Question

Suppose that a country has 20 million households. Ten million are poor households that each have labor market earnings of \(\$ 20,000\) per year, and 10 million are rich households that each have labor market earnings of \(\$ 80,000\) per year. If the government enacted a marginal \(\operatorname{tax}\) of 10 percent on all labor market earnings above \(\$ 20,000\) and transferred this money to households earning \(\$ 20,000\), would the incomes of the poor rise by \(\$ 6,000\) per year? Briefly explain.

Short answer

Yes, the incomes of the poor households would rise by \$6,000 per year.

Step-by-step solution

Calculate the tax collected from the rich households

Firstly, determine how much tax is collected from the rich households. To do this, subtract the tax-free income from the total income of the rich households, then multiply the result by the marginal tax rate amounting to the tax collected from each rich household. Since there are 10 million rich households, multiply the tax collected per household by the total number of rich households. Mathematically, \(Tax Collected = 10,000,000 * ((\$80,000 - \$20,000) * 10\%) = \$60,000,000,000\)

Calculate the tax transferred to the poor households

Next, we need to determine how much each poor household will receive from the tax transfers. To do this, divide the total tax collected by the total number of poor households. Mathematically, \(Tax Transferred = \$60,000,000,000 / 10,000,000 = \$6,000\)

Conclude if the income of poor households increase by \$6,000 annually

Based on the previous steps, we can conclude that the income of each poor household would indeed increase by \$6,000 annually through the marginal tax policy.

Key concepts

Marginal Tax Rate

The marginal tax rate refers to the rate at which tax is charged on an additional dollar of income. In our context, it is the additional tax imposed on labor market earnings exceeding a certain threshold, which in this example is \(20,000. The reason why the marginal tax rate is significant is that it influences behavior in the labor market. For instance, if the marginal tax rate is very high, individuals and households may be less motivated to earn more because a substantial portion of their additional earnings will be taxed.

Understanding the effect of marginal tax rates is essential for creating tax policies that do not discourage work effort unduly while still funding necessary government services. In the exercise, the 10 percent marginal tax rate applied to the rich households’ earnings above \)20,000 effectively redistributes income, but the impact it will have on the work incentives of the rich remains an important consideration for policy makers.

Labor Market Earnings

Labor market earnings represent the income individuals and households receive from employment and work-related activities. It is an essential concept in the study of income distribution, reflecting the value of the labor provided by workers in the market. In our exercise, we have two distinct groups: poor households with earnings of \(20,000 and rich households with earnings of \)80,000.

This disparity is a simplified representation of economic reality, where income varies widely among different people due to differences in skills, education, and job opportunities. The allocation of labor market earnings is a reflection of numerous economic factors and can be influenced by government policies such as minimum wage laws and tax legislation.

Tax Transfer System

A tax transfer system is a mechanism through which governments collect taxes from certain segments of the population and redistribute these funds to other groups, usually to promote social equity. In the given exercise, the tax collected from the rich through the 10 percent marginal tax is transferred directly to the poor households. Such systems aim to reduce poverty and narrow the income gap between different socioeconomic groups.

This redistribution of wealth plays a crucial role in addressing poverty and supporting those with lower incomes. However, the effectiveness of a tax transfer system can vary greatly depending on how it is structured and implemented. Policymakers must consider the balance between equity and efficiency to ensure that the system effectively meets societal goals without creating significant negative economic incentives.

Economic Inequality

Economic inequality refers to the extent of the differences in wealth, income, and living standards among individuals and groups in a society. It's a multidimensional issue, including inequality in earnings, property, and access to education and healthcare. The exercise showcases a stylized example of economic inequality with two distinct income groups and how policy measures like taxation can alter the distribution of wealth.

While taxation can be a tool to redistribute income, it may also have unintended consequences, such as creating work disincentives or driving high earners to find tax avoidance strategies. Therefore, the design of tax policies must carefully consider their impact not only on income redistribution but also on the overall economy. Addressing economic inequality effectively requires a nuanced approach that takes into account multiple facets of the issue, including labor market dynamics, education, access to resources, and social mobility.