1. Suppose a person earning £100 gets an additional £100 in benefits. Their marginal tax rate is 25 per cent and for each extra £10 of take-home pay a person loses benefits of £6. What will be...
1. Suppose a person earning £100 gets an additional £100 in benefits. Their marginal tax rate is 25 per cent and for each extra £10 of take-home pay a person loses benefits of £6. What will be the change in their income after taxes if the go from making £100 to £200 in take-home pay?
(Hints: What will their income after taxes and benefits be if the earn £100 in take-home pay? What will their income after taxes and benefits be if they earn £200 in take-home pay?
2. When means-tested benefits are combined with a progressive tax system there can be a serious problem with disincentives. A situation known as the ________. This is due to the loss of tax benefits and loss of in-kind benefits when income increases."
In order to answer this question, you have to understand the idea of marginal tax rates. These are tax rates that apply not to money already earned but to money earned after the present. In the scenario you have presented, the person has already earned £100. In the future, they are going to earn a further £100. Their marginal tax rate of 25%, then, applies only to the second £100. They will lose £25 in taxes from that £100. This means that their take home wages will be £175.
Now, we also have to look at how much their benefits will drop. If their take home pay has gone from £100 to £200, they will lose £40 in benefits (£6 for each £10 increase in income). When we combine these two things, we see that they got £200 total in wages and benefits when they made £100 in wages. When they made £200 in wages, they only got £235 in total wages and benefits. This means that they worked enough more to add £100 to their income but they only realized a gain of £35. This problem with the combination of progressive taxation and means-tested benefits is sometimes known as the poverty trap.