| Suppose that a worker is contemplating whether to accept a new, higher-paid position (see table at right). In her present position, she earns $30,000 annually. Her new job would increase her salary by $5,000 per year, but would also entail increased responsibility and stress, perhaps even including some uncompensated overtime. She must also consider the impact of her decision on her taxes under the convex income-tax structure. Under this hypothetical tax structure, her average tax rate is 25% in her present position, but would climb to 27.1% in the new position. Which of these rates, if either, must she consider in order to maximize her utility? |
|
| Income |
Tax |
Average
Tax Rate |
| $30,000 | $7,500 |
25.0% |
| $35,000 | $9,500 |
27.1% |
|
If she accepts the new job, her tax will rise from $7,500 to $9,500, for an increase of $2,000. Thus her pay increase of $5,000 is offset by $2,000, that is, by 40%, her
marginal tax rate. Her net increase in take-home pay would thus be only $3,000, which she must compare against the subjective costs associated with the increased stress and hours in the new position. Her marginal tax rate, it should be observed, is much higher than either her "before" or "after" average tax rate, and only this higher marginal rate is directly pertinent to her decision. If we consider how this structure impacts the decisions of millions of other workers like her, it becomes clear that this convex tax structure is far more devastating to production than would be a flat tax structure at either 25% or 27.1%, although even such a flat tax would necessarily have a significant injurious effect.
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