taxes, gift taxes, and estate taxes, replacing them with a single consumption tax on retail sales.
A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The amount of the tax is in proportion to the amount subject to taxation. "Proportional" describes a distribution effect on income or expenditure, referring to the way the rate remains consistent, where the marginal tax rate is equal to the average tax rate.
The United States federal government and most state governments impose an income tax. They are determined by applying a tax rate, which may increase as income increases, to taxable income, which is the total income less allowable deductions. Income is broadly defined. Individuals and corporations are directly taxable, and estates and trusts may be taxable on undistributed income. Partnerships are not taxed, but their partners are taxed on their shares of partnership income. Residents and citizens are taxed on worldwide income, while nonresidents are taxed only on income within the jurisdiction. Several types of credits reduce tax, and some types of credits may exceed tax before credits. Most business expenses are deductible. Individuals may deduct certain personal expenses, including home mortgage interest, state taxes, contributions to charity, and some other items. Some deductions are subject to limits, and an Alternative Minimum Tax (AMT) applies at the federal and some state levels.
Income tax in Australia is imposed by the federal government on the taxable income of individuals and corporations. State governments have not imposed income taxes since World War II. On individuals, income tax is levied at progressive rates, and at one of two rates for corporations. The income of partnerships and trusts is not taxed directly, but is taxed on its distribution to the partners or beneficiaries. Income tax is the most important source of revenue for government within the Australian taxation system. Income tax is collected on behalf of the federal government by the Australian Taxation Office.
Income taxes in Canada constitute the majority of the annual revenues of the Government of Canada, and of the governments of the Provinces of Canada. In the fiscal year ending March 31, 2018, the federal government collected just over three times more revenue from personal income taxes than it did from corporate income taxes.
The Fair Tax Act is a bill in the United States Congress for changing tax laws to replace the Internal Revenue Service (IRS) and all federal income taxes, payroll taxes, corporate taxes, capital gains taxes, gift taxes, and estate taxes with a national retail sales tax, to be levied once at the point of purchase on all new goods and services. The proposal also calls for a monthly payment to households of citizens and legal resident aliens as an advance rebate of tax on purchases up to the poverty level. The impact of the FairTax on the distribution of the tax burden is a point of dispute. The plan's supporters argue that it would decrease tax burdens, broaden the tax base, be progressive, increase purchasing power, and tax wealth, while opponents argue that a national sales tax would be inherently regressive and would decrease tax burdens paid by high-income individuals.
This is a list of the maximum potential tax rates around Europe for certain income brackets. It is focused on three types of taxes: corporate, individual, and value added taxes (VAT). It is not intended to represent the true tax burden to either the corporation or the individual in the listed country.
The kiddie tax rule exists in the United States of America and can be found in Internal Revenue Code § 1(g), which "taxes certain unearned income of a child at the parent's marginal rate, no matter whether the child can be claimed as a dependent on the parent's return".
Economic theory evaluates how taxes are able to provide the government with required amount of the financial resources and what are the impacts of this tax system on overall economic efficiency. If tax efficiency needs to be assessed, tax cost must be taken into account, including administrative costs and excessive tax burden also known as the dead weight loss of taxation (DWL). Direct administrative costs include state administration costs for the organisation of the tax system, for the evidence of taxpayers, tax collection and control. Indirect administrative costs can include time spent filling out tax returns or money spent on paying tax advisors.
Taxation in Denmark consists of a comprehensive system of direct and indirect taxes. Ever since the income tax was introduced in Denmark via a fundamental tax reform in 1903, it has been a fundamental pillar in the Danish tax system. Today various personal and corporate income taxes yield around two thirds of the total Danish tax revenues, indirect taxes being responsible for the last third. The state personal income tax is a progressive tax while the municipal income tax is a proportional tax above a certain income level.
In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and 100%, meaning that there is a tax rate between 0% and 100% that maximizes government tax revenue. Different Laffer curves are utilised for the US economy, the EU-14 aggregate economy, and for separate European countries. Generally, they are considered within the realm of long-term economic growth.
Taxation in Norway is levied by the central government, the county municipality and the municipality. In 2012 the total tax revenue was 42.2% of the gross domestic product (GDP). Many direct and indirect taxes exist. The most important taxes – in terms of revenue – are VAT, income tax in the petroleum sector, employers' social security contributions and tax on "ordinary income" for persons. Most direct taxes are collected by the Norwegian Tax Administration and most indirect taxes are collected by the Norwegian Customs and Excise Authorities.
Taxes in Germany are levied at various government levels: the federal government, the 16 states (Länder), and numerous municipalities (Städte/Gemeinden). The structured tax system has evolved significantly, since the reunification of Germany in 1990 and the integration within the European Union, which has influenced tax policies. Today, income tax and Value-Added Tax (VAT) are the primary sources of tax revenue. These taxes reflect Germany's commitment to a balanced approach between direct and indirect taxation, essential for funding extensive social welfare programs and public infrastructure. The modern German tax system accentuate on fairness and efficiency, adapting to global economic trends and domestic fiscal needs.
In general, the United States federal income tax is progressive, as rates of tax generally increase as taxable income increases, at least with respect to individuals that earn wage income. As a group, the lowest earning workers, especially those with dependents, pay no income taxes and may actually receive a small subsidy from the federal government.
Optimal labour income tax is a sub-area of optimal tax theory which refers to the study of designing a tax on individual labour income such that a given economic criterion like social welfare is optimized.
1 2 Bachman, Paul; Haughton, Jonathan; Kotlikoff, Laurence J.; Sanchez-Penalver, Alfonso; Tuerck, David G. (November 2006). "Taxing Sales under the FairTax – What Rate Works?"(PDF). Beacon Hill Institute. Tax Analysts. Archived from the original(PDF) on 2007-06-14. Retrieved 2007-04-24.
↑ N. Gregory Mankiw, Matthew Weinzierl, Danny Yagan. "Optimal Taxation in Theory"(PDF). Harvard University. Retrieved 2024-04-28.{{cite web}}: CS1 maint: multiple names: authors list (link)
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