Tax Efficiency - Video Tutorials & Practice Problems

Tax Efficiency

So when a government designs a tax system, they need to design it to be as efficient as possible. Let's go ahead and see what tax efficiency implies. So when we discuss tax efficiency, this is saying that there's one tax system that's going to be more efficient than another. So what are some problems that we run into when we have a tax system that could cause it to be less efficient? Well, the two efficiency problems here, as you see, are dead weight loss and administrative burden. We've talked about dead weight loss a bit right? As we increase taxes, Well then we're gonna restrict free trade, right? There's going to be trades that do not occur when we have taxes. Okay, So the taxes are going to restrict trade and that's gonna be an efficiency loss that we have because of the tax system. Okay, Just like if you don't remember, right taxes, they're raising the prices the consumers pay and they're also lowering the revenues of the producers that that they're gonna receive. Okay, now, the other side here is the administrative burden. So what does this administrative burden means? It means that there's going to be resources that are used in compliance of the tax system and enforcement by the government. So, if you think about filling out your taxes right? Sometimes it can be pretty difficult, right? Some of you have your parents do it or they hire an accountant to do it right? It's not so easy to fill out your taxes, especially once you start to get complicated business taxes get even more complicated, right? All sorts of write offs deductions, all sorts of things in the tax code that make it kind of complicated? And that ends up being an administrative burden one for the consumers, right? Because they have to fill out these forms and there's all this paperwork to fill out, Right? So the taxpayers must spend all this time filling out forms and keeping their records for the taxes, and then the government must employ uh people in the I. R. S to make sure that the taxpayers are doing it correctly. Right? So there's all these layers of administrative burden and those are inefficiencies if the tax system wasn't there? Well, there wouldn't be this time wasted by the taxpayers, there wouldn't be this money wasted by the government to uh to make to make sure that the taxes are done correctly. Right? So these are kind of a dead weight loss. These are sort of wasted resources. That time could have been spent doing something else by both the taxpayers and the government. Right? So when we talk about tax efficiency, we talk about two different tax rates when we're creating a tax system. Um So these are the two most important calculations when we're dealing with a tax system first is the average tax rate, and this is the average rate you pay on all your income. Right? So you're making a certain amount of income, you pay a certain amount of taxes? Well, what was the average amount of taxes that you paid? The other one is the marginal tax rate. So you're paying so much in taxes right now, what if you were to make a little more money? How much more taxes would you have to pay? Right marginal. So that's one more right? If we were to add one more dollar of income, how much more taxes would you have to pay? So let's try this example here and let's calculate our average tax rate and our marginal tax rate. So the government taxes in this example the 1st $50,000 earned at a rate of 20% While all income above 50,000 is taxed 50%. So notice there's different layers of taxes and this is similar to the US tax system that as you make more money you're gonna pay more percentage of taxes. Those marginal taxes are going to be increasing. Okay so what we're gonna do here, we're gonna calculate that average tax rate and the marginal tax rate. So as we see the average tax rate, what we need is we need to find out what the total amount of tax you paid and the total income you made. And then we'll find our average tax rate. So it tells us that this person made $80,000. So let's calculate their total taxes paid. So the total taxes. Well it says that they pay uh 20% on the 1st 50,000. So they made more than 50,000. So they're gonna pay 20% on the 1st 50,000. And then they're gonna pay some more taxes, right? Because they made more than 50,000, they made 80,000. So the amount above 50,000 they're gonna have to pay at 50%. So what we're gonna do here, we're gonna take the 80,000 total that they made, subtract out the 1st 50,000, right? Because it's everything above 50,000 gets taxed at this new rate. So, we'll have kind of a double parentheses here, 80,000 -50000. And we'll multiply that by that tax rate, so they're gonna pay 50,000 times 20% plus everything above it. That other 30,000 of income they're going to pay at a rate of 50%. Right? So what does this tell us? What's going to be their total taxes here? Well, we'll see that they paid 50,000 times 20%. That's going to be 10,000 in taxes from the 1st 50,000. And then they're also gonna pay on this 30,050% of it, which is another 15,000 in taxes. So 10,000 plus 15,000, that equals 25,000 in total taxes, right? 25,000 on the 80,000 that they earned. So let's go ahead and see what their average tax rate was. Now that we know the total taxes they paid, we can calculate the average tax rate here, So that's gonna be 25,000, right there, total taxes paid Divided by their total income of 80,000. So 25,000 divided by 80,000. Their average tax rate is 31.25% is their average tax rate. Cool. So nothing too crazy there. You just have to calculate the total taxes divided by the total income and you'll get your average tax rate. The trick in these questions is that you have to follow the rules, right? What were the rules for calculating the taxes? In this case? It was 50, of the 1st 50,000, and then 50% above that. Right? So each question could give you different tax rates and you just have to be aware of that. Now, the marginal tax rate is actually pretty simple, because in this question, What does it tell us if they make any money above 50,000? Well, they're gonna have to pay 50% on that money, right? So if this person was going to earn another dollar of income, well, guess how much tax they're gonna have to pay on it, 50%. Right? Everything above 50,000 is taxed 50%. So their marginal tax rate Is 50%. If they were to earn $80,000 and then add one more dollar, well, 50% of that is gonna have to go to taxes. Cool. So that's how we're gonna calculate our average tax and marginal tax, let's pause here and let's discuss hypothetical best most efficient system. Alright, let's do that in the next video.

Uniform Tax System

So what might be the most efficient tax system here? What would be what we call a uniform tax, a uniform tax? And that's where everybody pays the same amount of tax. There's no complicated calculations, you have to make? Everyone just pays a certain amount. Like in this example, the governor Imposes a tax of $5,000 on every citizen. Every person owes the same amount. There's no calculation to do right. It comes time to file your taxes at the end of the year. There's no administrative burden. You either paid your $5,000 or you didn't write very simple to enforce this and notice what this does to the marginal taxes, right? There's not gonna be any deadweight losses that come from this as well, because the marginal tax on earning additional income. Well, guess what? It's zero, right? Because if you earn any more money, well, you don't have to pay any more taxes, right? The tax is gonna be the same no matter how much you make. So it makes the ease of calculating taxes, it's gonna minimize that administrative burden. Like I just told you there's no paperwork, it's simple to enforce, right? It's very easy to see. Did they pay the 5000 or not? However, this system is gonna be uncommon. This is not a very good system because there's two goals for a tax system here. We've been discussing efficiency in our next video, we're gonna talk about tax equity, right? We want taxes to be fair as well, because let's see what happens in these situations, someone makes $10,000 of income in the year, and they have to pay 5000 in taxes. So what is their tax rate, 5000 out of the 10,000 in taxes they paid their average tax rate in this case is going to be 50%, right? They're paying 50% of their income in taxes. And now someone who makes $25,000, they they're still gonna pay 5000 in taxes, but they're making $25,000 here, right? So they're only paying 20% of their income, 5000, divided by 25,000, of their income is going to taxes. And what about someone who's making $100,000? So they still only pay $5,000 and they're making $100,000 So only 5% of their income is going to taxes. Right? So, although it is fair in the sense that everyone's paying the same amount, however, notice how much more of a burden it has on the poor people, right? When they're only making $10,000 half of their money is going to pay taxes, and they only have another 5000 left to spend on everything else with the 25,000, right, they start to have more and more disposable income As they have more income, because only that 1st 5000 is going to taxes. So this doesn't seem totally fair, right? Because as you make more and more money? Well, the portion of your money going to taxes is getting smaller. Some people might like that, right? The rich people are probably like, yeah, let's keep this system. But this puts a lot of burden on people that don't have a lot of income because they don't have very much disposable income left afterwards. Okay, so let's go ahead and discuss uh tax equity in the upcoming videos. Alright, let's check that out.