Chapter 6, Problem 6.1LO

To determine

:

The difference between average and marginal tax rates.

Concept Introduction:

Tax rate:It is the percentage of taxable income that an income earner pays to the government as tax.

Progressive taxation system:It is a taxation system in which the tax rate rises with an increase in the taxable income.

Regressive taxation system:It is a taxation system in which the tax rate falls with an increase in the taxable income.

Proportional taxation system:It is a taxation system in which the tax rate is a fixed percentage of the taxable income.

Explanation of Solution

Answer:

The average tax rate is the fraction of total taxable income that an individual or a company pays as tax.

ATR denotes the average tax rate, T denotes total tax paid and Y denotes the total taxable income.

The average tax rate is calculated as follows:

  $ATR=\frac{T}{Y}$

The marginal tax rate is the tax rate applicable to the additional dollar of taxable income earned by an individual or firm.

MTR denotes the marginal tax rate, ? T denotes the additional tax paid and ? Y denotes the additional taxable income.

The marginal tax rate is calculated as follows:

  $MTR=\frac{\Delta T}{\Delta Y}$

Taxable incomes are divided into slabs in both progressive and regressive taxation systems.

In a progressive taxation system, lower slabs attract lower marginal tax rates and higher slabs attract higher marginal tax rates.

Therefore, as taxable incomes of individuals and firms rise, the marginal tax rate also rises. Thus, in such a system, the marginal tax rate is always greater than the average tax rate.

In a regressive taxation system, lower slabs attract higher marginal tax rates and higher slabs attract lower marginal tax rates.

Therefore, as taxable incomes of individuals and firms rise, the marginal tax rate falls. Thus, in such a system, the marginal tax rate is always lower than the average tax rate.

In a proportional taxation system, there are no income slabs. The marginal tax rate remains the same, irrespective of the level of taxable incomes of individuals and firms.

Therefore, the marginal tax rate is a fixed percentage of the total taxable income. Thus, in such a system, the marginal tax rate is always equal to the average tax rate.