Why do tax analysts worry about marginal tax rates, not average effective rates, in looking for incentive effects of taxes
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3 Answers
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People make decisions based on how the decision will change things. If I work an extra \$1000 worth of time, then I have to pay $\$1000 * \text{marginal tax rate}$ in taxes. The average rate is irrelevant to that calculation. It's a little more complicated than that in that the marginal tax rate may change over that \$1000.
The only time that the average tax rate would matter would be if I were asking at the beginning of the year if it would make sense to not work at all that year. But I can reach the same result with marginal tax analysis and not be restricted to the beginning of the year. The marginal-based analysis already has to handle things like the marginal rate changing.
The average tax rate provides useful information so seldom that there's no real point in using it.
The marginal rate tells us how a change from the status quo will affect things. If my marginal rate in the example is 25%, then I can make an extra $750 by working that extra. Is that more or less than my value of my leisure time? That's a real decision.
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To add to Brythan's question: It is correct that the marginal tax rate is more important for incentives than the average tax rate, as economists regularly (and often rightly so) think about marginal changes to a given situation. There are however shortcomings to this.
One standard result in labor/public ecnomics is that labor supply is more responsive on the extensive margin (whether or not work) than on the intensive margin (how many hours to work). An inactive person that considers to take up work faces a possible transition from zero hours of work to some positive amount of hours per week (8, 20, 40...). For this person, the marginal tax rate tells little about the monetary gain of entering at a given number of hours and some potential earnings. For this reason, the OECD calculates alternative incentive measures. For example the Participation Tax Rate measures the share of additional earnings that is taxed away (including the potential loss of social welfare payments). This measure, though subject to many assumptions, might be more informative on the incentives on the extensive margin of labor supply.
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The entire Economic system, let alone incentives, are built on marginal effects Taxation may be charged on supply of production factors (labor, capital, for example) or up the value chain, on the final product ((VAT)
The supply curve, by definition, is the marginal cost function (where it exceeds average cost) So taxing labor or capital, will, by definition, tax the marginal cost of production, and will affect the incentive to produce more: for every point on top of the supply curve (the MC) there is an extra cost. The only reference to the average, is whether or not to supply the product. This mainly applies to the labor or capital supply curves, but will also affect the cost of the final product
Taxing the final product directly, will generate a similar effect, where basically the product will cost more, and the supply will meet the demand on a higher price level, less quantity consumed, which will affect the marginal production
