Guide to marginal and effective tax rates

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This article was first published in the November/December 2018 edition of Accounting and Business magazine.

Tax rates are used by authorities to determine mainly the amount of tax payable/tax credits. Two rates frequently used are the marginal tax rate (MR) and the effective tax rate (ER). The MR is the tax rate on the last dollar of income subject to tax, whereas the ER is the average tax rate¹ at which income is taxed. The tax rates for resident individuals are on a progressive basis and hence the MR for an individual will rise as income increases.

The Singapore tax rate structure for resident individuals has 11 tax brackets ranging from the lowest of 0% to the highest of 22%, as shown in table 1.

MR versus ER

For a given level of chargeable income (CI), the ER is lower² than the MR. Furthermore, two resident individuals with the same MR may still end up with different ER.

If a resident individual has a CI of S$50,000, the first S$20,000 is taxed at 0%, the next S$10,000 at 2%, the next S$10,000 at 3.5% and lastly the balance of S$10,000 at 7%, resulting in a total tax payable of S$1,250. In this case, the MR of this resident individual is 7% as their last dollar of CI is taxed at 7%. However, their ER is 2.5%³, ie the average tax payable per dollar of CI is 2.5 cents. Another resident individual with a CI of S$55,000 will have an ER of 2.9%⁴, even though their MR is 7%.

Purpose

In this article, we illustrate how the level of tax benefits can be quantified and explained using the concept of MR (see tables 2 and 3), as well as how resident individuals may employ the concept of MR in certain situations to help them decide the most appropriate timing and/or the optimal amount in claiming tax deduction in respect of the following items/personal reliefs (‘specified items’):

1. discretionary tax deductible expenditures for, for example, approved donations
2. discretionary contributions to the supplementary retirement scheme (SRS⁵); voluntary contributions to medisave account, voluntary Central Provident Fund (CPF) cash top-up under the CPF Retirement Sum Topping-Up Scheme and voluntary CPF contributions for a self-employed individual^6;
3. capital allowance⁷ claim
4. certain personal reliefs – for example, parent relief/handicapped parent relief⁸, qualifying child relief and handicapped sibling⁹ relief –may be shared with other claimants based on an agreed apportionment.

Tax benefits

Benefits at constant MR  

Table 2 shows the tax computations of three resident individuals before and after the personal relief deduction for an SRS contribution of S$1,000. Although all three taxpayers contribute the same amount (S$1,000) to SRS, they each have different amounts of tax benefits due to their different MRs.

Amy, whose MR is at 22%, has the highest tax benefit of S$220¹⁰ (S$1,000 x MR of 22%). Bob, whose MR is at 2%, has a tax benefit of S$20¹¹ (S$1,000 x MR of 2%), whereas Don, whose MR is at 0%, has S$0 tax benefit (S$1,000 x MR of 0%). Taxwise, it does not make sense for Don to make any SRS contribution in the year.

Notice the MRs in table 2 remain the same for each of the three resident individuals before and after their respective SRS contribution. The higher the MR, the higher the tax benefits which are at their maximum when the MR is at 22%, as in the case of Amy.

The ER is not relevant in this case in determining the amount of tax benefits that will accrue to each of the individuals arising from their decision whether to make an SRS contribution.

Benefits at existing MR but falling into the next lower income tax bracket

Suppose Eve’s CI is S$85,000 before making a one-time SRS contribution of S$6,000. Her MR is 11.5% before making the contribution and will fall to 7% after.

Her tax payable will be reduced by S$645 with the SRS contribution as shown in table 3. Eve’s tax benefits of S$645 arising from her SRS contribution of S$6,000 can alternatively be computed using the concept of MR as follows: (S$5,000 x 11.5%) + (S$1,000 x 7%).

Again, the ER is not relevant here in determining the amount of tax benefits arising from Eve’s SRS contribution.

Enlarged tax deduction

When more tax deduction is given than the actual amount incurred, the amount of tax benefits will be multiplied by an enlarged factor. For example, as an approved donation is given two-and-a-half times the deduction of the actual amount donated, the tax benefit will be 2.5 times more. Assuming an MR of 15%, S$1,000 of approved donation will reduce tax payable by S$375 (S$1,000 x 2.5 x 15%) instead of S$150¹². Hence, the cash outlay of making an approved donation will now be S$625, net of tax.

Restricted tax deduction

The amount of tax benefits will also depend on whether one can get full tax deduction for any of the specified items above.  

Suppose that, in table 3, Eve’s personal tax relief totals S$75,000 prior to making an SRS contribution of S$6,000. As there is a cap of S$80,000 on personal relief deductions with effect from year of assessment 2018, Eve will only be allowed restricted tax deduction of S$5,000 for her SRS contribution. The remaining S$1,000 SRS contribution will not bring about any tax benefits. Hence, Eve should limit her SRS contribution to only S$5,000 and defer the remaining S$1,000 to the following year, assuming she is in a taxable position.

Where future MR is expected to change

If an individual’s MR is expected to change in the following year, they may need to consider whether it is more optimal to defer or bring forward the tax deduction for the specified items. For example, if the individual is planning to retire in June of the following year and expects their MR to be lower because of a lower CI, they should claim tax deduction for the specified items in the current year when their MR is higher.  

However, if they expect their MR to increase (for example, due to higher income) in the following year, they should consider deferring tax deduction for these specified items if possible to the subsequent year¹³ when their MR is higher, so as to realise a higher amount of tax benefit.

Conclusion

Tax deduction at higher MR will accord higher tax benefits. We have illustrated how the understanding of the MR concept will help tax-resident individuals in certain situations decide the most appropriate timing and/or optimal amount of tax deduction in respect of the specified items mentioned in this article, in order to achieve greater tax benefits.

Khoo Teng Aun, associate professor of accounting, Singapore Management University

Clement Tan Kai Guan, associate professor (practice) of accounting, Nanyang Technological University

1 Total tax payable/total chargeable income. In practice, the calculation of ER may vary depending on what is used as a measure of ‘total income’. 2 Except in the first income tax bracket where the tax rate is 0%. 3 S$1,250/S$50,000. 4 S$1,600/S$55,000. 5 SRS contribution can be made by a tax resident on an annual basis and is given tax deduction in the form of a personal relief. 6 Tax relief is given only to Singapore citizens or permanent residents who make voluntary contributions to their CPF account, including contributions to MediSave account. 7 Available to a self-employed individual who derives a section 10(1)(a) source income and satisfies the conditions to qualify for capital allowance claim. 8 May be claimed by those who support their parents, grandparents, parents-in-law or grandparents-in-law up to a maximum of two dependants. 9 Includes siblings-in-law. 10 S$44,770-S$44,550. 11 S$200-S$180. 12 S$1,000 x 15%.13 We ignore the time value of money as we consider it insignificant since the period involved is a year and we are in a relatively low interest rate environment.