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 tax rate rises with increase in taxable income.

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

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

Explanation of Solution

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

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

The average tax rate is calculated as follows:

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

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

The marginal tax rate is calculated as follows:

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, 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, 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.