Questions: Designing a Tax System: Efficiency and Equity
4 questions to test your understanding
Score: 0 / 4
Question 1 Multiple Choice
An income tax charges 10% on the first $20,000 of income and 30% on income above $20,000. For a person earning $50,000, what are the average and marginal tax rates?
AAverage 30%, marginal 30%
BAverage 22%, marginal 30%
CAverage 20%, marginal 10%
DAverage 10%, marginal 22%
Tax owed is 0.10 × 20,000 + 0.30 × 30,000 = 2,000 + 9,000 = 11,000. The average rate is 11,000 / 50,000 = 22%. The marginal rate, the rate on the next dollar earned, is 30%.
Question 2 Multiple Choice
Why does a lump-sum tax, a fixed amount owed by every person whatever they do, create no deadweight loss?
ABecause it raises no revenue
BBecause the marginal tax rate is zero, so it does not change the reward from working or buying one more unit
CBecause it falls only on high-income people
DBecause it is collected by the central bank
Deadweight loss arises when a tax changes choices at the margin. A lump-sum tax takes the same amount whatever a person earns or buys, so extra effort or purchases are not taxed. It is efficient but widely seen as unfair, because it takes the same amount from rich and poor.
Question 3 True / False
A payroll tax that takes 6% of all wages up to a cap and nothing on wages above the cap is regressive at incomes above the cap.
TTrue
FFalse
Answer: True
Above the cap, the tax paid stays fixed while income keeps rising, so the average tax rate falls as income rises. A falling average rate is the definition of regressive.
Question 4 Short Answer
Explain the difference between vertical and horizontal equity and give an example of a tax rule that could violate horizontal equity.
Think about your answer, then reveal below.
Model answer: Vertical equity says people with greater ability to pay should pay more. Horizontal equity says people with similar ability to pay should pay similar amounts. A deduction available only to homeowners could violate horizontal equity, because a renter and a homeowner with the same income would pay different taxes.
Both are applications of the ability-to-pay principle. Vertical equity concerns comparisons across income levels; horizontal equity concerns comparisons among people at the same level.