Test A – Question 5

There is a proposal to lower the maximum marginal income tax rate from 50% to 40%.

1. Explain what a marginal tax is.
2. Show and explain, using the Lorenz curve, how a reduction in the marginal income tax rate will affect inequality in the distribution of income in the economy.

answer:

Section A:

The marginal income tax rate indicates the income tax rate we pay on the last shekel of our income.

For example: If a certain person earns a salary of 6,000 NIS and it is given that for income up to 4,000 NIS he pays 10% tax, for income between 4,000 and 5,000 NIS he pays 13% tax, and for income between 5,000 and 6,000 NIS he pays 15%, then that 15% tax is that person’s “marginal tax rate.”

Note: Marginal tax rates generally increase with income, so the highest marginal tax rate will be for those with particularly high incomes.

Section B:

The Lorenz curve is a curve that graphically depicts the level of income inequality among a country’s residents. Each point on the curve refers to two pieces of data:

1. Cumulative income in %.
2. Cumulative decile distribution (by income) of the country’s residents.

Income data is listed on the vertical axis on the right and decile data is listed on the lower horizontal axis.

AC is the squared diagonal. Each point on the Lorenz curve shows the cumulative share of national income of the decile below the point and all deciles below it. The further the Lorenz curve moves away from the AC line, the greater the income inequality, and the closer the curve is to the AC line, the less the income inequality.

Since tax rates increase with income growth, lowering marginal tax rates will benefit high-income earners in particular. This will increase inequality in the distribution of income in the economy – a matter that will be reflected in the Lorenz curve moving away from the AC line.

Figure 7:

Lorenz curve after lowering the marginal income tax rate

Lorenz curve before lowering the marginal income tax rate