What is marginal tax?

In Australia we have a Marginal income tax system where the annual taxable income of an individual is aggregated and separated into increasing Brackets of income; and each bracket is taxed at increasing rates as income falls into higher brackets.  Marginal tax systems are designed to raise tax revenue from those having the means to pay; that is, the greater the entity’s income the more tax it will pay as a proportion of that income.  Some countries have flat rate of tax but different rates for different sources of income (like 20% tax on rental income or 10% tax on dividends etc).  The marginal tax rates that applied to the Financial Year Ended 30 June 2010 for Australia are as follows:-

  • Nil:  $0 - $6,000
  • 15%:  $6,001 - $35,000
  • 30%:  $35,001 - $80,000
  • 38%:  $80,001 - $180,000
  • 45%:  $180,001 +

For example an individual earns a salary of $1,000 per week, or $52,000 per year and has no tax deductions would pay:-

  1. (52,000 – 35,000) x 30% = $5,100
  2. (35,000 – 6,000) x 15% = $4,350
  3. 5,100 + 4,350 = $9,450 = 18% of $52,000

In another example an individual earning $200,000 per year would pay:-

  1. (200,000 – 180,000) x 45% = $9,000
  2. (180,000 – 80,000) x 38% = $38,000
  3. (80,000 – 35,000) x 30% = $13,500
  4. (35,000 – 6,000) x 15% = $4,350
  5. 9,100 + 38,000 + 13,500 + 4,350 = $64,850 = 32% of $200,000

Also in Australia, the government raises funds for public healthcare through a tax on an individual’s income known as the Medicare Levy, which is a flat rate of 2% of the individual’s total taxable income for the year.  The medicare levy increases to 4% for high income earners that don’t have private hospital insurance.  For example; our individual earning $52,000 would pay an additional $1,040 (52,000 x 2%) as medicare levy; and the example earning $200,000 would pay an additional $8,000 if they didn’t have private hospital cover (200,000 x 4%).  The medicare levy is deducted from your pay along with your Pay-As-You-Go tax withheld from your salary or wages.

How do tax deductions work?

Many people hold a misconception that whatever you spend on a tax deduction will be returned to them as a refund when they do their tax return; we've all heard the saying "you'll get it all back in your tax".  This is not true and has never been true in Australia and I believe it stems from salespeople trying to convince people to buy tax deductible items.  All you are entitled to get back from your tax return is the amount of tax you have already paid on the income that was used to fund the expense on the tax deduction.

Tax deductions are subtracted from your Assessable Income before your final tax is worked out on your Taxable Income.  The amount of tax you will save when claiming a tax deduction will depend on your marginal tax bracket for the claim year.  If you are in the 15% tax bracket you will save only $15 per $100 you spend and if in the 45% bracket you will save $45 per $100 spent.

If your tax deductions bring your taxable income below the next marginal tax bracket, the tax savings will be a combination of the two tax brackets.  For example; if your assessable income was $80,500 and your tax deductions were $1,000; your tax saving will be $500 x 38% = $190 and $500 x 30% = $150 which comes to a total of $340 or an average 34% tax saving [this example assumes the 2010 marginal tax rates of $80,001-$180,000 = 38% and $35,001-$80,000 = 30% and does not include Medicare].

What are tax offsets?

Tax Offsets are the way our government uses the tax system as an instrument of social policy to provide for taxation relief for certain prescribed classes of taxpayer.  Offsets may come and go depending on the socio-political climate; for example the former Family Tax Offset was a means of providing social welfare to low and middle income families through the tax system and the Senior Australians Tax Offset is designed to relieve the tax burden on retirees who saved for their retirement.

Tax offsets are subtracted from the taxpayer’s gross tax to arrive at their net tax assessment.  When the applciation of tax offsets generates a negatve net tax assessment, the balance may or may not be refunded to the taxpayer depending on the type of offset; refundable or non-refundable:-

Non-refundable – the offset can only reduce the tax obligation to zero and the balance of the offset is not refunded.  Examples inlcude the Low Income Tax Offset which is designed to amelierate the tax burden on our lowest income earners or the Spouse Offset which is designed to releive the burden on single income couples without any kids entitled to family tax benefit.

Refundable – refundable offests are meant to refund a portion of certain costs incured by the taxpayer or taxes paid by other entities.  When refundable offsets reduce the taxpayer's net tax to below zero, the balance is refunded as part of their tax assessment.  Examples include Imputation Credits which are a refund of taxes already paid the the company paying the dividend or Private Health Insurance Offset whcih refunds a portion of the taxpayer's health insurance premiums paid through the year.

The actual tax refundable or payable is be the taxpayer's net tax less any income taxes actaully paid, such as pay you go tax withheld or instalments paid during the year etc.