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.