Question

Assume that your country’s income tax structure has the following tax rates: if your income is $30,000 or less you pay no income tax; if your income is above $30,000, you pay 30 percent of the amount above $30,000. And so, for example, someone who earns $60,000 would pay 30% × ($60,000 − $30,000) = $9,000. Your marginal tax rate is defined as the taxes you pay if you earn one more dollar. Your average tax rate is defined as the total taxes you pay divided by your income. And so, to continue with this example, someone who earns $60,000 would have a marginal tax rate of 30 percent and an average tax rate of $9,000/$60,000 = 15%. You have three alternatives. You could not work at all, you could work half time, or you could work full time. If you do not work at all, you will earn $0; if you work half-time you will earn $30,000; and if you work full-time, you will earn $60,000. Any time you do not work, you can spend surfing. You love to surf: surfing full-time is worth $50,000 per year to you, surfing half-time is worth $25,000 per year to you, and not surfing at all is worth nothing to you. As you are making your decision about how much to work, should you pay attention to your average tax rate or to your marginal tax rate? Explain your answer carefully.

Answer 1

Scenario 1 - No work
Income - 0
Tax - 0
Surfing Benefits - $50000
Total Benefits = 0 - 0 + 50000
= 50000

Scenario 2 - Half Time Work
Income - $30000
Tax - 0
Surfing Benefits - $25000
Total Benefits = 30000 - 0 + 25000
= 55000

Scenario 3 - Full Time Work
Income - $60000
Tax - $9000
Surfing Benefits - 0
Total Benefits = 60000 - 90000 + 0
= $51000

A rational person would make his decision considering the maximum benefits he receives from the choosen option.
If we compare the three scenarios then it can be seen that he will receive maximum benefits when he chooses to work half time. In that case, he has an income of $30000 but no tax and also has benefits of surfing worth of $25000.