By working and being productive, households earn an income and businesses make a profit. The total amount that households and businesses receive before taxes and other expenses are deducted is called aggregate income. The amount of money that is left after taxes and other expenses have been deducted from one’s pay is called disposable income. Discretionary income is what consumers (households) have to pay for the goods and services they desire. We shall focus only on households and how they consume their income. Households spend most of their discretionary income on consumption.
Some consumers spend even more than their current discretionary income on consumption by borrowing. Consumption consists of almost everything that consumers purchase, from durable to nondurable goods as well as all types of services. The only exception to this rule is the purchase of a new home: It is counted as an investment because homes tend to appreciate in value.
Households (individuals) cannot spend all their earnings on consumer goods and services. Part of the income each household receives must be used to pay different kinds of taxes, such as income taxes to federal, state, and local governments. Most state and local governments also impose sales taxes. In addition to paying income and sales taxes, households may also have to pay property taxes to local governments. After paying taxes and spending income on consumables, some households put aside money as savings to be used for consumption at a later time.
Earnings differ among individuals and households because of several factors: (1) inborn differences, (2) human-capital differences, (3) work and job performance, (4) discrimination, (5) age, (6) labor mobility, (7) government programs and policies, and (8) luck.
Inborn differences are those characteristics that one is blessed with, such as strength, energy, stamina, mental capacity, natural ability, and motivation.
Human-capital differences reflect how people invest various amounts of both their physical and mental capacities toward the achievement of specific goals.
Work and job performance indicates how individuals differ in their preferences regarding the trade-off between work and leisure. Those who wish to work more usually receive a higher income; others prefer more leisure at the cost of earning a lower income. People also prefer different types of jobs. These specific job choices will affect the distribution of income.
Discrimination is treating people differently solely on the basis of factors unrelated to productivity.
Age affects earnings significantly. Most individuals earn little before the age of eighteen. Earnings tend to increase as workers gain experience and their productivity increases.
Labor mobility the willingness to go where the jobs are or to move wherever the company has a need enhances an individual’s income potential. Immobility limits workers’ response to changes in wage rates and can contribute to an unequal distribution of income.
Government policies and programs, such as benefit programs and the progressive income tax, reduce income inequality. The minimum wage may also increase income inequality.
Luck plays a role in determining the distribution of income, but choices are perhaps the most important factor.
A tax consists of a rate and a base. Because income is the base for the income tax, a central question is: What constitutes income? Different theoretical concepts of income exist in economics, accounting, and taxation. The base of income to which the federal income tax rate structure applies is taxable income as constitutionally and statutorily defined. Thus, the concept of taxable income is grounded in theory and modified by political dynamics and administrative concerns. From its modern introduction in 1913, the rate structure for the individual income tax has been progressive, meaning that tax rates graduate upward as the base of taxable income increases.
Different tax rates apply to ranges of income, called brackets. Over time, the number of brackets and tax rates that apply to them have varied greatly. The tax rate applied to the last dollar of taxable income earned by a taxpayer is called the marginal tax rate. Total income tax as a percentage of total taxable income is the average tax rate, whereas total income tax as a percentage of total economic income is the effective tax rate.
