Addressing income and wealth inequality — practice questions

(a) Worker A (£20,000)

• Taxable income above allowance = £20,000 − £15,000 = £5,000
• Tax paid = 20% × £5,000 = £1,000
• Average tax rate = (£1,000 ÷ £20,000) × 100 = 5%

Worker B (£60,000)

• Tax on income up to £40,000 = 20% × (£40,000 − £15,000) = 20% × £25,000 = £5,000
• Tax on income above £40,000 = 40% × (£60,000 − £40,000) = 40% × £20,000 = £8,000
• Total tax paid = £5,000 + £8,000 = £13,000
• Average tax rate = (£13,000 ÷ £60,000) × 100 = 21.7%

(b) Yes, the system is progressive. This is because the average tax rate increases as income increases. Worker A, the lower earner, pays 5% of their income in tax, while Worker B, the higher earner, pays a much larger proportion at 21.7%.

(a) Calculating the change in final income:

• Increase in Gross Earnings = $350 - $300 = $50
• Increase in Income Tax Paid = 20% of $50 = 0.20 × $50 = $10
• Benefit Withdrawal: The benefit taper applies to the extra earnings. Reduction = 65% of $50 = 0.65 × $50 = $32.50
• Net Gain = (Increase in Gross Earnings) - (Increase in Tax) - (Benefit Withdrawal)
• Net Gain = $50 - $10 - $32.50 = $7.50

For a $50 increase in gross pay, the individual's final income only rises by $7.50.

(b) Calculating the Effective Marginal Tax Rate (EMTR): The EMTR is the percentage of additional gross income that is lost to higher taxes and withdrawn benefits.

• Total 'loss' from extra earnings = (Increase in Tax) + (Benefit Withdrawal) = $10 + $32.50 = $42.50

$EMTR = \frac{\text{Total Income Lost}}{\text{Increase in Gross Earnings}}$ $EMTR = \frac{42.50}{50} = 0.85 \text{ or } \mathbf{85\%}$

Conclusion: The EMTR of 85% is extremely high and creates a significant disincentive to work extra hours. This illustrates the 'poverty trap' where individuals are 'trapped' on low incomes by the benefit system.