Effective vs Marginal Tax Rate: Which One Should Freelancers Use?

In countries with progressive tax, income is taxed in bands. The first slice is taxed at a low rate, the next at a higher one, and so on. That creates two different rates, and mixing them up is one of the most common planning mistakes.

The two rates

• Marginal rate: the rate on your next unit of income, meaning your top band.
• Effective rate: total tax ÷ total income, the average across all bands.

An illustration

Take a simple, made-up system: 0% on the first 10,000, 20% on income from 10,000 to 50,000, and 40% above 50,000. On 60,000 of taxable income, tax is 0 + 8,000 + 4,000 = 12,000. The marginal rate is 40%, but the effective rate is 12,000 ÷ 60,000 = 20%.

Setting aside 40% of every payment would lock away twice what you need.

Which to use when

• Setting money aside for tax: use your effective rate, plus any social contributions.
• Deciding whether extra work or a deduction is worth it: use your marginal rate, because that's what applies to the change.

Tip: Last year's return is the easiest way to find your effective rate: divide the total income tax by your taxable income.