19 Taxation and Resource Allocation The taxing power of the government must be used to provide revenues for legitimate government purposes. It must not be used to regulate the economy or bring about social change. RONALD REAGAN Taxation and Resource Allocation The taxing power of the government must be used to provide revenues for legitimate government purposes. It must not be used to regulate the economy or bring about social change. RONALD REAGAN

●The Level and Types of Taxation ●The Federal Tax System ●The State and Local Tax System ●The Concept of Equity in Taxation ●The Concept of Efficiency in Taxation ●Shifting the Tax Burden: Tax Incidence ●The Level and Types of Taxation ●The Federal Tax System ●The State and Local Tax System ●The Concept of Equity in Taxation ●The Concept of Efficiency in Taxation ●Shifting the Tax Burden: Tax Incidence Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

●When Taxation Can Improve Efficiency ●Equity, Efficiency, and the Optimal Tax ●When Taxation Can Improve Efficiency ●Equity, Efficiency, and the Optimal Tax Contents Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Level and Types of Taxation ●Average tax rates have been roughly constant over the past two decades, at both the federal and the state and local levels. ●Taxes can be classified in terms of whether they are progressive, proportional, or regressive. ●Average tax rates have been roughly constant over the past two decades, at both the federal and the state and local levels. ●Taxes can be classified in terms of whether they are progressive, proportional, or regressive.

FIGURE 19-1 Taxes as Percentage of GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved State and local government Federal government 2 Percentage of GDP 0

FIGURE 19-2 The Tax Burden in Selected Countries, 2000 Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Tax Revenues as a Percentage of GDP United States JapanSwitzerlandGermany Netherlands SwedenItalyUnited Kingdom

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Level and Types of Taxation ●Progressive tax = the fraction of income paid in taxes rises as a person’s income increases ●Proportional tax = this fraction is constant ●Progressive tax = the fraction of income paid in taxes rises as a person’s income increases ●Proportional tax = this fraction is constant

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Level and Types of Taxation ●Regressive tax = the fraction of income paid to the tax collector declines as income rises ●The marginal tax rate, not the average tax rate, most directly affects economic incentives. ●Regressive tax = the fraction of income paid to the tax collector declines as income rises ●The marginal tax rate, not the average tax rate, most directly affects economic incentives.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Level and Types of Taxation ●Direct taxes are levied directly on people; primary examples are income taxes and inheritance taxes. ●Indirect taxes are levied on particular activities, such as buying gasoline, using the telephone, or owning a home. ●Direct taxes are levied directly on people; primary examples are income taxes and inheritance taxes. ●Indirect taxes are levied on particular activities, such as buying gasoline, using the telephone, or owning a home.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The principal federal taxes, in descending order of revenue, are: ♦The personal income tax ♦The payroll tax ♦The corporate income tax ♦Excise taxes ●The principal federal taxes, in descending order of revenue, are: ♦The personal income tax ♦The payroll tax ♦The corporate income tax ♦Excise taxes

FIGURE 19-3 Sources of Federal Revenue Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Individual income taxes 48.8% Corporate income taxes 10.3% Excise taxes 3.4% All other 1.1%Payroll taxes (Social Security taxes and contributions) 36.4%

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The Federal Personal Income Tax ♦The personal income tax is generally progressive, but with many loopholes. ■Every tax loophole encourages particular patterns of behavior and favors particular types of people. ■Among the major tax loopholes are the exempt status of municipal bond interest and tax benefits for homeowners. ●The Federal Personal Income Tax ♦The personal income tax is generally progressive, but with many loopholes. ■Every tax loophole encourages particular patterns of behavior and favors particular types of people. ■Among the major tax loopholes are the exempt status of municipal bond interest and tax benefits for homeowners.

TABLE 19-1 Federal Personal Income Tax Rates in 2001 Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The Payroll Tax ♦The proceeds of this tax are paid into “trust funds,” such as Social Security, Medicare, and unemployment benefits. ♦ The payroll tax is highly regressive. ●The Payroll Tax ♦The proceeds of this tax are paid into “trust funds,” such as Social Security, Medicare, and unemployment benefits. ♦ The payroll tax is highly regressive.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The Corporate Income Tax ♦Tax applies only to profits, not to income; wages, rents, and interest paid by corporations are deducted before the tax is applied. ♦All large corporations currently pay a basic marginal tax rate of 35%. ♦Since WWII, has accounted for a declining share of federal tax revenue--now just 12%. ●The Corporate Income Tax ♦Tax applies only to profits, not to income; wages, rents, and interest paid by corporations are deducted before the tax is applied. ♦All large corporations currently pay a basic marginal tax rate of 35%. ♦Since WWII, has accounted for a declining share of federal tax revenue--now just 12%.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●Excise Taxes ♦a sales tax on the purchase of a particular good or service ♦Sales taxes are mainly reserved for state and local governments. ♦A minor source of federal government revenue, some taxes seek to discourage consumption of a good, such as cigarettes, by raising its price. ●Excise Taxes ♦a sales tax on the purchase of a particular good or service ♦Sales taxes are mainly reserved for state and local governments. ♦A minor source of federal government revenue, some taxes seek to discourage consumption of a good, such as cigarettes, by raising its price.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The Payroll Tax and the Social Security System ♦For the most part, Social Security is not a true trust fund, but a pay-as-you-go transfer system. ♦For many years, this system managed to give every generation of retirees more in benefits than it had contributed in payroll taxes. ■Population growth ■Wage growth ●The Payroll Tax and the Social Security System ♦For the most part, Social Security is not a true trust fund, but a pay-as-you-go transfer system. ♦For many years, this system managed to give every generation of retirees more in benefits than it had contributed in payroll taxes. ■Population growth ■Wage growth

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The Payroll Tax and the Social Security System ♦“Growth magic” stopped in the 1970s. ■Wage growth stopped. ■Population growth slowed. ■Life expectancy increased. ■Retirement age fell. ♦The burdens on the payers are increasing over time. ●The Payroll Tax and the Social Security System ♦“Growth magic” stopped in the 1970s. ■Wage growth stopped. ■Population growth slowed. ■Life expectancy increased. ■Retirement age fell. ♦The burdens on the payers are increasing over time.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Federal Tax System ●The Payroll Tax and the Social Security System ♦Because of recent changes, the system is currently building up a trust fund, but projections show that the fund will be depleted in less than 50 years. ♦Eventually, taxes will have to rise and/or benefits will have to be cut. ●The Payroll Tax and the Social Security System ♦Because of recent changes, the system is currently building up a trust fund, but projections show that the fund will be depleted in less than 50 years. ♦Eventually, taxes will have to rise and/or benefits will have to be cut.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The State and Local Tax System ●State and local governments depend mostly on sales, excise and property taxes. ●Under the U.S. system of fiscal federalism, grants (often restricted) are made from higher to lower levels of government. ●The federal government is currently devolving increased funds and responsibilities to state governments. ●State and local governments depend mostly on sales, excise and property taxes. ●Under the U.S. system of fiscal federalism, grants (often restricted) are made from higher to lower levels of government. ●The federal government is currently devolving increased funds and responsibilities to state governments.

FIGURE 19-4 Sources of State and Local Revenue Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Income taxes (personal and corporate) 15.6% All other 28.5% Property taxes 16.7% Sales and gross receipts taxes 20.3% From federal government 18.9%

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Equity in Taxation ●The three principles are: ♦Horizontal equity ♦Vertical equity ♦The benefits principle ●It is often difficult to apply these principles in real situations. ●The three principles are: ♦Horizontal equity ♦Vertical equity ♦The benefits principle ●It is often difficult to apply these principles in real situations.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Equity in Taxation ●Horizontal Equity ♦Horizontal equity = equally situated individuals should be taxed equally ♦The current tax code frequently violates this principle. ●Horizontal Equity ♦Horizontal equity = equally situated individuals should be taxed equally ♦The current tax code frequently violates this principle.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Equity in Taxation ●Vertical Equity ♦Vertical equity = unequals should be treated unequally ♦Often translated into the ability-to-pay principle, according to which those most able to pay should pay the highest taxes ●Vertical Equity ♦Vertical equity = unequals should be treated unequally ♦Often translated into the ability-to-pay principle, according to which those most able to pay should pay the highest taxes

TABLE 19-2 Three Alternative Income-Tax Plans Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Equity in Taxation ●Vertical Equity ♦Regressive taxes are generally thought to be unfair. ♦There is much less agreement about the relative merits of progressive versus proportional taxes. ●Vertical Equity ♦Regressive taxes are generally thought to be unfair. ♦There is much less agreement about the relative merits of progressive versus proportional taxes.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Equity in Taxation ●The Benefits Principle ♦Benefits principle of taxation = those who reap the benefits from government services should pay the taxes ●The Benefits Principle ♦Benefits principle of taxation = those who reap the benefits from government services should pay the taxes

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Efficiency in Taxation ●Because most taxes induce changes in behavior, the burden of the tax exceeds the revenue generated with the result that an excess burden is created. ●In comparing two taxes that raise the same total revenue, the one that produces less excess burden is the more efficient. ●Because most taxes induce changes in behavior, the burden of the tax exceeds the revenue generated with the result that an excess burden is created. ●In comparing two taxes that raise the same total revenue, the one that produces less excess burden is the more efficient.

A SIMPLE TAX SCHEDULE Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Tax $1, Car Type Cadillac Catera Chrysler 300 Ford Escort

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Concept of Efficiency in Taxation ●Tax Loopholes and Excess Burden ♦When tax loopholes exist, economic choices are distorted by tax considerations. ♦This impairs economic efficiency. ●Tax Loopholes and Excess Burden ♦When tax loopholes exist, economic choices are distorted by tax considerations. ♦This impairs economic efficiency.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. Shifting the Burden of Taxation: Tax Incidence ●Incidence of a tax = an allocation of tax burden to specific individuals or groups ●Flypaper theory of tax incidence = theory that the tax burden always sticks where the government puts it ♦This theory is often wrong because the people who pay a tax are often able to shift its burden to other people. ●Incidence of a tax = an allocation of tax burden to specific individuals or groups ●Flypaper theory of tax incidence = theory that the tax burden always sticks where the government puts it ♦This theory is often wrong because the people who pay a tax are often able to shift its burden to other people.

FIGURE 19-5 The Incidence of an Excise Tax Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price of Luxury Cars, Including Tax $40,000 $40,600 Number of Luxury Cars Rise in price = $600 Tax = $1,000 S 0 S 0 S 1 S 1 D D B A

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. Shifting the Burden of Taxation: Tax Incidence ●The Incidence of Excise Taxes ♦The incidence is determined not by who physically pays the tax, but by the elasticities of supply and demand. ♦The more inelastic the demand (supply), the larger is the share of the tax that consumers (producers) pay. ●The Incidence of Excise Taxes ♦The incidence is determined not by who physically pays the tax, but by the elasticities of supply and demand. ♦The more inelastic the demand (supply), the larger is the share of the tax that consumers (producers) pay.

FIGURE 19-6 An Extreme Case of Tax Incidence Copyright © 2003 South-Western/Thomson Learning. All rights reserved. S 0 S 0 S 1 S 1 Tax = $1,000 Price of Luxury Cars, Including Tax $40,000 $41,000 Number of Luxury Cars Rise in price = $1,000 D D

FIGURE 19-7 Another Extreme Case of Tax Incidence Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Price of Luxury Cars, Including Tax $40,000 Number of Luxury Cars D D S S

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. Shifting the Burden of Taxation: Tax Incidence ●The Incidence of the Payroll Tax ♦The incidence is the same whether it is levied on employers or employees. ♦Because the supply of labor is probably less elastic than the demand, the incidence falls mostly on workers. ●The Incidence of the Payroll Tax ♦The incidence is the same whether it is levied on employers or employees. ♦Because the supply of labor is probably less elastic than the demand, the incidence falls mostly on workers.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. When Taxation Can Improve Efficiency ●Some taxes that change behavior are nevertheless good because: ♦They help to achieve some other goal. ♦They compensate for an inefficiency in the market. (See, for example, the discussion of pollution taxes in Chapter 20.) ●Some taxes that change behavior are nevertheless good because: ♦They help to achieve some other goal. ♦They compensate for an inefficiency in the market. (See, for example, the discussion of pollution taxes in Chapter 20.)

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. Equity, Efficiency and the Optimal Tax ●All taxes have some negative effects in terms of efficiency and equity. ●The comprehensive personal income tax with no loopholes is the best we can do. ●All taxes have some negative effects in terms of efficiency and equity. ●The comprehensive personal income tax with no loopholes is the best we can do.

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Pros and Cons of the Bush Tax Cuts ●First: Reduced marginal tax rates ♦improved economic efficiency ●Second: tax cuts skewed toward upper- brackets ♦con: why rich get large breaks? ♦Pro: people who received largest breaks, paid most in taxes ●First: Reduced marginal tax rates ♦improved economic efficiency ●Second: tax cuts skewed toward upper- brackets ♦con: why rich get large breaks? ♦Pro: people who received largest breaks, paid most in taxes ?

Copyright© 2003 Southwestern/Thomson Learning. All rights reserved. The Pros and Cons of the Bush Tax Cuts ●Third: large magnitude once phased in ♦government afford “generosity”? ♦Bush argued surpluses justified but surpluses disappeared after Sept. 11 ●Conclusion: It is public policy debate with plenty of room for reasonable people to disagree. ●Third: large magnitude once phased in ♦government afford “generosity”? ♦Bush argued surpluses justified but surpluses disappeared after Sept. 11 ●Conclusion: It is public policy debate with plenty of room for reasonable people to disagree. ?