1. Chapter Fourteen Taxes, Transfers, and Income Distribution

2. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 2 Figure 14.1: Taxes Paid to the Federal Government

3. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 3 The Tax System Personal Income Tax: A tax on all forms of income an individual or household receives. –Wage, interest, dividends, rents, capital gains Taxable Income: A household’s income minus exemptions and deductions –Exemption: Amount to be subtracted for each person –Deduction: Other items that can be subtracted

4. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 4 Figure 14.2: Two Tax Rate Schedules from the 1040 Form

5. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 5 Computing Taxes Tax Bracket: A range of taxable income that is taxed at the same 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 –Use marginal tax rates when considering the impact of personal income tax on people’s behavior –Marginal rate was 91 percent before President Kennedy

6. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 6 Figure 14.3: Marginal Tax Rates

7. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 7 Taxes 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 –Marginal tax rate rises as people’s income rises 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 –Could use deductions to pay a smaller percent of income than people with lower incomes 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

8. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 8 Taxes Personal Income Tax (and taxable income) is $0 for household incomes up to the sum of exemptions and deductions. Flat tax: A tax system in which there is a constant marginal tax rate for all levels of taxable income Payroll tax: Tax on the wages and salaries of individuals –Most goes towards funding Social Security. –Submitted by employers –Economically speaking, doesn’t matter who pays the 15.3%

9. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 9 Other Taxes Corporate income taxes: A tax on the accounting profits of a corporation –34% for those with earnings over $75,000 Excise tax: A tax paid on the value of goods at the time of the purchase –Ex: Gasoline, tobacco, beer, wine, and liquor Sales tax: Type of Excise tax that applies to total expenditures on a broad group of goods Tariffs: Taxes imposed on imports –Used to be a major source of revenue before 16 th Amendment introduced personal income tax Property tax: A tax on the value of property owned

10. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 10 Effects of Taxes A tax adds the amount of the tax to the marginal cost of the seller of the good (NOT the marginal benefit) –An increase in tax shifts the supply curve left How it affects price and quantity depends on elasticity

11. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 11 Figure 14.4: How Elasticities Determine the Effects of Taxes

12. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 12 Effects of Taxes Tax incidence: The allocation of the burden of the tax between buyer and seller. –If the price rises by a lot, then the tax is passed on to buyers in higher prices and the burden of the tax falls more on the buyers –If the price rises little or not at all, then the seller absorbs the burden of the tax and most of the tax is not passed on to buyers

13. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 13 Effects of the Personal Income Tax Personal income tax is a tax on labor income (salaries and wages) and capital income (interest and dividends) –75% of income of all 1040s filed is labor income Will cause the supply curve of labor to shift left, depending on the marginal tax rate –Quantity declines

14. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 14 Figure 14.5: Effects of a Higher Income Tax on Labor Supply

15. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 15 Effect of a Payroll Tax Remember that payroll tax is paid by both employee and employer In case where employer pays the tax, demand decreases causing lower quantity and wage In case where employee pays the tax, demand decreases causing a lower quantity but a slightly higher wage –However, after tax, take home pay is the same

16. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 16 Figure 14.6: Effect of a Payroll Tax

17. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 17 Possibility of a Perverse Effect on Tax Revenue Tax revenue: The tax rate times the amount subject to tax –Example: Gas: Revenue is gallons * tax. As tax goes up, revenue goes up UNTIL a certain point. As price is increasing, demand is decreasing so tax revenue could actually be decreasing. Same for payroll or income taxes. Initially, as taxes increase, revenue goes up. But as taxes increase further, supply decreases –Tax avoidance: finding legal ways to reduce taxes (buying a home) –Tax evasion: Illegal ways to reduce taxes (not reporting tips)

18. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 18 Figure 14.7: A Tax Rate and Tax Revenues

19. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 19 Tax policy There is a tradeoff between equality and efficiency. If taxes are too high, the total amount of income may decline To be more efficient, should tax items with small elasticities Should keep the marginal tax rate low but increase the amount subject to the tax Ability to pay principle: The view that those with greater income should pay more in taxes than those with less income –Unfair if people who make the same income pay different amounts (example: married people)

20. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 20 Transfer Payments Transfer payment: A grant of funds from the government to an individual –Can be either cash or in kind (food or housing vouchers) Two types of transfer payments –Means-tested transfers: Depends on the income of the recipient –Social insurance transfers: Does NOT depend on the income of the recipient

21. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 21 Means-tested transfers Family Support Programs (Welfare): Payments to poor families with children as determined by each state Medicaid: Health insurance primarily for welfare recipients SSI (Supplemental Security Income): Payments to poor people who are old, disabled, or blind Food Stamp Program: Coupons for low-income people to buy food Head Start: Preschool education for low-income children Housing Assistance: Rental subsidies and aid for construction

22. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 22 The Earned Income Tax Credit (EITC) Earned Income Tax Credit (EITC): A part of the personal income tax through which people with low income who work receive a payment from the government or a rebate on their taxes

23. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 23 Figure 14.8: Welfare Reform to Improve Work Incentives

24. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 24 Social Insurance Programs Many programs are not Means-tested –Social security: System through which individuals make payments to the government when they work and receive payments from the government when they retire or become disabled. –Medicare: A government health insurance program for the elderly. –Unemployment insurance: A program that makes payments to people who lose their job. –Called social insurance because they are paid to people regardless of their circumstances –Transfer wealth from others (ex: payroll taxes for SS). Sometimes inefficient because they transfer from people who “need” it more to those who do not need it

25. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 25 Mandated Benefits Mandated benefits: Benefits that a firm is required by law to provide to its employees. –Must give maternity leave –Costs the firm –Because of the effect on the supply and demand graph, most of the benefit ends up being paid by the employee

26. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 26 Figure 14.9: Effect of a Mandate Benefit

27. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 27 Distribution of income in the United States 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. Sample size is about 70,000. Divides income into quintiles, with the same percentage in each quintile

28. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 28 Distribution of family income QuintileIncomePercent of Income Cumulative Percentage Bottom 20% 0 - 22,826 4.3 2 nd 20% 22,826 – 39,600 9.914.2 3 rd 20% 39,600 – 59,400 15.629.8 4 th 20% 59,400 – 88,082 23.052.8 5 th 20% 88,082 + 47.2100.0

29. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 29 Figure 14.10: The Lorenz Curve for the U.S.

30. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 30 Income Distribution 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. It measures income inequality. Gini coefficient: An index of income inequality ranging between 0 (equality) and 1 (inequality); it is defined as the ration of the area between the Lorenz curve and the perfect equality line to the area between the lines of perfect equality and perfect inequality.

31. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 31 Figure 14.11: Changes in Income Inequality: The U.S. Gini Coefficient

32. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 32 Income distribution Annual income is what you earn each year. Wealth (net worth) is all you own minus what you owe others. –These two can vary greatly. We talk about income distribution in Economics. 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 severe economic hardship.

33. Copyright © by Houghton Mifflin Company, Inc. All rights reserved14 - 33 Income distribution Census Bureau estimates that tax and transfer system has brought the poverty rate down by about 10 points.