Imagine the economy as a big circle where money keeps moving around. Households provide labour and capital to firms, and in return they receive income (wages, rent, interest, profits). Firms use that income to buy goods and services from households. This back‑and‑forth movement is the circular flow of income.
1️⃣ Household → Firm: labour & capital
2️⃣ Firm → Household: wages, rent, interest, profits
3️⃣ Household → Firm: consumption of goods
4️⃣ Firm → Household: production of goods
5️⃣ Government ↔ Households/Firms: taxes & public spending
Taxes are like toll booths on the circular flow. The average rate of tax (ART) tells you the overall proportion of income that goes to the government, while the marginal rate of tax (MRT) tells you the rate applied to the next unit of income earned.
The ART is calculated as the total tax revenue divided by total income:
\$ART = \frac{T}{Y}\$
where T = total tax revenue and Y = total income.
Analogy: If you have a pizza (income) and you give 20% of it to the pizza shop (government), your ART is 20%. It’s the average slice you give away.
The MRT is the tax rate applied to the next unit of income earned. In a progressive tax system, the MRT increases as you move into higher income brackets:
\$MRT = \frac{dT}{dY}\$
Analogy: Think of a staircase where each step represents a tax bracket. The MRT is the height of the step you’re stepping onto. The higher the step, the more tax you pay on the next pound you earn.
| Income Range (£) | Tax Rate | Cumulative Tax (£) |
|---|---|---|
| 0 – 12,570 | 0% | 0 |
| 12,571 – 50,270 | 20% | 7,540 |
| 50,271 – 150,000 | 40% | 34,000 |
| >150,000 | 45% | — |
Calculating ART for a £60,000 earner:
Total tax = £7,540 (first bracket) + £34,000 (second bracket) = £41,540
ART = 41,540 ÷ 60,000 ≈ 69.3%
Calculating MRT for the next £1,000 earned:
Since £60,000 falls in the 40% bracket, the MRT = 40%. So, for every extra £1,000 earned, £400 goes to tax.
• Understanding ART helps you see how much of your income is taken by the state on average.
• Knowing MRT is crucial for decisions about extra work, overtime, or investment – it tells you how much of that extra money you’ll keep.
• In the circular flow, higher taxes can reduce consumption and investment, affecting the whole economy.
💡 Tip: When planning your budget, think of the MRT as the “tax on the next slice” – it’s the most immediate impact on your disposable income.