Tax comes in many different forms – VAT, capital gains tax, inheritance tax, income tax – and different people pay it at different rates. Typically, the more you earn, the more tax you pay; this is what’s known as a “progressive” tax system.
Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. For example, take income tax rates in the UK. As of the tax year that started in April 2021, there is no income tax due on any money you earn up to £12,570. Then, for every pound you earn above that, you will pay 20%. This is your marginal tax rate.
Then once you earn more than £50,270, your marginal income tax rate goes up to 40%. Once you earn over £150,000, it goes up again, to 45%, so for every pound you earn, you keep 55p and 45p goes to the tax office.
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So far, so straightforward – as you earn more, you pay more tax.
However, years of government tinkering designed to raise more money without upsetting too many voters has left us with a very complicated tax and benefits system. As a result, different taxes kick in at different income levels, while certain benefits are clawed back. These interactions sometimes create huge spikes in marginal tax rates for certain groups.
For example, child benefit is clawed back once one person in a household starts earning above £50,000 a year. This could result in a marginal tax rate of more than 58% on earnings above £50,000 – or even more in the case of families with more than one child.
Similarly, once someone earns more than £100,000 a year, their personal allowance – the amount on which they pay 0% income tax – starts to be clawed back. This creates a marginal tax rate of 60%.
Taxing marginal income at these levels seems counterproductive. However, a cleaner, more transparent tax system might make it clear just how much we have to pay. And governments tend to lack the political nerve to embrace that sort of transparency.
To learn more about tax and tax efficiency, subscribe to MoneyWeek magazine.
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