1. Final Lecture TOPICS

2. 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?

3. Federal Budget, FY 2004 ($ billions) Receipts Individual Income Tax765 Corporate Income Tax169 Social Insurance Taxes732 Other Revenue132 Total Revenue 1798 Expenditures 2319 Deficit -521

4. Wages + Interest + Dividends + Business Income + Capital Gains = Adjusted Gross Income

5. Adjusted gross income - personal exemptions - deductions = Taxable income

7. $109,250 – $45,200 = $64,050 $ 166,500 – $109,250 = $ 57,250 $ 297,350 – $166,500 = $ 130,850

8. 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

9. “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.”

10. “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.”

11. “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.”

12. 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?

13. 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?

14. 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.

15. 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!

16. 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.

17. 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.

18. 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?

19. 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!

20. 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.

21. 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’?

22. 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?

23. 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?

24. 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!

25. 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.

26. 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.