Chapter 12 The Design of the Tax System

Objectives 2.) Understand the efficiency cost of taxation. 3.) Learn the criteria for evaluating the equity of a tax system. 4.) Recognize that understanding tax incidence is important for evaluating tax issues 5.) Understand some of the tradeoffs between equity and efficiency in a tax system. 1.) Learn how the various governments in our economy raise and spend money.

“In this world nothing is certain but death and taxes.” (Benjamin Franklin) Taxes paid in 1789 accounted for 5% of personal income

“In this world nothing is certain but death and taxes.” (Benjamin Franklin) Today Today, taxes account for about 35 % of personal income!

Government Revenue as a Percentage of GDP

The Tax System u When the government addresses the problem of externalities, provides public goods, or regulates the use of common resources, it can raise economic well-being. u For the government to perform these and its other many functions, it needs to raise revenue.

The Tax System u Most people agree that taxes should impose as small a cost on society as possible, i.e... … the tax system should be efficient and equitable.

A Financial Overview of the U.S. Government u Where does the government get its income from? u What does the government spend its income on? u Who contributes the most to the U.S. Government in the form of taxes? u What does the government spend most of it’s income on?

The U.S. Economy may be divided into two major sectors: u The Private Sector –About two-thirds of all economic activity in the U.S. takes place within the private sector. u The Public Sector –About one-third of all economic activity in the U.S. involves the government sector.

The Government Sector: Federal, State and Local u The Federal Government collects about two-thirds of the taxes in our economy. (Table 12-1) –Individual Income Taxes48% –Social Insurance Taxes 34% –Corporate Income Taxes 10% –Excise Taxes 4% –Other 4%

Receipts of the Federal Government Personal Tax Social Insurance Tax Corporate Tax Excise Tax Other 48% 34%10%4% 4%

Individual Income Taxes... The largest source of government revenue u Tax Liability is how much taxes a family owes and is based upon total income. u Marginal Tax Rate is the tax rate applied to each dollar of income. (Table 12-2) u Higher-income families pay a larger percentage of their income in taxes.

The Federal Income Tax Rates: 1999 On Taxable Income.... The Tax rate is.... Up to $25,750 From $25,750 - $62,450 From $62,450 - $130,250 From $130, ,150 Over $283,150 Up to $25,750 From $25,750 - $62,450 From $62,450 - $130,250 From $130, ,150 Over $283, % 28.0% 31.0% 36.0% 39.6% 15.0% 28.0% 31.0% 36.0% 39.6%

Federal Government Spending u Spending of government revenues (taxes) includes transfer payments and the purchase of public goods and services. (Table 12-3) u A Transfer Payment is a government payment not made in exchange for a good or a service. –Transfer payments account for the largest expenses of the government.

The Federal Government and Taxes u Payroll Taxes: tax on the wages that a firm pays its workers. u Social Insurance Taxes: revenue from these taxes is earmarked to pay for Social Security and Medicare. u Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic beverages.

Spending of the Federal Government Expense Category: Social Security National Defense Income Security Net Interest Medicare Health Other

Spending of the Federal Government Social Security Defense Net Interest Income Security Medicare Health Other 23% 16% 14% 13% 12% 8% 14%

Federal Government Spending: 1999 Category Amount (billions) Amount per Person Percent of Spending Social security $ 393$1,44523% National defense2771,01816 Net interest Income security Medicare Health Other Total$1,727$6,350100%

Financial Conditions of the Federal Budget u Budget Deficit –Situation where the expenses of the budget are greater than the revenues for a given period of time. –Government finances the deficit by borrowing from the public u Budget Surplus –Situation where the revenues are greater than the expenses for a given period of time.

State and Local Governments: Collect about one-third of taxes paid u Expenses –Education –Public Welfare –Highways –Other u Receipts –Sales Taxes –Property Taxes –Individual Income Taxes –Corporate Income Taxes –Federal Government –Other

Receipts of State and Local Governments: 1992 Tax Sales taxes Property taxes Individual income tax Corporate income taxes From Federal government Other Total Sales taxes Property taxes Individual income tax Corporate income taxes From Federal government Other Total $249 $209 $147 $ 32 $235 $351 $1223 $249 $209 $147 $ 32 $235 $351 $1223 Amount (Billions) Amount (Billions) Amount Per Person Amount Per Person Percent of Receipts Percent of Receipts $940 $789 $554 $ 121 $887 $1,324 $4,615 $940 $789 $554 $ 121 $887 $1,324 $4,615 20% 17% 12% 3% 19% 29% 100% 20% 17% 12% 3% 19% 29% 100%

Spending of State and Local Governments: 1992 Category Education Public welfare Highways Other Total Education Public welfare Highways Other Total $399 $197 $ 79 $518 $1,193 $399 $197 $ 79 $518 $1,193 Amount (Billions) Amount (Billions) Amount Per Person Amount Per Person Percent of Spending Percent of Spending $1,506 $ 743 $ 298 $1,955 $4,502 $1,506 $ 743 $ 298 $1,955 $4,502 33% 17% 7% 43% 100% 33% 17% 7% 43% 100%

Quick Quiz! u What are the two most important sources of tax revenue for the federal government? u What are the two most important sources for state and local governments?

Taxes and Efficiency u The aim of a tax system is to raise revenue for the government. Two objectives of designing a tax system: Efficiency Equity u A tax system is more efficient if it can raise the same amount of revenue at a smaller cost to the taxpayers.

Related Costs of Taxes to Taxpayers u The costs of taxes to taxpayers: –The tax payment itself v Transfer of money from taxpayer to government. –Deadweight losses –Administrative burdens

Deadweight Loss of Taxation (Chapter 8) u When a tax is levied on buyers, the demand curve shifts downward by the size of the tax... u When a tax is levied on sellers, the supply curve shifts upward by that amount... The losses to buyers and sellers exceed the tax revenue, leading to a Deadweight Loss.

Tax Costs: Administrative Burdens u Includes not only the time spent in early April filling out forms. u Payment for tax experts in assisting the taxpayer in filing tax returns. u The cost to the taxpayer is greater than the actual tax payment made.

The Goal of an Efficient Tax System An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

Alternative Tax Rates Efficiency and equity of income taxes leads to three notions of tax rates: À Average Tax Rate......is total taxes paid divided by total income Á Marginal Tax Rate......is the extra taxes paid on an additional dollar of income. Â Lump-Sum Tax Rate......everyone owes the same amount of tax.

Quick Quiz! u What is meant by the efficiency of a tax system? u What can make a tax system inefficient?

Taxes and Equity u How should the burden of taxes be divided among the population? u How do we evaluate whether a tax system is fair? Benefits Principle Ability-to-pay Principle

Taxes and Equity: Benefit Principle “People should pay taxes based on the benefits they receive from government services.” u Example: –Gasoline Tax: These tax revenues are used to finance our highway system. –People who drive the most, use the road the most, also pay the most toward their upkeep.

Taxes and Equity: Ability-to-pay Principle “Taxes should be assigned based on an individual’s ability to shoulder the tax burden.” u Two notions of equity: –Vertical Equity –Horizontal Equity

Vertical Equity “Differently situated individuals should be treated differently.” u Example: People with higher incomes should pay more than people with lower incomes. –Alternative Tax Systems: v Proportional v Regressive v Progressive

l A progressive tax is one in which the average effective tax rate rises as income rises l A regressive tax is one in which the average effective tax rate declines as income rises l A proportional tax is one in which the average effective tax rate remains unchanged, whatever the size of the taxpayer’s income

Three Tax Systems Income $ 50,000 $100,000 $200,000 $ 50,000 $100,000 $200,000 $12,500 25,000 50,000 $12,500 25,000 50,000 Amount of Tax Amount of Tax 25% Percent of Income Percent of Income Proportional Tax

Three Tax Systems Income $ 50,000 $100,000 $200,000 $ 50,000 $100,000 $200,000 $10,000 25,000 60,000 $10,000 25,000 60,000 Amount of Tax Amount of Tax 20% 25% 30% 20% 25% 30% Percent of Income Percent of Income Progressive Tax

Three Tax Systems Income $ 50,000 $100,000 $200,000 $ 50,000 $100,000 $200,000 $15,000 25,000 40,000 $15,000 25,000 40,000 Amount of Tax Amount of Tax 30% 25% 20% 30% 25% 20% Percent of Income Percent of Income Regressive Tax

The Burden of Federal Taxes Quintile Lowest Second Middle Fourth Highest Lowest Second Middle Fourth Highest Average Income Average Income Percent of all Income Percent of all Taxes Taxes as a Percent of Income Taxes Minus Transfers as a Percent of Income $ 7,386 $18,380 $29,849 $43,363 $99,197 $ 7,386 $18,380 $29,849 $43,363 $99, % 9.2% 14.2% 21.7% 51.4% 3.7% 9.2% 14.2% 21.7% 51.4% 1.4%.4% 12.5% 21.2% 58.2% 1.4%.4% 12.5% 21.2% 58.2% 8.9% 15.8% 19.5% 22.1% 25.5% 8.9% 15.8% 19.5% 22.1% 25.5% -29.8% -2.1% 9.5% 16.2% 23.1% -29.8% -2.1% 9.5% 16.2% 23.1%

Horizontal Equity “Would require people of like incomes to pay the same amount of tax.” u Example: Two different families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.

The “Marriage Tax” u Marriage affects the tax liability of a couple in that tax law treats a married couple as a single taxpayer. u When a couple gets married, they stop paying taxes as individuals and start paying taxes as a family. u If each has a similar income, their total tax liability rises when they get married.

Taxes and Equity u The difficult part of tax policy is to balance the sometimes conflicting nature of the efficiency and equity goals. u The study of who bears the actual burden of taxes is central to evaluating tax equity. This is called Tax Incidence.

Flypaper Theory of Tax Incidence According to the flypaper theory, the burden of a tax, like a fly on flypaper, sticks wherever it first lands.

The Flat Tax u First proposed by economist Robert Hall in the 1980s. u Proposed as an alternative to the current tax system. u A single, low tax rate would apply to all income in the economy.

Proposed Benefits of the Flat Tax u The flat tax would eliminate many of the deductions allowed under the current income tax thereby broadening the tax base and reducing marginal tax rates for most people. u Because the flat tax is simple, the administrative burden of taxation would be greatly reduced.

Proposed Benefits of the Flat Tax u Because all taxpayers would be faced with the same marginal tax rate, the tax could be collected at the source of income. u The flat tax would replace both the personal and corporate income taxes and would eliminate the current double taxation of corporate profits. u The flat tax could increase the incentive to save.

Quick Quiz! u Explain the benefits principle and the ability-to-pay principle. u What are vertical equity and horizontal equity? u Why is studying tax incidence important in determining equity in a tax system?

Conclusion: The tradeoff between equity and efficiency u Equity and efficiency are the two most important goals of the tax system. But often these goals conflict. u Many proposed changes in the tax laws increase efficiency while reducing equity, or increase equity while reducing efficiency.