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Explain the difference between marginal and average tax rates, and identify which of these rates is...

Explain the difference between marginal and average tax rates, and identify which of these rates is used in capital budgeting and why.

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Answer #1

Marginal tax rate is the rate of tax applicable on the incremental income or the additional income of the tax payer. On the other hand, average tax rate is the effective rate of tax on the total taxable income which includes incremental income also. Average tax rate can be calculated by dividing the amount of tax for the year, by the taxable income for that year.

Capital budgeting needs evaluation of net incremental income from the project. Incremental income of the project will be taxed at the marginal rate. Hence marginal tax rate is used for capital budgeting.

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