Chapter Fourteen Taxes, Transfers, and Income Distribution

14 | 2 Copyright © Houghton Mifflin Company. All rights reserved. The Tax System In this chapter, we discuss several different types of taxes used in the United States. The major types of taxes in the United States are: 1)Personal income tax 2)Payroll tax on wage and salary income 3)Corporate income tax 4)Estate and Gift Taxes 5)Tariffs 6)Property Taxes

14 | 3 Copyright © Houghton Mifflin Company. All rights reserved. Table 14.1 shows the shares of the different tax types on the tax revenues of the federal government. From the table, nearly 85 percent of all federal government tax revenues are personal income and payroll taxes. The Tax System (cont’d)

14 | 4 Copyright © Houghton Mifflin Company. All rights reserved. The Tax System (cont’d)

14 | 5 Copyright © Houghton Mifflin Company. All rights reserved. The Personal Income Tax Personal income tax: A tax on all forms of income that an individual or household receives.

14 | 6 Copyright © Houghton Mifflin Company. All rights reserved. Computing the Personal Income Tax Taxable income – A household’s income minus exemptions and deductions. Exemptions – The dollar amount that can be subtracted from taxable income based on the number of persons in the household. Deductions – Other items—such as interest on mortgages, charitable donations, and moving expenses—that can be subtracted from taxable income.

14 | 7 Copyright © Houghton Mifflin Company. All rights reserved. Tax Bracket – A range of taxable income that is taxed at the same rate. Figure 14.2 shows a sample tax rate schedule from a 1040 federal tax form. The tax form shows the tax brackets of the taxable income and the marginal tax rates corresponding to the tax bracket. Computing the Personal Income Tax (cont’d)

14 | 8 Copyright © Houghton Mifflin Company. All rights reserved. Computing the Personal Income Tax (cont’d) Figure 14.2

14 | 9 Copyright © Houghton Mifflin Company. All rights reserved. Marginal Tax Rate Marginal tax rate – The change in total tax divided by the change in income. Average tax rate – The total tax paid divided by the total taxable income.

14 | 10 Copyright © Houghton Mifflin Company. All rights reserved. Progressive tax – A tax for which the amount of an individual’s taxes rises as a proportion of income as the person’s income increases. Regressive tax – A tax for which the amount of an individual’s taxes falls as a proportion of income as the person's income increases. A sales tax is generally regressive. A tax system can also be regressive if the people with higher incomes are afforded larger and larger deductions. Marginal Tax Rate (cont’d)

14 | 11 Copyright © Houghton Mifflin Company. All rights reserved. A proportional tax – A tax for which the amount of an individual’s taxes as a percentage of income is constant as the person’s income rises. Figure 14.3 illustrates the actual marginal tax rates for the United States, taken from an IRS tax schedule. Since the marginal tax rate is increasing, the tax system is progressive (unless the richer people are afforded a larger and larger deduction). Marginal Tax Rate (cont’d)

14 | 12 Copyright © Houghton Mifflin Company. All rights reserved. Marginal Tax Rate (cont’d) Figure 14.3

14 | 13 Copyright © Houghton Mifflin Company. All rights reserved. A flat tax – Occurs when the marginal tax rate is a constant number. An example of a flat tax is Steve Forbes’ 17 percent Flat Tax plan in 1996 and Some of the Eastern Bloc countries like Estonia (24%), Latvia (25%), and Russia (13%) have flat taxes. The Netherlands has a been considering a 40 percent flat tax. Marginal Tax Rate (cont’d)

14 | 14 Copyright © Houghton Mifflin Company. All rights reserved. Steve Forbes’ Flat Tax When Steve Forbes ran for president in 1996, his campaign centered on a flat tax of 17 percent. Here is how it worked: 1)A flat, 17 percent marginal tax rate. 2)No tax for the first $36,000 of income. 3)Taxes applied only to wages. No tax on personal savings, pensions, etc.

14 | 15 Copyright © Houghton Mifflin Company. All rights reserved. The Payroll Tax Payroll Tax – A tax on wages and salaries of individuals. Payroll taxes go to programs such as social security, Medicare, and unemployment insurance.

14 | 16 Copyright © Houghton Mifflin Company. All rights reserved. All Other Taxes Corporate income tax – A tax on the accounting profits (not economic profits) of corporations. Currently, the corporate income taxes range from 15 to 38 percent.

14 | 17 Copyright © Houghton Mifflin Company. All rights reserved. Excise tax – A tax paid on the value of goods at the time of purchase. Sales tax – A type of excise tax that applies to total expenditures on a broad group of goods and services. Property tax – A tax on the value of property owned. All Other Taxes (cont’d)

14 | 18 Copyright © Houghton Mifflin Company. All rights reserved. Effects of Taxes From chapter 3, we know that a tax on a good shifts the supply curve to the right. From chapter 7, we learned that a tax on a good drives a wedge between the price that buyers and sellers pay. The change in the price that buyers and sellers pay determines the tax incidence.

14 | 19 Copyright © Houghton Mifflin Company. All rights reserved. Tax incidence – The allocation of the burden of the tax between the buyer and the seller. The buyer’s share of the tax is the difference between the old equilibrium price and the new equilibrium price after the tax. The seller’s share of the tax is the difference between the old equilibrium price and the price that sellers receive net of taxes. Effects of Taxes (cont’d)

14 | 20 Copyright © Houghton Mifflin Company. All rights reserved. Figure 14.4 shows the effect of a specific tax on the market equilibrium with elastic and inelastic demand curves. Note that the deadweight loss resulting from the tax is smaller when the demand curves and the supply curves are inelastic. Effects of Taxes (cont’d)

14 | 21 Copyright © Houghton Mifflin Company. All rights reserved. Effects of Taxes (cont’d) Figure 14.4

14 | 22 Copyright © Houghton Mifflin Company. All rights reserved. From Figure 14.4, the buyer’s share and the seller’s share of the tax varies with the elasticity of the demand and the supply curve. In particular, notice that when the demand curve is inelastic or when the supply is very elastic, the buyer’s share of the tax is high (i.e., the difference between the old and new equilibrium price is large). The top left graph and the bottom right graph in Figure 14.4 illustrates this scenario. Effects of Taxes (cont’d)

14 | 23 Copyright © Houghton Mifflin Company. All rights reserved. Similarly, when the demand curve is elastic or when the supply is inelastic, the seller’s share of the tax is high (i.e., the difference between the old equilibrium price and the seller’s price net of taxes is large). The top left graph and the bottom right graph in Figure 14.4 illustrates this scenario. Effects of Taxes (cont’d)

14 | 24 Copyright © Houghton Mifflin Company. All rights reserved. Effects of Personal Income Taxes The effects of a tax on labor income can easily be analyzed using a labor supply and labor demand curve, as illustrated by Figure 14.5.

14 | 25 Copyright © Houghton Mifflin Company. All rights reserved. Effects of Personal Income Taxes (cont’d) Figure 14.5

14 | 26 Copyright © Houghton Mifflin Company. All rights reserved. A personal income tax shifts the labor supply curve to the left, with the vertical distance between the old and new labor supply curves depending on the value of the tax. As the labor supply shifts up, the equilibrium quantity decreases and the equilibrium wage rises. The reduced work will cause a deadweight loss. Just like with a tax on a commodity, the size of the deadweight loss depends on the elasticity of the demand and the supply curve. Effects of Personal Income Taxes (cont’d)

14 | 27 Copyright © Houghton Mifflin Company. All rights reserved. Effect of a Payroll Tax Since part of the payroll tax is paid by the employer and part by the employee, then we need to analyze both effects. Figure 14.6 illustrates the effect of a payroll tax if the employer pays for the tax and if the employee pays for the tax. If the payroll tax is shared by both employer and employee, then the effect is the combination of both graphs.

14 | 28 Copyright © Houghton Mifflin Company. All rights reserved. Effects of a Payroll Tax (cont’d) Figure 14.6

14 | 29 Copyright © Houghton Mifflin Company. All rights reserved. If the payroll tax is paid by the employer, then an increase in the tax is an increase in cost of hiring a worker and results in a decrease in the demand for workers. This is shown in the graph on the left side of Figure If the payroll tax is paid by the employee, then an increase in the tax is an increase in cost of working and results in a decrease in the supply of workers. This is shown in the graph on the right side of Figure Effects of a Payroll Tax (cont’d)

14 | 30 Copyright © Houghton Mifflin Company. All rights reserved. Tax Rates and Tax Revenues From Figures 14.5 and 14.6, an increase in personal income and payroll taxes will result in a decrease in the quantity of hours worked. This is important for the government to know if the government’s objective is to maximize government tax revenue. Figure 14.7 shows that higher tax rates do not always lead to higher tax revenues. The graph in Figure 14.7 is also known as the Laffer curve.

14 | 31 Copyright © Houghton Mifflin Company. All rights reserved. Tax Rates and Tax Revenues (cont’d) Figure 14.7

14 | 32 Copyright © Houghton Mifflin Company. All rights reserved. A higher tax rate may increase the tax revenues if the increase in revenue brought about by the higher tax rate outweighs the decline in revenue brought about by the decrease in working hours. This is usually true at lower tax rates. A higher tax rate may decrease the tax revenues if the increase in revenue brought about by the higher tax rate is smaller than the decline in revenue brought about by the decrease in working hours. This is usually true at higher tax rates. Tax Rates and Tax Revenues (cont’d)

14 | 33 Copyright © Houghton Mifflin Company. All rights reserved. Transfer Payments Transfer Payments – A grant of funds from the government to an individual. The grant can be in cash or in kind, and does not require repayment. Means-tested transfer: A transfer of payments that depends on the income of the recipient. Social insurance transfer – A transfer payment, such as social security, that does not depend on the income of the recipient.

14 | 34 Copyright © Houghton Mifflin Company. All rights reserved. Table 14.2 lists some of the means-tested transfer programs in the United States. Means-Tested Transfer Payments

14 | 35 Copyright © Houghton Mifflin Company. All rights reserved. Means-Tested Transfer Payments (cont’d)

14 | 36 Copyright © Houghton Mifflin Company. All rights reserved. Means-Tested Transfer Payments (cont’d) Family support programs – Transfer programs through which the federal government makes grants to states to give cash to certain low-income families. Medicaid – A health insurance program designed primarily for families with low incomes.

14 | 37 Copyright © Houghton Mifflin Company. All rights reserved. Supplemental security income (SSI) – a means-tested transfer program designed primarily to help the poor who are disabled or blind. Food stamp program – A government program that provides people with low incomes with coupons (food stamps) that they can use to buy food. Means-Tested Transfer Payments (cont’d)

14 | 38 Copyright © Houghton Mifflin Company. All rights reserved. Housing assistance programs – Government programs that provide subsidies either to low-income families to rent housing or to contractors to build low- income housing. Means-Tested Transfer Payments (cont’d)

14 | 39 Copyright © Houghton Mifflin Company. All rights reserved. The Earned Income Tax Credit (EITC) Earned income tax credits – A part of the personal income tax through which people with low income who work receive a payment from the government or a rebate in their taxes. This program is designed for workers who have low incomes because of low wages or from working part-time. The program works by providing a refundable credit that raises the worker’s take-home pay.

14 | 40 Copyright © Houghton Mifflin Company. All rights reserved. Incentive Effects While a variety of government transfer programs aim at reducing inequality, these programs also create a disincentive to work. Figure 14.8 shows the first disincentive problem.

14 | 41 Copyright © Houghton Mifflin Company. All rights reserved. Figure 14.8 Incentive Effects (cont’d)

14 | 42 Copyright © Houghton Mifflin Company. All rights reserved. The incentive to work for the individual is the additional take home pay he/she gets from working an additional hour. From the top graph of Figure 14.8, transfer programs such as welfare reduces the incentive to work because the transfer payment is gradually reduced as the worker works more hours. The additional take-home pay the worker receives from working is illustrated by the slope of the income line with welfare payments. Incentive Effects (cont’d)

14 | 43 Copyright © Houghton Mifflin Company. All rights reserved. Incentive Effects (cont’d) To increase the incentive to work, i.e., make the slope of the income line steeper with welfare payments, two solutions exist: 1)Reform by phasing out the welfare payments more slowly. For example, a worker who earns an extra dollar may find his welfare benefit reduced by 50 cents. His incentive for working is reduced by 50 percent. This reform suggests that the benefit be decreased at a slower rate (say 25 cents per dollar earned, instead of 50). This is illustrated in the middle graph on Figure 14.8.

14 | 44 Copyright © Houghton Mifflin Company. All rights reserved. Incentive Effects (cont’d) 2)Reform by paying less welfare – This reform suggests that the benefit received be reduced, as illustrated in the lower graph in Figure 14.8.

14 | 45 Copyright © Houghton Mifflin Company. All rights reserved. Social Insurance Programs Social Security – The system through which individuals make payments to the government when they work and receive payments from the government when they retire or become disabled.

14 | 46 Copyright © Houghton Mifflin Company. All rights reserved. Medicare – A government health insurance for the elderly. Unemployment insurance – A program that makes payment to people who lose their jobs. These social insurance programs are not means-tested, as wealthy individuals can also receive benefits. Social Insurance Programs (cont’d)

14 | 47 Copyright © Houghton Mifflin Company. All rights reserved. The Distribution of Income in the United States (cont’d) Current Population Survey – A monthly survey of a sample of U.S. households done by the U.S. Census Bureau; it measures employment, unemployment, the labor force, and other characteristics of the U.S. population.

14 | 48 Copyright © Houghton Mifflin Company. All rights reserved. The Personal Distribution of Income To summarize income data, we rank the population according to income and divide the population into fifths, or quintiles. Quintiles – Division or groupings of one-fifth of a population ordered by income, wealth, or some other statistic. Table 14.3 shows the range of annual family incomes for the quintiles for the U.S. in 2004.

14 | 49 Copyright © Houghton Mifflin Company. All rights reserved. The Personal Distribution of Income (cont’d)

14 | 50 Copyright © Houghton Mifflin Company. All rights reserved. Table 14.4 illustrates the distribution of family income by quintile. From the table: the top 20 percent of the population earn 47.6 percent of total income, while the lower 20 percent earn only 4.2 percent of total income. The Personal Distribution of Income (cont’d)

14 | 51 Copyright © Houghton Mifflin Company. All rights reserved. The Personal Distribution of Income (cont’d) Table 14.4

14 | 52 Copyright © Houghton Mifflin Company. All rights reserved. The Lorenz Curve and the Gini Coefficient We can construct a measure for income inequality using our data for income distribution in Figures 14.3 and Specifically, we can construct the Lorenz curve and the Gini coefficient. Both measures for income inequality can be used to compare inequality across nations or inequality within a nation through time.

14 | 53 Copyright © Houghton Mifflin Company. All rights reserved. Lorenz Curve – A curve showing the relation between the cumulative percentage of the population and the proportion of total income earned by each cumulative percentage. Figure illustrates a sample Lorenz curve. The Lorenz Curve and the Gini Coefficient (cont’d)

14 | 54 Copyright © Houghton Mifflin Company. All rights reserved. The Lorenz Curve and the Gini Coefficient (cont’d) Figure 14.10

14 | 55 Copyright © Houghton Mifflin Company. All rights reserved. If income is perfectly distributed, then the cumulative proportion of the population equals the cumulative proportion of income earned by the population. If income is perfectly distributed, the Lorenz curve should be a 45-degree line from the origin. The Lorenz Curve and the Gini Coefficient (cont’d)

14 | 56 Copyright © Houghton Mifflin Company. All rights reserved. On the other extreme, if income is perfectly unequal, then only one person earns all income, and the rest of the population earns nothing. In this scenario, the Lorenz curve should be an inverted L shaped line. The Lorenz Curve and the Gini Coefficient (cont’d)

14 | 57 Copyright © Houghton Mifflin Company. All rights reserved. Most economies have a Lorenz curve between the two extreme income distributions. The shaded area between the 45-degree line and the Lorenz curve is a measure of inequality. This area depicts the deviation from perfect equality, and is used to measure the Gini coefficient. The Lorenz Curve and the Gini Coefficient (cont’d)

14 | 58 Copyright © Houghton Mifflin Company. All rights reserved. Gini Coefficient – An index of income inequality ranging between zero (perfect equality) and 1(for absolute inequality); it is defined as the ratio of the area between the Lorenz curve and the perfect equality line to the area between the lines of perfect equality and perfect inequality. The Lorenz Curve and the Gini Coefficient (cont’d)

14 | 59 Copyright © Houghton Mifflin Company. All rights reserved. The larger the Gini coefficient, the more unequal the distribution of income. The smaller the Gini coefficient, the more equal the distribution of income. The Lorenz Curve and the Gini Coefficient (cont’d)

14 | 60 Copyright © Houghton Mifflin Company. All rights reserved. Income Distribution Around the World The figure below compares the income distribution of the United States, Brazil, Bangladesh, and the World. Two facts are of interest: 1)There is great income inequality in the world. 2)The income distribution in the United States is worse than that of Bangladesh.

14 | 61 Copyright © Houghton Mifflin Company. All rights reserved. Income Distribution Around the World (cont’d)

14 | 62 Copyright © Houghton Mifflin Company. All rights reserved. The Poor and the Poverty Rate Poverty rate – The percentage of people living below the poverty line. Poverty line – An estimate of the minimum amount of annual income required for a family to avoid sever hardship.

14 | 63 Copyright © Houghton Mifflin Company. All rights reserved. The poverty line is based on data that families spend 1/3 of their incomes on food. It is calculated as three time the Department of Agriculture’s estimate of the amount of money needed to purchase low-cost nutritionally adequate amount of food, adjusted for the size of the family. Table 14.5 shows the poverty line for several family sizes in The Poor and the Poverty Rate (cont’d)

14 | 64 Copyright © Houghton Mifflin Company. All rights reserved. The Poor and the Poverty Rate (cont’d)

14 | 65 Copyright © Houghton Mifflin Company. All rights reserved. Key Terms Personal income tax Taxable income Tax bracket Marginal and average tax rate Progressive tax rate Regressive tax rate Flat tax

14 | 66 Copyright © Houghton Mifflin Company. All rights reserved. Payroll tax Corporate income tax Excise tax Property tax Tax incidence Tax revenue Transfer payments Means-tested transfer Key Terms (cont’d)

14 | 67 Copyright © Houghton Mifflin Company. All rights reserved. Social insurance transfer Family support programs Medicaid Supplemental security income (SSI) Food stamp program Head Start Housing assistance programs Earned income tax credit Key Terms (cont’d)

14 | 68 Copyright © Houghton Mifflin Company. All rights reserved. Social Security Medicare Unemployment insurance Mandated benefits Current population survey Quintiles The Lorenz curve and the Gini coefficient Poverty rate and poverty line Key Terms (cont’d)