Question

How does a proportional income tax introduce a wedge between the gross wage paid by employers and the net wage received by workers? Explain how this tax wedge results in efficiency losses in labor markets.

Answer 1

Gross pay, also known as gross wages, is what attracts many people to a job. They see the advertised salary or hourly pay and think of everything they could do with that income. However, when they receive a paycheck, they realize that they didn’t take into account the difference in gross wages vs. net wages.

Gross wages are the total amount an employee is paid before any taxes, deductions, insurance premiums, and other payroll withholding. In fact, a person’s take-home pay may be significantly less than their gross wages.

n employee’s net wages can be calculated after subtracting everything that an employer must withhold by law and everything that the employee voluntarily has withheld. Thus, the basic formula to calculate net pay will look something like this:

Net Wages = Gross Wages – Withholding

Withholdings all employers are required to make:

• Medicare tax
• Social Security tax
• Federal income tax
• State income tax
• Applicable local taxes