Average, Marginal, and Graduated Tax Rates: A Primer

• 7 min read

It’s Friday everyone!

There has been an influx of vaccine in Manitoba this week (and what appears to be on an ongoing basis throughout July, fortunately) and I was able to walk up and grab my second dose on Wednesday. As of the time of writing, there are some side effects making their way through my body, but nothing in comparison to what some of my friends are going through. I’ve had it easy.

The influx of vaccine has provided the largest amount of hope Manitoba has seen in the last 16 months. Right now, it feels like summer may actually happen, and the hope of a fun summer is everything.

Wherever you find yourself, I hope you’re seeing the same hope on the horizon. It feels like this pandemic may be losing some of its grip on us right now.

This week, I want to briefly discuss marginal, average, and graduated tax rates. I think, when most people say “tax rate”, they mean “average tax rate”, even though marginal and graduated tax rates are much more applicable to any tax planning decision.

What is a Marginal Tax Rate?

A definition for “marginal tax rates” can be summed up in the following:

A marginal tax rate is the tax rate on the next dollar of income earned.

In theory, if you make $100,000, the marginal tax rate is the tax rate paid on your $100,001st dollar of income.

But what do people define as tax?

Is it the total amount payable, which includes unpaid portions of CPP, federal tax, and provincial tax? What if it includes paying back Old Age Security benefits? Does it include the new Climate Action Initiative in provinces with different carbon tax programs?

And what do people define as income?

Total income, which includes all sources of income? How about net income for tax purposes, which takes into account moving expenses, childcare expenses, and RRSP contributions? If not those, then taxable income, which is the actual amount of income which tax is calculated on?

I like to think of marginal tax rates as the increase to your “Total Payable” (Line 43500) amount under Step 7 on the T1 tax return in Canada. This amount includes the following:

  • Net federal tax (your basic federal tax less your non-refundable tax credits)
  • CPP contributions payable (generally paid by self-employed individuals)
  • EI premiums payable (again paid by self-employed individuals if that individual has opted into paying employment insurance)
  • Social benefits repayment (which includes the repayable portion of employment insurance and Old Age Security)
  • Provincial/territorial tax

For most working individuals, Step 7 is made up of net federal tax and provincial or territorial tax.

So what is my general definition of marginal tax rates then? Your marginal tax rate, in my opinion, is:

Marginal tax rate = Increase to total payable for each additional dollar earned

Once you have this marginal tax rate calculated, you’ll have the necessary information to make a tax decision on a go-forward basis.

Say it’s August and you’re considering starting up a side hustle business to work alongside your day job. Your day job has resulted in income that has moved you up through some of the graduated tax brackets (more below) and you want to know how much tax will be owing on additional income the business. Using your marginal tax rate, you can better determine the impact of tax on any decisions you’ll make on a go-forward basis.

What is an Average Tax Rate?

Once you know your total payable Line 43500 amount, calculating an average tax rate is nice and easy. To calculate an average tax rate, it’s as simple as taking your total payable and dividing it by your total income.

I do, however, think it’s wiser to calculate your average tax rate on your taxable income. Again, taxable income is the amount of income you are taxed on, after deductions such as union dues, RRSP contributions, childcare expenses, and moving expenses.

The reason I tend to use taxable income when considering average tax rates — and marginal tax rates, for that matter — is because you have more control over taxable income than total income. You control whether you contribute to the RRSP or whether you move to start a new job. Therefore, these deductions provide you a little control over your average tax rate and should be considered when making a tax decision.

Average tax rates are useful for tracking the performance of your tax decisions over long periods of time, especially in your retirement years. For instance, an ideal tax planning situation would involve paying about the same (or every so slightly more, due to tax inflation) average tax rate over a 10-year period. If there is a blip upwards in your average tax rate somewhere, it either needs to be followed by a momentary valley or you’re potentially looking at a poorly planned tax situation. (Obviously this isn’t always the case — there are times where large amounts of income come in that can’t be entirely planned for, but usually there are ways to smooth out income over time.)

And What are Graduated Tax Rates Then?

Canada has a progressive tax system, in that the more income you earn, the higher the rate of tax you will pay. To achieve this, Canada’s federal tax system is broken into the following brackets (as of 2021):

  • 15% on the first $49,020 of taxable income, plus
  • 20.5% on the next $49,020 of taxable income (on the portion of taxable income over 49,020 up to $98,040), plus
  • 26% on the next $53,939 of taxable income (on the portion of taxable income over $98,040 up to $151,978), plus
  • 29% on the next $64,533 of taxable income (on the portion of taxable income over 151,978 up to $216,511), plus
  • 33% of taxable income over $216,511

This was taken straight from the Canada Revenue Agency’s website and is a little wordy, but I think it does the trick.

The issue I have with these tax brackets though: There’s actually a sixth tax bracket that needs to be included in nearly all tax calculations.

Canada has a system of non-refundable tax credits which aim to reduce tax in the first tax bracket. “Non-refundable credits” are credits that reduce tax and which are not refunded to you if you do not pay tax. There’s quite the list of non-refundable credits — too many to name here — but they are provided to all Canadian resident taxpayers.

If you’ll note the first tax bracket above, there is a 15% tax on the first $49,020 of taxable income. Non-refundable credits are credited to you at 15% — perfectly reducing tax you pay in that first tax bracket.

All Canadian resident taxpayers receive a Basic Personal Amount — a non-refundable tax credit designed to provide every Canadian taxpayer with an amount of about $13,000 (I say “about” because taxpayers with high income have an amount below $13,000 and average taxpayers have an amount just below $14,000). This amount provides $13,000 tax-free to all Canadian taxpayers to help pay for clothing, shelter, and groceries.

So in reality, this provides a sixth tax bracket to the list above:

  • 0% on the first $13,808 of taxable income, plus

To give a very simplistic tax calculation rundown through the tax brackets.

  • $175,000 of taxable income
  • 0% on the first $13,808 of taxable income — $0.00
  • 15% on the portion of taxable income over $13,808 up to $49,020 of taxable income — $5,281.80
  • 20.5% on the portion of taxable income over 49,020 up to $98,040 — $10,049.10
  • 26% on the portion of taxable income over $98,040 up to $151,978 — $14,023.88
  • 29% on the portion of taxable income over 151,978 up to $175,000 — $6,676.38
  • Total federal tax payable — $36,031.16

This is the federal tax calculation — the same calculation will be done on the provincial tax brackets, increasing the amount of tax further. I guarantee the actual amount of federal tax will be lower than $36,031.16 due to additional non-refundable tax credits like the Canada Employment Amount, amounts for CPP and EI paid, and other amounts, but you get the drift.

Wrap Up

So the real question becomes:

When should I use marginal and average tax rates in my tax planning and when should I use graduated tax rates?

I generally have the conversation about graduated tax rates most often when discussing whether to contribute to an RRSP. If you earn $55,000 of income, for instance, you will be paying an increased tax rate on about $6,000 income. To defer the tax to a future year where you may be in a lower tax bracket, you could contribute $6,000 to an RRSP and pay only that 15% tax rate shown above.

An example of average tax rate usage lies in the discussion on whether to incorporate your business or to continue as a sole proprietor. Average tax rates are useful to determine if there is a long-term tax advantage to deferring income inside a corporation or if using an RRSP will be sufficient for your business needs.

And as I described above, marginal tax rates are best used when making go-forward decisions. If you want to undertake an investment and want to determine how that investment will be taxed on top of your current salary and other income, understanding your marginal tax rate will help you determine whether or not to undertake the investment. (Hint: You should undertake the investment. Tax is almost never a defining factor to reject an investment.)

Tax is a pretty complex beast, no matter which jurisdiction you look at. The world of non-refundable tax credits runs deep, as do the boutique tax credits available inside most Canadian provinces (one day I will discuss all the individual Manitoba tax credits and I will blow your mind).

But the concept of marginal tax rates, graduated tax rates, and average tax rates are reasonably understandable and broadly applicable across nearly all tax planning discussions.

If you’re like me and the above discussion on taxation rates didn’t bore you to death, then thank you for reading this week! If you feel so inclined, please share with your friends and family so I can get this newsletter off the ground.

And if I bored you to death, well — there’s likely more where this came from. I’m not going to lie.

I wish you and your family and a wonderful weekend, a Happy Father’s Day, and a healthy and prosperous summer week ahead.’


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