The Circular Flow of Income

You can review the circular flow of income in the toolkit. As the economy expands, the amount of taxes paid starts to increase. In other words, one consequence of a tax cut is that the tax base (income) expands. The ultimate effect of a tax cut on the overall amount of taxes paid depends on both this expansion of the tax base (income) and the reduction of the tax rate. Taxes and Income Distribution The effects of a tax cut are not the same for everyone. Changes in the tax code affect the distribution of income. If we want to understand such effects, however, it is a mistake to use our simple model of the tax system. We must instead examine how marginal tax rates are different at different levels of income. Suppose that marginal tax rates increase with income, which means that average tax rates increase with income. Higher income households then pay a larger fraction of their income as taxes to the government. As a result, the distribution of income after taxes is more equal than the distribution of income before taxes. Imagine that we take two individuals with different levels of income and calculate their tax payments and after-tax income. Suppose that the first individual earns $20,000 per year and the other earns $200,000. Table 12.2 “The Redistributive Effects of Taxation (in US$)” shows the amount of tax each pays and their income after taxes, based on the tax schedule from Table 12.1 “Revised 2010 Tax Rate Schedules”. Notice from the table that the marginal tax of the high-income household is 33 percent, compared with the 15 percent marginal tax of the low-income household. The total tax paid by the high-income individual is $51,116.75, which is almost 20 times the tax paid by the low-income household. Whereas the pre-tax income of the richer household was 10 times greater than that of the poorer household, its after-tax income is 8.5 times greater.