Average and marginal tax rates

Tax rates determine how much of an individual's or business's income is paid to the government. There are two key types: average tax rates, which look at the overall proportion of tax paid, and marginal tax rates, which focus on the tax paid on additional income.

Average tax rate

The average tax rate is the total tax paid as a percentage of total income.

$\text{Average tax rate}=\frac{\text{total tax paid}}{\text{total income}}\times 100$

Where:

• Total tax paid = The overall amount of tax owed (£)
• Total income = The total earnings before tax (£)

Marginal tax rate

The marginal tax rate is the rate of tax applied to the next pound of income earned. In a progressive tax system like the UK's, this rate increases as income rises above certain thresholds. Only the income above each threshold is taxed at the higher rate, not the entire income.

UK marginal income tax rates (2019/20):

• 0% on income up to £12,500
• 20% on income between £12,501 and £50,000
• 40% on income between £50,001 and £150,000
• 45% on income over £150,000

Calculating income tax in a progressive system

In a progressive tax system, income is divided into brackets, with each portion taxed at a different rate. This ensures that higher earners pay a greater proportion of their income in tax.

To calculate total income tax:

1. Identify the tax brackets that apply to the total income.
2. Determine the amount of income in each bracket.
3. Apply the relevant tax rate to each portion.
4. Add up the tax from each bracket to find the total tax paid.
5. Use the total tax paid to calculate the average tax rate if needed.

The marginal tax rate is simply the rate applied to the highest bracket of income.

Worked example - Calculating income tax and average tax rate

An individual earns £62,000 in a year. Using the 2019/20 UK tax rates, calculate the total income tax paid and the average tax rate.

Step 1: Identify the values

• Total income = £62,000
• Tax brackets:
  • 0% on first £12,500
  • 20% on next £37,500 (up to £50,000)
  • 40% on remaining £12,000 (over £50,000)

Step 2: Calculate tax for each bracket

• Tax on first £12,500 = £12,500 × 0% = £0
• Tax on next £37,500 = £37,500 × 20% = £7,500
• Tax on remaining £12,000 = £12,000 × 40% = £4,800

Step 3: Calculate total tax paid

Total tax paid = £0 + £7,500 + £4,800 = £12,300

Step 4: Calculate average tax rate

$\text{Average tax rate}=\frac{\pounds \mathrm{12,300}}{\pounds \mathrm{62,000}}\times 100=19.8\%$

Main sources of government tax revenue

Governments collect tax revenue from various sources to fund public services. The main sources include direct taxes on income and profits, as well as indirect taxes on spending.

Key sources of tax revenue:

• Income tax - A direct tax on individuals' earnings, contributing roughly 30% of central government tax revenue.
• Value added tax (VAT) - An indirect tax on goods and services, making up about 20% of revenue.
• National Insurance contributions - Payments by employees and employers towards social security, accounting for around 20%.
• Excise duties - Taxes on specific goods like alcohol, tobacco, and fuel, providing about 10%.
• Corporation tax - A tax on company profits, contributing approximately 8%.
• Council tax and business rates - Local taxes on households and businesses, paid to local government for community services.

Main areas of government expenditure

Government expenditure involves spending tax revenue on public services and obligations. The largest portions go towards supporting citizens' welfare and health.

Key areas of government spending:

• Social support including pensions - About 40% of expenditure, covering benefits and retirement payments.
• National Health Service (NHS) - Around 20%, funding healthcare services and hospitals.
• Education - Approximately 15%, supporting schools, universities, and training.
• Debt interest - About 6%, paying interest on government borrowing.
• Police, law courts, and prisons - Around 5%, maintaining law and order.
• Defence - Approximately 5%, funding the armed forces and national security.