Video Transcript: Lesson 28

Okay, let's start Unit 10 here. Lesson 1, we're going to talk about the effects of  changes in tax rates. So we can use a simple model of the tax system to see  how a change in the income tax rate affects both individuals and the economy  as a whole. Suppose there is a cut in the tax rate, since taxes paid equals the  tax rate times income. The immediate impact is to reduce the amount of taxes  households pay for a given income. A reduction in the tax rate reduces taxes  paid. This means that there is more disposable income for households and  families, which is the income left over after paying taxes and receiving transfers  or increases. So, what do households do with an increase in disposable  income? Likely answer is that a typical household spends some of the extra  cash and saves the remainder. So, if all households follow this pattern, then the  increased spending by each household translates into larger consumption in the aggregate economy. If households have more money that's disposable, they're  probably going to spend it, which is going to spur economic growth, right?  Because people are going to have more money to spend. People will sell more  goods and services, and then therefore the economy and the markets will  continue to grow. At this point, the power of the circular flow of income will take  over, and the level of income and output in the economy will increase even  further. So you'll see that through tax breaks and incentives, that households will have greater disposable income, and that'll spur the growth of the economy in  general. As the economy expands, the amount of taxes paid starts to increase  because people are spending more money. They're going to be taxed more  because they spend more frequently. Therefore, they've lowered taxes right from your income, but you're going to spend that disposable income back into the  market, and you're going to pay a sales tax, which is going to be tax given taxes  given to the state. But then you're also going to fuel the growth of that in that  particular business you're spending with, right? And then in turn, they're going to pay greater tax receipts at the end of the year too, so disposable income is you  know greater because of a tax cut to the you know aggregate base, the  consumers in the economy. Your income is taxed less, therefore you'll have  more money to spend. You'll go spend that cash back out into the market, and  because you'll have more money to spend, you'll make more purchases.  Therefore, the revenues brought in by a particular business will grow, and  therefore the tax receipts paid out by that business will be greater. Therefore,  the government will take in greater taxes than they would have if they left taxes  high or increased taxes. Because now households will spend more, companies  will grow larger, and they'll take in greater revenues and pay out more in taxes  back to the government because they brought in more money overall. The  ultimate effect of a tax cut on the overall amount of taxes paid depends on both  the expansion of the tax base and the reduction of the tax rate. So 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 the average tax rate  increases 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. So, they  want to make the you know the gap between people that are making a high  income versus the gap that people are making a low income. They want to  shrink that down by taxing people that make more money more, so that way we  have a social fabric that is more equal.