What it means
Most tax systems charge higher rates as income rises. When you earn extra, the extra is taxed at the top rate that applies to you, not at your average rate.
The incremental tax is the difference between the tax you pay with the extra income and the tax you would have paid without it. This matters for decisions.
A manager offered a $10,000 bonus wants to know how much will remain after tax, and a company assessing a new product needs to know how much of the extra profit will go to the tax authority. Ignoring the incremental tax can make an option look more attractive than it really is.
Businesses use the idea in project appraisal. When comparing two options, they compute the tax payable under each and use the difference, rather than the average tax rate on the whole business.
Costs that reduce taxable profit, such as depreciation, lower the incremental tax on a project. The concept also applies to a one-off event, for example the extra tax triggered by selling an asset, or by moving income from one year to another.
Because tax rules vary by country and change often, the calculation must use the rates and rules that apply to the specific situation. Care is needed with thresholds.
Earning an extra dollar can push someone over a line where a benefit is reduced or a higher rate applies, so the incremental tax may be much larger than the headline rate suggests. Checking the full tax calculation is the safest approach.
Timing also plays a part. Income received in a different tax year, or costs brought forward, can change which band the extra money falls into, so planners often model two or three alternatives before deciding.
In practice
Real-world examples.
Example
A consultant is offered extra weekend work worth $8,000. She calculates that her top tax rate means about $2,400 of it goes in tax, leaving $5,600. She decides the extra work is still worthwhile. She also sets aside the tax immediately so that it is not spent by mistake.
Example
A company considers opening a second restaurant expected to earn $200,000 of profit before tax. Its finance team estimates the incremental tax at $50,000, so the extra after-tax profit is $150,000. That figure is used to judge the return on the investment. The board compares it with the cost of the fit-out.
Example
A property owner is thinking of selling a building this year rather than next. His accountant compares the tax in both years and finds that selling now would push income into a higher band. The incremental tax is high enough that he waits. He also asks whether part of the gain can be offset by losses.
Formula
Calculation
Incremental tax = Tax with the additional income - Tax without the additional income
Suppose, for illustration, a tax schedule charges 20% on the first $50,000 of income and 30% on income above $50,000. A person earning $50,000 pays 50,000 x 20% = $10,000.
If the person receives a $10,000 bonus, income rises to $60,000. Tax becomes 10,000 + (10,000 x 30%) = 10,000 + 3,000 = $13,000. The incremental tax is 13,000 - 10,000 = $3,000, so the bonus delivers $7,000 after tax. The rates here are illustrative only.Case study
Seen in the real world.
Pinecrest Engineering is a fictional firm that was offered a one-off contract worth $500,000 with direct costs of $350,000. The owner assumed that profit would be taxed at the firm's average rate.
The accountant explained that the extra $150,000 of profit would fall entirely in the highest band. Using an illustrative top rate of 30%, the incremental tax would be 150,000 x 30% = $45,000, leaving $105,000 after tax.
In this illustrative case the contract was still worth taking, but the owner set aside the full $45,000 for the tax bill instead of the smaller amount first expected. He also asked whether buying equipment in the same year would reduce the tax.
Watch out
Common mistakes.
- Using the average tax rate to estimate the tax on extra income, when the top rate usually applies.
- Ignoring thresholds where extra income reduces a benefit or triggers a higher rate.
- Forgetting that extra costs and allowances can reduce the incremental tax.
Questions
People also ask.
Is incremental tax the same as marginal tax?
They are closely linked: the marginal rate is the percentage on the next dollar, while incremental tax is the dollar amount for a whole extra block of income.
Why does it matter for investment decisions?
Only the extra after-tax profit counts when comparing projects, so the incremental tax must be deducted.
Where can I find the right rates?
Tax authorities publish them, and an accountant can apply them to your specific position.
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