Final Lecture TOPICS

1. Final LectureTOPICS

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)

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 $100that 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.