Question

1. Taylor hopes to earn a $10,000 bonus at year-end. Her expected tax rates are as follows: average tax rate—19%, effective rate—17% and marginal tax rate—22%. Ignoring state and payroll taxes, she will have the following funds available from the bonus to use for a trip to Europe

A.	$10,000
B.	$8,300
C.	$8,100
D.	$7,800
E.	Some other amount

Just one question about this one, why is the correct answer is D, using marginal rate, not the average rate, since average rate is using Total tax liability/ Taxable Income.

Answer 1

Solution)

Correct answer will be Option D that is

Marginal tax = $10000 * 22% = $2200

Funds available for europe trip = $10000 - $2200 = $7800

Here Marginal tax rate will be considered not the average tax rate. As Average tax rate is the taxes paid divided by total income. While marginal tax is to be calculated on additional dollar of income to be earned. Here Taylor is expecting income from bonus which is not yet earned. The concept of marginal rate applies to such incomes which are expected in future and on such incomes, marginal tax rate is calculated as it is the highest tax rate that the tax payer would have paid if his incomes exceed the predefined tax bracket. Actual tax rate at the end of the year would always be less than the marginal tax. Marginal tax is just the estimate of tax liability that can be possible if there is rise in income level. Under progressive system, as the income level increases, the tax rate rises. So the concept of marginal tax is used to estimate the future tax liablity. So here in this case, Taylor is expecting an additional income of $10000, which is not actually earned. This is the case of additional income expected to be earned, so we use marginal rate here to calcultate additional tax liability that may arrise in future. Average tax rate cannot be used as bonus has not been yet earned.