Final LectureTOPICS
Introduction
• In this lecture we will use some of what we have learned to answer some important recent questions of the day:– How is the tax system designed and why does it mean
that richer families pay less for daycare and healthcare?
– Why is the ‘forever’ stamp doomed?
– What does the internet have in ‘common’ with sheep?
– How should you bid in a second price auction and does it matter?
Federal Budget, FY 2004 ($ billions)
Receipts
Individual Income Tax 765
Corporate Income Tax 169
Social Insurance Taxes 732
Other Revenue 132
Total Revenue 1798
Expenditures 2319
Deficit -521
Wages + Interest + Dividends + Business Income + Capital Gains = Adjusted Gross Income
Adjusted gross income - personal exemptions - deductions = Taxable income
Taxable income As of 2005 Over But not
over Amount
over 0 14,600 10%
14,600 59,400 1,460+15% 14,600 59,400 119,950 8,180 + 25% 59,400
119,950 182,800 23,317.50 + 28% 119,950 182,800 326,450 40,915.50 + 33% 182,800 326,450 -- 88,320+ 35% 326,450
• $109,250 – $45,200 = $64,050
• $ 166,500 – $109,250 = $ 57,250
• $ 297,350 – $166,500 = $ 130,850
• AGI = $144,200, four person family, standard deduction
• Taxable income = $144,200 - $11,600 - $7,600 = $125,000
• Tax– $45,200 @ 15.0% = $6,780.00– $64,050 @ 27.5% = $17,613.75– $15,750 @ 30.5% = $4,803.75– Total $29,197.50
• “The average tax rate is total taxes paid divided by total income.”
• “The marginal tax rate is the extra taxes paid on an additional dollar of income.”
• “Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts.”
• “Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amount.”
“A proportional (or “flat”) tax is a tax for which high-income and low-income taxpayers pay the same fraction of income.”
“A regressive tax is a tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers.”
“A progressive tax is a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.”
Dependent Care Savings Accounts
• DCSAs allow families with young children to put aside as much as $5000 a year before paying taxes on it, to spend on daycare services.
• Health Care SAs work in a similar way.
• Why does this mean daycare and healthcare costs less for rich people?
Two Families
• Consider a two income professional family earning $350,000 a year. It puts aside $5000 for DCSA.
• Consider another family with income $50,000 a year. It puts aside $5000 for DCSA.
• Both families use all of the $5000 for childcare.• How much does each save?
The Rich Family
• Suppose the state income tax is 10% flat rate for each family.
• For every extra dollar the rich family earns, it pays $0.45 in income taxes (its marginal rate is 45%).
• But that also means, for every dollar of taxable income it reduces, it saves $0.45.
• Thus, the DCSA saves it 0.45*5,000=$2250.
The Middle Income Family
• By the same reasoning, for every extra dollar the middle income family earns, it pays $0.25 in income taxes (its marginal rate is 15+10=25%).
• But that also means, for every dollar of taxable income it reduces, it saves $0.25.
• Thus, the DCSA saves it 0.25*5,000=$1250. • Thus, $5000 of daycare costs the rich family,
$2750 and the middle income family $3750!
Post Office Hopes Idea Of 'Forever Stamp' Sticks
First-Class Rate Would Be Locked In
The forever stamp, which would cost the same as a first-class stamp, would provide a hedge against future postal rate increases and end the search for 2- or 3-cent stamps that usually follows a price increase. The stamps could pose unusual challenges for the Postal Service, however, and officials say many details still have to be worked out.
The cost of a first-class stamp has gone up 13 times since 1974, when the price was raised from 8 cents to a dime. Kearney said rate increases soon could become an annual affair.
Average Rate of Return
• A first class stamp now costs 39 cents. An investment of 8 cents in 1974 at 6% per year would have yielded 46 cents in 2004.
• Does this mean the post office does not need to care about people hoarding stamps to make money?
Marginal Rate of Return
• A first class stamp now costs 39 cents. • Suppose you learn that the first class rate is
going up 2 cents next week.• What is the (marginal) rate returned by a
forever stamp that costs 39 cents?• 2/39 times 100=5%. That means, this
investment pays 5 times 52 = 260% on a per annum basis!
Net Neutrality
• An HUGE issue that is making the rounds these days is something called net neutrality.
• This refers to the principle that the companies that offer network services on the internet, cable and telecom companies, must treat all applications in a similar fashion.
• This means that email packets, web page packets, e-commerce packets, VOIP packets and streaming video packets all must be treated identically.
Net Neutrality
• However, different applications, take up different amounts of bandwidth of the broadband connection.
• For example, P2P (Peer to Peer) applications, video applications, gaming applications suck up a lot of the ‘pipe’ to the home.
• Since these end up being treated similarly to less bandwidth hungry applications in terms of priority and pricing, what type of incentives are created?
• How does this relate to the ‘tragedy of the commons’?
Second Price Auctions
• An odd kind of auction format made popular by the Nobel Prize winning economist, William Vickrey, is the second price sealed bid auction.
• In a SPA, a bidder submits a sealed bid for an object.
• The bids are ordered from highest to lowest. The highest bidder wins and pays the second highest price.
• How should you bid in this auction?
Second Price Auctions
• Suppose you know you are willing to pay at most $100 for the object.
• Now, let P be the highest bid that any of your rival bidders submit.
• When do you want to win?
• When do you want to lose?
Second Price Auctions
• If P is ever below $100, you want to win because 100-P is better than zero.
• If P is ever above $100, you want to lose because 100-P is worse than zero.
• What strategy ensures winning when you want to win and losing when you want to lose?
• Bid exactly $100 that is, exactly your own value.• Since this is always best no matter what P is, this
is your DOMINANT STRATEGY!
First Price, Second Price?
• Would a bid of $100 be optimal in a first price auction where you pay the number you bid?
• NO! Because this ensure you always get exactly zero!
• In a first price auction, you should ‘shade’ your bid down.
• How much depends on how much competition you face. A hard guess to make.
First Price, Second Price?
• Since bidders ‘shade’ bids in first price auctions and bid their true value in second price auctions, is it better for a seller to use a SPA?
• It turns out that, in many circumstance, the two different auctions yield revenues that are exactly the same!
• This is known as the Revenue Equivalence Theorem in auction theory.