Statutory, Average, and Effective Marginal Tax Rates in the Federal Individual Income Tax: Background and Analysis
Released: 2017-03-16T00:00:00

Introduction

The 115 th Congress states that tax reform is a priority. In recent years, the focus of individual income tax reform has been on reducing the number of statutory tax brackets as part of a base broadening, rate reducin g tax reform. On June 24, 2016, Republicans released a tax reform blueprint, "A Better Way for Tax Reform." This blueprint proposes to consolidate the seven individual income tax brackets under current law into three, and to eliminate the alternative minimum tax (AMT). Tax reform legislation introduced in the 113 th Congress, the Tax Reform Act of 2014 ( H.R. 1 ), also proposed to reduce the number of individual income tax brackets, and repeal the AMT.

Tax reform debates often highlight statutory rates. As is illustrated in this report, however, under the current tax system, statutory rates provide limited information on tax burden. Statutory rates also provide limited information on the economic incentives created by the tax code. When evaluating the equity and economic efficiency (behavioral) effects of tax reform proposals, it is important to look beyond the statutory rate. This report highlights two other tax rate measures: average tax rates and effective marginal tax rates. A taxpayer's average tax rate is the share of total income that is paid in taxes. A taxpayer's effective marginal tax rate is the portion of an additional dollar in earnings that is paid in individual income tax.

The analysis in this report relies on the 2010 Internal Revenue Service (IRS) Statistics of Income (SOI) individual public use file. The individual public use file is a microdata file designed to provide a representative sample of individual income tax filers in a given year. The 2010 file contains 159,791 records designed to provide statistical information for the 142.9 million individual income tax returns filed. The report uses the National Bureau of Economic Research's TAXSIM model to compute tax liability, for the purposes of calculating average tax rates, and effective marginal tax rates.

The focus of this report is on the federal individual income tax. Thus, the tax rates reported here do not include payroll taxes, corporate income taxes, excise taxes, or estate taxes at the federal level. Nor do the tax rates in this report include any state tax liability. The report also does not include any analysis of the effect of transfer payments on effective marginal tax rates.

Not all individuals or households file income tax returns. For example, in 2016, an estimated 83% of "tax units" are expected to file individual income tax returns. The other 17% of tax units are not expected to file returns and have no federal individual income tax liability. Overall, roughly 44% of tax units are expected to have zero or negative income tax liability in 2016. But, many taxpayers that have zero or negative income tax liability have positive payroll tax liability. When both income and payroll taxes are considered, an estimated 18% of tax units are expected to have no income or payroll tax liability in 2016. Since this report relies on data from the IRS SOI public use file, only individuals and households (or tax units) that filed individual income tax returns are included in the analysis.

This report provides an overview of the three types of tax rates commonly considered in tax reform debates: statutory, average, and effective marginal tax rates. The first part of the report defines these concepts, and discusses them in the context of the current federal individual income tax system. The report also includes an analysis of how these tax rates vary across the income distribution. The report also looks at variation in average and effective marginal tax rates across taxpayers with similar levels of income. The report concludes with a discussion of potential implications of the analysis for tax reform.

Statutory, Average, and Effective Marginal Tax Rates

Many tax policy debates focus on the statutory tax rates, or the tax rates applied to taxable income. However, in practice, statutory rates do not necessarily reflect a taxpayer's tax burden. Other measures of tax rates that provide more information on tax burdens include average tax rates and effective marginal tax rates. Average tax rates provide a good measure for comparing the burden of taxes across different taxpayers, while both average and effective marginal tax rates provide information on potential economic distortions caused by taxation.

Defining Tax Rates

The following sections define and describe three common tax rate metrics—statutory, average, and effective marginal rates. Statistics are provided to show how these rates vary for taxpayers at different income levels. A case study is also included to illustrate how statutory, average, and effective marginal tax rates differ for a hypothetical taxpayer.

Statutory Tax Rates

Statutory rates are the tax rates applied to taxable income that falls within a given range or tax bracket. The federal income tax system is designed to be progressive, meaning that higher tax rates are applied at higher income levels. By design, only income that falls within each tax bracket is taxed at that tax rate. For example, if a single filer has taxable income of $10,000 in 2016, that taxpayer would fall in the 15% statutory tax bracket (see Table 1 ). However, only $725 would be taxed at a rate of 15%. For all single filers, income up to $9,275 is taxed at 10%, regardless of the taxpayer's total taxable income.

Most tax returns filed fall into one of the lower tax brackets. Figure 1 classifies returns according to the highest statutory tax rate applied to each return. In 2014, the most recent year for which these data are available, 43% of tax returns filed were either non-taxed or in the 10% tax bracket. These returns contained 9% of all adjusted gross income (AGI) reported on 2014 tax returns. Less than 1% of returns filed in 2014 were in the top tax bracket (39.6% in 2014). These returns, however, accounted for 16% of all AGI.

Another way to look at the distribution of income across statutory tax rates is to look at the amount of taxable income taxed at a particular rate. In 2014, 29% of taxable income at the marginal rate was taxed at the 39.6% rate. However, less than half of the AGI reported on tax returns falling in the 39.6% bracket was taxed at that rate. The remaining income was taxed at lower rates, per the progressive tax structure.

Much of the analysis below examines tax returns filed for 2010. In 2010, the top statutory tax rate was 35% (the 2010 statutory tax rates and brackets are shown in Table A-3 ). The top rate increased to 39.6% following the enactment of the American Taxpayer Relief Act (ATRA; P.L. 112-240 ). As noted above, very few returns filed fell into the top statutory rate bracket (less than 1% in 2014). However, because the top statutory rate is higher now than it was in 2010, the very highest income taxpayers may face higher average and effective marginal tax rates than in 2010. This is important to keep in mind when considering the results of the analysis presented below.

Average Tax Rates

A taxpayer's average tax rate is the percentage of total income that is paid in taxes. For the purposes of this report, the average tax rate is calculated as income tax liability divided by cash income. Since the analysis only looks at individual income taxes, payroll taxes, for example, are excluded.

The progressive nature of the tax system, coupled with a variety of tax preference items (credits, deductions, exclusions, exemptions, etc.), makes it so that for nearly all taxpayers, average tax rates are less than statutory tax rates. Further, many taxpayers, particularly lower-income taxpayers, have negative average tax rates. Refundable tax credits, such as the earned income tax credit (EITC), can lead to negative average tax rates. Taxpayers that have average individual income tax rates that are negative often have positive payroll tax liability.

In 2010, average tax rates were negative for taxpayers in the bottom four income deciles (or the bottom 40% of taxpayers, in terms of income) (see Figure 2 ). The average of average tax rates (or mean average tax rate) for taxpayers in the second income decile is less than the mean average tax rate for taxpayers in the lowest 10% of the income distribution, reflecting the phase-in of certain refundable credits (e.g., the EITC).

As illustrated in Figure 2 , average tax rates tend to rise with income. For taxpayers in the top income decile, or those with incomes above $123,230 in 2010, the mean average tax rate was 13.6%. Average tax rates continue to rise towards the very top of the income distribution. For taxpayers in the top 1% in 2010, or those with incomes above $421,340, the mean average tax rate was 19.8% (see Table B-1 in Appendix A ). While the top statutory rate in 2010 was 35%, average tax rates, even for the highest-income taxpayers, were less.

For the income tax system as a whole, average tax rates have fluctuated over time (see Figure 3 and the related discussion). Between 1960 and 2016, the average tax rate for the U.S. income tax system generally fluctuated between 10% and 16%. Over this time period, the individual income tax system-wide average tax rate was highest in the period immediately preceding the 1986 tax reform, and before the tax cuts of the early 2000s. System-wide average individual income tax rates in the 2000s tended to be lower than the historical average. Beginning in 2009, the system-wide average tax rate began increasing. As of 2016, the system-wide average tax rate approached levels seen before the 1986 tax reform and tax cuts of the early 2000s.

Effective Marginal Tax Rates

Effective marginal tax rates are the amount paid in tax on the next dollar of income. A taxpayer's effective marginal tax rate can affect work and savings decisions. Higher effective marginal tax rates make non-taxable forms of compensation, such as non-taxable fringe benefits, more attractive. When taxes distort taxpayer choices, society's economic resources may not be put to their most productive use.

Effective marginal tax rates are determined by (1) a taxpayer's statutory tax bracket; and (2) interactions with other credits, deductions, exemptions, and special provisions in the tax code. For the purposes of this report, effective marginal tax rates include only changes to individual income taxes paid from increased earnings. The effective marginal tax rates in this report do not include payroll taxes or reductions in benefits from other government programs. Effective marginal tax rates are computed using the National Bureau of Economic Research's (NBER's) full TAXSIM program. In an uncomplicated tax system, the effective marginal rate would equal the statutory rate.

Both phase-ins and phaseouts of various tax provisions affect a taxpayer's effective marginal tax rate. For example, the earned income tax credit (EITC) can increase or decrease a taxpayer's effective marginal tax rate depending on their level of earnings. In 2016, an unmarried tax filer with one child claiming the EITC would get an EITC of $0.34 for each dollar in earnings, up to $9,920. In other words, in the phase-in range, the EITC reduced the effective marginal tax rate by 34%. The EITC is the primary reason why many lower-income taxpayers have negative average and effective marginal tax rates. The phaseout range for an unmarried taxpayer with one child started at $18,190 in 2016. For every dollar earned beyond $18,190, until earnings reached $39,296, the EITC was reduced by $0.1598. In other words, in the phaseout range, the EITC increased the effective marginal tax rate by 15.98%. The effect of the EITC phaseout on marginal tax rates is also illustrated in the shaded text box ("Case Study") below.

Effective marginal tax rates tend to rise with income (see Figure 4 ). On average, taxpayers in the first two income deciles face negative effective marginal tax rates. These taxpayers tend to be in the phase-in range of the EITC. On average, taxpayers in the top income decile faced an effective marginal tax rate of 28.5%. Marginal tax rates tend to be higher than average tax rates, reflecting the progressive nature of the income tax system. Further, phaseouts of tax benefits for higher-income taxpayers contribute to enhanced progressivity, making marginal tax rates higher for certain higher-income taxpayers.

While effective marginal tax rates tend to rise with income, there is substantial variation in the effective marginal tax rates faced by taxpayers within income groups. This observation is discussed further below (see " Tax Rates Vary Across and Within Income Groups ").

The Importance of Weights: Taxpayer-Weighted versus Earnings-Weighted Tax Rate Statistics

When looking at average marginal tax rates for a group of taxpayers, or for the tax system as a whole, it is important to distinguish between averages that are taxpayer-weighted (or return-weighted) as opposed to earnings-weighted. Taxpayer-weighted (or return-weighted) summary statistics average the marginal tax rates paid by each taxpayer. Earnings-weighted summary statistics, by contrast, weight each return by the amount of earnings reported, or the earnings reported at the marginal rate. Recall that most taxpayers file returns in the lower statutory rate brackets, but that a larger share of income is reported in the higher statutory rate brackets. As a result, earnings-weighted measures of average effective marginal tax rates tend to be higher than taxpayer-weighted measures.

Mean average tax rates and mean effective marginal tax rates reported in Figure 2 and Figure 4 above are taxpayer weighted. However, since the taxpayers are grouped according to income, means calculated on a taxpayer-weighted basis should be similar to earnings-weighted means. The mean average and effective marginal tax rates in Figure 3 are earnings-weighted, such that the means better reflect tax rates applied to income in the economy. When considering how marginal tax rates might affect economic output, earnings-weighted marginal tax rates are more appropriate.

Observations Using Individual Taxpayer Data

The following sections take a closer look at average and effective marginal tax rates. Specifically, the analysis highlights the variation in tax rates within income groups, and how family composition affects tax burden. Findings are discussed in greater detail below and include the following:

In 2010, 46% of taxpayers faced an effective marginal tax rate that was different than their statutory rate. Average tax rates tend to rise across income groups. Effective marginal tax rates, however, are higher for many low- and middle-income taxpayers, particularly those with children, than they are for higher-income taxpayers. For low- and middle-income taxpayers, family composition explains much of the variation in average tax rates within income groups. For higher-income taxpayers, controlling for family composition does less to reduce variation in average tax rates.

Statutory Tax Rates Do Not Necessarily Reflect Tax Burden

While statutory tax rates are often highlighted in tax reform debates, statutory tax rates are often not a good measure of either taxes paid on additional earnings or overall tax burden. In 2010, 54% of tax filers had an effective marginal tax rate that was the same as the statutory tax rate. For 29% of taxpayers, the effective marginal tax rate was higher than the statutory rate. For 16% of taxpayers, the effective marginal tax rate was less than the statutory rate. The reasons why effective marginal rates differ from statutory rates are discussed in more detail below.

In 2010, taxpayers in the 28% and 33% brackets were most likely to face effective marginal rates higher than their statutory rate (see Figure 5 ). Many taxpayers with little or no income face negative effective marginal tax rates. Thus, taxpayers in the zero statutory rate bracket are among those most likely to face effective marginal tax rates that are below their statutory rate. Taxpayers in the highest tax bracket, 35% in 2010, are also among the most likely to have an effective marginal rate that is less than the statutory rate.

How Much Do Effective Marginal Rates and Average Rates Differ from Statutory Rates?

For many taxpayers, not only do effective marginal and average tax rates differ from statutory rates, but they differ by a sizable amount. Table 4 provides more information on the magnitude of differences between effective marginal and statutory rates, as well as average and statutory rates.

In the lower tax brackets, when taxpayers faced an effective marginal tax rate above their statutory rate, the difference in the two rates tended to be substantial. In 2010, approximately 41% of taxpayers in the 10% statutory rate bracket had an effective marginal tax rates that was higher than their statutory rate. Approximately 36% of taxpayers in the 10% bracket in 2010 faced effective marginal tax rates that were at least 5 percentage points higher than 10% (faced an effective marginal tax rate of at least 15%), while 20% of taxpayers in the 10% bracket faced effective marginal tax rates that were at least 10 percentage points higher than 10% (faced an effective marginal tax rate of at least 20%).

Taxpayers in higher tax brackets are also more likely to face an effective marginal tax rate that is above their statutory rate. However, the difference between the effective marginal rate and statutory rate tends to be smaller. In 2010, more than half of taxpayers in the 28% bracket, and more than three-quarters of taxpayers in the 33% bracket, faced effective marginal tax rates higher than their statutory rate. Looking at magnitude, nearly 10% of taxpayers in the 28% bracket faced an effective marginal tax rate that was at least 5 percentage points higher than their statutory rate. However, less than 1% of taxpayers in the 28% bracket faced an effective marginal tax rate that was at least 10 percentage points higher than their statutory rate. Very few taxpayers in the 33% bracket faced an effective marginal tax rate that was more than 5 percentage points above their statutory rate.

Average tax rates are at least 5 percentage points less than statutory tax rates for nearly all taxpayers. For many taxpayers, average tax rates are less than statutory rates by 10 percentage points. In the 25% bracket, an estimated 94% of taxpayers had an average tax rate of 15% or less in 2010. In the 35% tax bracket, an estimated 44% of taxpayers had an average tax rate of 25% or less.

Why Do Effective Marginal Tax Rates Differ from Statutory Rates

The U.S. individual income tax system is complex. There are many provisions with phase-ins, phaseouts, floors, or other features that cause effective marginal tax rates to differ from statutory rates. A survey of all provisions that cause effective marginal tax rates to differ from statutory rates is beyond the scope of this report. However, some of the provisions that cause effective marginal tax rates to differ from statutory rates are briefly discussed below.

For lower- and moderate-income families, the earned income tax credit (EITC) and child tax credit (CTC) cause effective marginal tax rates to differ from statutory rates. In 2010, the phase-in rate for the EITC was 40% for a married couple with two children. Thus, for married couples with two children with up to $12,590 in income in 2010, the EITC reduced effective marginal tax rates by 40 percentage points. The EITC phased out at a rate of 21.06% for married couples with two children in 2010, causing effective tax rates to rise by this amount for taxpayers with incomes between $16,450 and $40,363. Thus, the EITC helps explain effective marginal tax rates that are less than statutory rates for many low-income families. The EITC also helps explain effective marginal tax rates that exceed statutory rates for some middle-income families (e.g., married couples with two children in the 15% statutory rate bracket in 2010).

In 2010, the child tax credit affected marginal tax rates for many families with children. Families with earnings of a least $3,000 could receive a refundable credit of up to $1,000 per qualifying child. The credit was phased in at a rate of 15%, therefore reducing effective marginal tax rates by 15 percentage points in the phase-in range. The child tax credit phases out at a rate of 5% for joint filers with incomes above $110,000 ($75,000 for head of household filers). Thus, the CTC decreases effective marginal tax rates for those in the very lowest tax bracket, but increases effective marginal tax rates for those in higher brackets, the 25% statutory bracket in particular. Phaseouts for the EITC and the CTC ensure that the benefits of these provisions are targeted towards the lower and middle portions of the income distribution.

In 2010, the making work pay credit and its associated phaseout increased effective marginal tax rates for many taxpayers in the 25% and 28% tax brackets. The making work pay credit provided a tax credit of up to $400 for single filers, or $800 for married couples filing jointly. The credit was designed to phase out at a rate of 2% of income. The phaseout range for single filers began at $75,000, such that those with income above $95,000 would not receive the credit. For married couples filing joint returns, the phaseout range began at $150,000, and the credit was fully phased out for couples with income above $190,000. The 2% of income phaseout increases effective marginal tax rates for taxpayers in the phaseout range by 2 percentage points.

The alternative minimum tax (AMT) affects effective marginal tax rates for many higher-income taxpayers. Broadly, the AMT has a two-tiered rate structure, with rates set at 26% and 28%. In 2010, the AMT had exemption amounts of $72,450 for joint filers, and $47,450 for non-joint filers. These exemption amounts, however, are phased out above certain income thresholds (in 2010, the phaseout started at $150,000 for joint filers, and $112,500 for single or head of household filers). The exemption amount is phased out at a rate of 25%, making the effective AMT rates 32.5% and 35% in the exemption phaseout range. In 2010, 85% of returns filed in the 33% bracket were returns with alternative minimum tax. The AMT and the associated exemption phaseout explain why most returns filed in the 33% statutory bracket face an effective marginal tax rate of 35% (see Table B-3 ). Of returns filed in the top bracket, or the 35% bracket in 2010, 53% were returns with alternative minimum tax. Thus, for a large proportion of taxpayers in the top statutory tax brackets, the relevant marginal rate is not the statutory rate of the ordinary individual income tax, but instead the effective marginal rate under the AMT.

Most of the 16% of taxpayers with effective marginal tax rates below their statutory rate either do not pay income taxes (are in the 0% bracket) or were in the top tax bracket, the 35% bracket, in 2010. For tax filers with a 0% rate, effective marginal tax rates are the result of phased-in refundable tax credits (e.g., the EITC, child tax credit, or, in 2010, the making work pay tax credit). The AMT, with a top effective rate of 28%, explains why approximately 45% of tax filers in the top statutory tax bracket have a marginal effective tax rate that is less than the statutory rate. Of the less than 1% of taxpayers in 2010 that filed returns that placed them in the top statutory bracket (the 35% bracket), nearly half of those taxpayers face an effective marginal tax rate that is less than the statutory rate, and for most of those taxpayers, the effective marginal tax rate was 30% or less.

Effective marginal tax rates can fluctuate from year to year, as policy changes mean that phase-ins and phaseouts come in and out of the code. For example, in 2010, effective marginal tax rates were affected by the making work pay tax credit. This temporary policy was only available during 2009 and 2010.

Other provisions that increase effective marginal tax rates on higher-income taxpayers are the personal exemption phaseout (PEP) and limitation on itemized deductions (Pease). Notably, these provisions were repealed for 2010, and thus did not affect the effective marginal tax rates summarized in this report. PEP reduces personal exemptions by 2% for each $2,500 that income exceeds phaseout thresholds (in 2016, the phaseout begins at $259,400 for single filers, $311,300 for joint filers). The Pease limitation on itemized deductions is triggered by income, and is not a function of the amount of deductions claimed. For taxpayers above the Pease earnings threshold in a given tax year (same as the PEP threshold noted above for 2016), the Pease limitation increases tax liability by $0.03 for each dollar of earnings. Thus, for tax years when Pease is in effect, the Pease limitation serves to increase effective marginal tax rates by 3%.

Tax Rates Vary Across and Within Income Groups

There is substantial variation in average tax rates within income groups. As a result, some higher-income taxpayers have average tax rates that are less than the average tax rate faced by lower-income taxpayers. For example, taxpayers in the 90 th percentile of the 4 th income decile (cash income between $24,160 and $31,310) had an average tax rate of 5.6% in 2010 (see Figure 6 ). In contrast, taxpayers in the 10 th percentile of the 9 th income decile ($84,970 - $123,230) had an average tax rate of 3.6% in 2010. Various features of the U.S. tax system make it so that some taxpayers with higher income have average tax rates that are less than average rates paid by some lower-income taxpayers. While there is variation in tax rates within income groups, median average tax rates rise across income groups, reflecting the generally progressive nature of the individual income tax system.

The dispersion of tax rates within income groups tends to be widest for taxpayers in the lower-income deciles. Much of this dispersion is due to family composition (discussed more below). That is, lower-income taxpayers with children qualify for refundable credits that reduce average tax rates. As these credits phase-out, there is less dispersion in average tax rates within income groups. Dispersion of average tax rates rises towards the top of the income distribution, after declining in the middle of the income distribution.

There is also a substantial amount of variation in effective marginal tax rates within income deciles (see Figure 7 ). Most taxpayers in the first two income deciles (those with incomes up to $17,610) face negative effective marginal tax rates. Thus, each dollar in earnings results in more than a dollar of after-tax income. Negative effective marginal tax rates are the result of phase-ins of refundable tax credits.

The median effective marginal tax rate holds steady at 15% through the middle of the income distribution (the 4 th through 8 th income deciles). This is consistent with the observations above that (1) approximately two-thirds of taxpayers in the 15% statutory tax bracket face an effective marginal tax rate of 15%; and (2) a plurality of tax returns filed fall in the 15% bracket (a plurality of taxable income is also taxed at the 15% rate).

Some taxpayers in the middle of the income distribution face higher effective marginal tax rates than most taxpayers with higher incomes. These relatively high effective marginal tax rates reflect phaseouts of tax credits.

Family Composition and Tax Rates

Family composition is a key factor explaining much of the variation in average and effective marginal tax rates across the income distribution. Figure 8 illustrates average tax rate by income group for six family types: (1) single, with no dependents; (2) head of household, with one child; (3) head of household, with two children; (4) married, with no dependents; (5) married, with one child; and (6) married, with two children. An estimated 80% of tax filers fell into one of these six family type categories in 2010. In Figure 8 , income deciles are calculated separately for each family type. For example, for single tax filers in 2010, the top income decile starts at $76,010 (see Table B-4 for the income ranges associated with the decile break points for the six family types). For married filers, the top income decile starts at $176,160. Looking at Figure 8 , the distribution of average tax rates for single filers in the top income decile appears roughly similar to the distribution of average tax rates for married filers without children that are in the top 10% of that family type group. The incomes of taxpayers in these two groups, however, are very different.

For low- and moderate-income taxpayers, controlling for family type tends to reduce the variation in average tax rates within income groups. This is less true, however, at the top of the income distribution. In 2010, for the entire sample, tax filers in the 10 th percentile of the top income decile faced an average tax rate of 3.8%. Tax filers in the 90 th percentile of the top income decile faced an average tax rate of 23.3%. Similar differences between the 10 th and 90 th percentiles can be observed in Figure 8 for tax filers in different family type groups in the top income decile. This suggests that for higher-income taxpayers, variation in average tax rates is generally driven by factors other than family composition.

There are several other trends that can be observed in Figure 8 . For head of household taxpayers, average tax rates tend to decrease across the lowest income deciles, before increasing. This reflects the phase-in of family-related tax benefits, and that married taxpayers' incomes tend to be higher. For head of household taxpayers with one child, the median average tax rate is negative across the first six income deciles (or the first eight income deciles for head of household filers with two children). For married tax filers with two children, the median average tax rate in the 10 th decile is higher than the median average tax rate for other married filers. The 10 th income decile also starts at a higher value for married filers with two dependents ($200,890) than for married filers with one dependent ($180,310) or married filers without children ($176,160). For head of household filers, in contrast, the 10 th income decile starts at a lower level for head of household filers with two children ($63,410) as opposed to one child ($72,710) or single filers without children ($76,610).

Evaluating effective marginal tax rates by family type also reveals some broad trends (see Figure 9 ). In the lowest income deciles, there is less variation in effective marginal tax rates for taxpayers without children (either single or married), than for taxpayers with children. For taxpayers with children, there is still substantial variation in effective marginal tax rates within income groups for lower-income deciles. The variation is driven by eligibility for child- and family-related tax benefits.

While average tax rates tend to rise across the income distribution, a different trend appears for effective marginal tax rates for taxpayers with children. Median effective marginal tax rates rise initially, but then tend to decline as incomes increase, before increasing again at the top of the income distribution. This trend is most pronounced for head of household taxpayers with children. Tax credit phaseouts for taxpayers with children cause effective marginal tax rates to be higher for some lower income taxpayers than for higher income counterparts.

In the lower and middle parts of the income distribution, households with children tend to have average tax rates and effective marginal tax rates that differ from households without children. These differences, however, largely disappear at the top of the income distribution, as tax benefits for families with children phase out.

Discussion

The differences between statutory, average, and effective marginal tax rates are important when analyzing tax policy and considering matters of equity and efficiency. Since statutory tax rates provide limited information about tax burdens, questions of equity are often better addressed by using average rates. Since effective marginal tax rates do not equal statutory tax rates for a large proportion of taxpayers, statutory rates provide limited information on the incentives created by the tax code.

Measuring Tax Burden

In the current tax system, statutory tax rates do not provide much information about individual taxpayers' overall tax burden. Average tax rates provide better information about how much taxpayers are paying in income tax. For that reason, analysis of tax policy proposals tends to focus on average tax rates, rather than statutory rates.

In a progressive tax system, average tax rates rise with income. Taxpayers with a greater ability to pay contribute a larger share of their income to taxes, consistent with the notion of vertical equity. A progressive tax system also means that average tax rates tend to be less than statutory tax rates. In 2010, taxpayers in the top 1% of the income distribution had an average tax rate of 19.8%, even though the top statutory rate was 35%.

Summarizing average tax rates for different income groups can also mask variation in average tax rates within income groups. Exemptions, deductions, exclusions, credits, and other features of the tax code mean that, even for taxpayers with similar incomes, average tax rates can vary substantially. Thus, there can be (and are) taxpayers in the 35% statutory rate bracket with average tax rates below taxpayers in the 10% or 15% statutory bracket.

Efforts to address horizontal equity may result in average tax rates that differ for taxpayers with similar levels of income. Horizontal equity suggests that taxpayers who are equal before paying taxes should face a similar tax burden. Horizontal equity also provides that some allowance could be made for family size or composition. In the existing tax system, controlling for differences in family composition reduces, but does not eliminate, variations in tax burden across the income distribution. Further, controlling for family composition tends to expose differences in average tax burdens and effective marginal tax rates between taxpayers with and without children in the lower and middle parts of the income distribution. However, towards the top of the income distribution, average and effective marginal tax rates tend to be more similar across family types. This suggests that how the tax system adjusts for horizontal equity depends where a taxpayer is on the income distribution.

The Tax Code and Taxpayer Behavior

Marginal tax rates can affect taxpayers' work and savings decisions. Increases in marginal tax rates reduce the after-tax returns to work, and tend to cause taxpayers to work less (economists call this the "substitution effect"). With higher tax rates, however, taxpayers may work more to maintain their standard of living (economists call this the "income effect"). Theoretically, the income effect might offset some of the reduction in labor supply following tax increases, or increases in labor supply following tax cuts. Empirical evidence suggests that increases in marginal tax rates reduce labor supply, but that the effects are small. A 2012 survey of the literature found that a policy that reduced after-tax income by 1% would lead to a 0 to 0.2% decrease in hours worked (or a 0 to 0.2% decrease in labor force participation).

There are also questions about the extent to which taxpayers know their marginal tax rate, or understand how and when it changes. Analysis of taxpayer behavior regarding effective marginal tax rates has shown that while some taxpayers do report income to maximize tax credits and avoid high effective marginal tax rates, these patterns are not observed consistently in response to various phase-ins and phaseouts in the tax code.

Broadly, however, there is agreement that taxes distort behavior, and result in taxpayers making decisions that are different than they would have made in the absence of taxes. To the extent that effective marginal tax rates lead to taxpayers changing behavior—whether it be changes in labor supply, changes in the form of compensation received (un-taxed fringe benefits as opposed to wages), or non-reporting of income—effective marginal tax rates are the metric that can be used to measure the efficiency cost of taxation.

The notion that an economically efficient tax system is one with a broad base, allowing for low tax rates, is based on the belief that higher rates impose a larger efficiency cost. As illustrated above, for many taxpayers, effective marginal tax rates differ from statutory rates. A tax system with low statutory rates, but high effective marginal tax rates, could cause more distortions than a system with higher statutory rates, but lower effective marginal rates or effective marginal rates closer to statutory rates.

While marginal tax rates can distort taxpayer behavior, for these tax rates to drive changes in behavior, taxpayers need to understand what they are. In the current system, complexity and a lack of transparency regarding effective marginal tax rates makes it hard for taxpayers to understand the economic incentives created by the tax code. In other words, if taxpayers are not aware that they face a high effective marginal tax rate, then they would not be expected to respond by reducing work hours or changing behavior in some other way.

Considerations for Tax Policy Design

Policymakers engaged in tax reform efforts may seek to make the tax system simpler, fairer, and more efficient. With respect to statutory, average, and effective marginal tax rates, there are several considerations for policymakers designing a tax reform plan that achieves these goals.

First, the number of statutory tax brackets has little impact on complexity. Instead, complexity comes from defining the tax base, or what is treated as taxable income. For example, are employee-provided fringe benefits taxable? The rules created in response to this and similar questions make for a complex tax system. Other sources of complexity include various tax incentives designed to address social and economic issues, including but not limited to tax benefits for families, children, education, housing, and charitable giving. Temporary tax provisions, as well as frequent changes in tax policy, also contribute to a complicated individual income tax system. While there is ample room for simplification in tax reform, consolidating and reducing the number of tax brackets alone does little to achieve this objective.

Second, evaluations of equity should consider differences in tax burdens both across and within income groups. The extent to which the tax system is proportional, progressive, or regressive can be evaluated by looking at the average tax burden across income groups. However, as illustrated in this report, under the current individual income tax system, there is substantial variation in tax burdens within income groups. Policymakers might consider whether this variation is desirable, perhaps because it makes adjustments for family size or other ability-to-pay considerations (in other words, makes adjustments to enhance horizontal equity).

Third, low effective marginal tax rates do more than low statutory rates to promote economic efficiency (that is, they introduce fewer distortions in real economic activity). In an uncomplicated tax system, effective marginal rates are equal to statutory rates. Under the current system, however, a taxpayer's effective marginal tax rate often differs from the statutory rate. Phaseouts of various tax benefits, limiting the benefits of certain provisions to low- and moderate-income taxpayers, results in marginal tax rates that exceed the statutory rate. Thus, there is a tradeoff between equity and efficiency objectives. If a reformed tax system includes provisions to reduce the tax burden for low- and moderate-income taxpayers without extending those benefits to higher-income taxpayers, policymakers might consider the marginal tax rate effects of phaseouts associated with those policies.

Finally, it is helpful to remember the primary goal of taxation: raising revenue. That said, the individual income tax can, and often is, used to achieve social, regulatory, and other policy objectives. Doing so, however, introduces complexity, and can involve trade-offs between other objectives. For example, refundable tax credits enhance the progressivity of the tax system, increasing after-tax income for those with little or no tax liability. With a fixed revenue target, refundable tax credits might be compensated for elsewhere in the system with higher rates. These higher rates could distort taxpayer behavior, possibly creating a disincentive to work. The need to raise revenues can constrain the extent to which the tax code can be used to achieve other policy objectives.

Appendix A. The 2010 Public Use File and the Individual Income Tax System in 2010

Much of the analysis in this report relies on data from the IRS SOI public use file. The most recent public use file available at the time this report was written was for tax year 2010. This appendix provides additional information on the IRS SOI public use file and the individual income tax system in 2010, highlighting differences between the system in 2010 and the current system.

The 2010 IRS SOI public use file contains 159,791 records designed to provide statistical information for the 142.9 million individual income tax returns filed in 2010. The focus of this report is on the 2010 tax year. Thus, records pertaining to previous tax years (5,117 records in total) are dropped, leaving a file that represents 138.3 million returns. Information on the filing status of taxpayers filing 2010 returns in the IRS SOI public use file can be found in Table A-1 . An estimated 45.1% of returns filed for 2010 were for single taxpayers. An estimated 38.0% were for married filers filing joint returns. The remainder of returns were filed using the married filing separately or head of household filing status.

Table A-2 provides information on returns filed, categorized according to adjusted gross income (AGI). In 2010, 57.6% of returns filed reported an AGI of less than $40,000, while 87.1% of returns filed reported an AGI for less than $100,000.

Statutory tax rates applied in 2010 appear in Table 1 . In 2010, the top statutory tax rate was 35%. In 2010, less than 1% of tax returns filed had income taxed at the top marginal statutory rate (see Figure A-1 ). These returns accounted for 14% of AGI in 2010. Just over 27% of taxable income was taxes at the 35% rate in 2010. The proportion of taxpayers taxed at the top rate and the share of income taxed at the top rate were similar between 2010 and 2014. However, the top rate increased from 35% to 39.6% between these two years. Overall, given the current statutory rate bracket structure, changes in the top statutory rate would affect few taxpayers, but would affect a larger proportion of income.

There are several features of the 2010 tax code that differ from the tax code in 2016 that affect effective marginal tax rates. For example, the making work pay tax credit was available in 2010, providing up to $800 for joint returns, or $400 for single returns. This credit phased out for higher-income taxpayers. Some taxpayers may have claimed the first-time homebuyer tax credit for property purchased in 2010. Like the making work pay tax credit, this provision phased out for higher-income taxpayers. Both of these provisions generated increased effective marginal tax rates for taxpayers in the phaseout range.

Under current law, the Pease itemized deduction limit and the personal exemption phaseout (PEP) raise effective marginal tax rates for higher-income taxpayers. These provisions were not in effect in 2010.

Appendix B. Supplemental Tables and Data

This appendix contains charts and figures to supplement the analysis presented in the body of the report. Table B-1 contains data underlying Figure 2 and Figure 6 in the body of the report. Table B-2 contains data underlying Figure 4 and Figure 7 in the body of the report. Table B-3 contains data underlying Figure 5 , as well as additional information on the distribution of effective marginal tax rates within statutory tax brackets.

Table B-4 contains information on the income levels in the income deciles for each of the family types included in Figure 8 and Figure 9 in the body of the report. The final two figures presented in this appendix, Figure B-1 and Figure B-2 , reproduce Figure 8 and Figure 9 using the income decile break points for the entire sample of taxpayers (as opposed to break points determined for each individual family type).