Public Goods, Externalities, and the Role of Government ‹ 161progressive, regressive, and proportional taxes, and use the marginal and average concepts
again in this new context.
Marginal and Average Tax Rates
Marginal tax rateis the rate paid on the last dollar earned. This is found by taking the ratio
of the change in taxes divided by the change in income:
Marginal tax rate =(Dtaxes due)/(Dtaxable income)Example:
If my income rises by $100 and the taxes that I owe the government rise by $25,
the marginal tax rate is 25 percent on those additional $100.Average tax rateis the proportion of total income paid to taxes. It is calculated by
dividing the total taxes owed by the total taxable income:
Average tax rate =(Total taxes due)/(Total taxable income)Example:
If my monthly taxable income is $1,000 and $200 is deducted for taxes, my average
tax rate is 20 percent.Progressive, Regressive, and Proportional Taxes
The way in which a redistributive tax works depends upon how the average tax rate changes
as income changes.
A Progressive Tax
A progressive taxexists if as income increases, the average tax rates increase. The federal
income tax works this way. If your household income is above a certain minimum level but
below a certain maximum level (a tax bracket), you might pay an average of 20 percent of
your income in taxes. If your household income rises above that upper limit and falls into
a higher tax bracket, your average tax rate might increase to 24 percent. A tax bracketis a
range of income on which is applied a given marginal tax rate. This structure is designed so
that the lowest incomes pay taxes at a much lower rate than the highest incomes.
A Regressive Tax
A tax is regressiveif the average tax rate falls as income rises. A sales tax on consumption
is a good example of a regressive tax.
Example:
Two unmarried consumers with no children both shop at the grocery store in a
state with a 5 percent sales tax. One consumer, Bill, earns a modest $20,000
and spends $10,000 annually on food at the store. He pays $500 in sales tax.
A second consumer, Mary, earns $200,000, or 10 times as much as Bill. Can
we expect her to spend 10 times as much on food? Doubtful. Let’s be generous
and say that Mary spends $20,000 annually on food at the grocery store and
pays $1,000 in sales tax. Everyone in the state pays 5 percent sales tax on his or
her consumption spending, but as a percentage of income, Bill pays a much
higher average tax rate.Bill’s average tax rate =$500/$20,000 =2.5%Mary’s average tax rate =$1,000/$200,000 = .5%