Understanding marginal and average tax rates Consider the economy of Pomistan, w
ID: 1206651 • Letter: U
Question
Understanding marginal and average tax rates
Consider the economy of Pomistan, where citizens consume only apples. Assume that apples cost $1 each, and each person can buy at most 5,000 apples. The government has devised the following tax plans:
Plan A
Plan B
Derive the marginal and average tax rates under each tax plan at the consumption levels of 500 apples, 1,500 apples, and 2,500 apples, respectively. Fill in the following table with your results.
Plan A
Plan B
Plan A
Plan B
Consumption up to 1,000 apples is taxed at 10%. Consumption up to 2,000 apples is taxed at 20%. Consumption higher than 1,000 apples is taxed at 40%. Consumption higher than 2,000 apples is taxed at 10%.Explanation / Answer
Average tax rate = Tax paid / Consumption
PLAN - A
(a) 500 apples:
(i) Marginal rate = 10%
(ii) Tax paid = $500 x 10% = $50
Average rate = $50 / $500 = 0.1 = 10%
(b) 1500 apples
(i) Marginal rate = 40%
Tax paid ($) = 1000 x 10% + (1500 - 1000) x 40% = 100 + (500 x 40%) = 100 + 200 = 300
Average rate = $300 / $1500 = 0.2 = 20%
(c) 2500 apples
(i) Marginal rate = 40%
(ii) Tax paid ($) = 1000 x 10% + (2500 - 1000) x 40% = 100 + (1500 x 40%) = 100 + 600 = 700
Average rate = $700 / $2500 = 0.28 or 28%
PLAN - B
(a) 500 apples:
(i) Marginal rate = 20%
(ii) Tax paid = $500 x 20% = $100
Average rate = $100 / $500 = 0.2 = 20%
(b) 1500 apples
(i) Marginal rate = 20%
Tax paid ($) = 1500 x 20% = 300
Average rate = $300 / $1500 = 0.2 = 20%
(c) 2500 apples
(i) Marginal rate = 10%
(ii) Tax paid ($) = 2000 x 20% + (2500 - 2000) x 10% = 400 + (500 x 10%) = 400 + 50 = 450
Average rate = $450 / $2500 = 0.18 or 18%
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