1. The Design of the Tax System
Chapter 12
The Design of the Tax System
© 2002 by Nelson, a division of Thomson Canada Limited 1 1 1 1 1 1

2. Overview Financial Overview of the Canadian Government
Taxes and Efficiency
Taxes and Equity
Conclusion 2 8 15 15 8 8 2 2 30 8

3. In 1961, taxes accounted for about 28 % of
“In this world nothing is certain but death and taxes.” (Benjamin Franklin)
Percent of total income
In 1961, taxes accounted for about 28 % of
total income! 2 3 2 3 3 2

4. Today, taxes account for about 40 % of
“In this world nothing is certain but death and taxes.” (Benjamin Franklin)
Percent of total income
Today, taxes account for about 40 % of
total income! 3 3 3 4 4 3

5. The Tax System
When the government addresses the problem of externalities, provides public goods, or regulates the use of common resources, it can raise economic well-being.
For the government to perform these and its many other functions, it needs to raise revenue. 4 4 4 5 5 4

6. The Tax System
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. 5 5 5 6 6 5

7. A Financial Overview of the Canadian Government
Where does the government get its income from?
What does the government spend its income on? 6 6 6 7 7 6

8. The Canadian Federal Structure
There are three levels of government -federal, provincial, local.
The B.N.A. Act sets out the responsibilities of the federal and provincial governments.
The local governments derive authority from the provincial governments.
The Federal government has unlimited taxing powers. 7 7 7 8 8 7

9. The Federal Government: Revenue
The major sources of tax revenue of the federal government include:
Personal Income Taxes
Corporate Income Taxes
Goods and Services Taxes
Payroll Taxes
Other 8 8 8 9 9 8

10. The Federal Government: Revenue9 9 9 9 10 10

11. Personal Income Taxes... The largest source of government revenue
Tax Liability is how much tax an individual owes and is based upon total income.
Marginal Tax Rate is the tax rate applied to each additional dollar of income. Higher-income individuals pay a larger percentage of their income in taxes. 10 10 10 11 11 10

12. Federal Government Spending
About 30% of total government spending is on servicing the public debt.
The remaining 70% of government spending is called “Program Spending.” 11 11 11 12 12 11

13. Federal Government Spending12 13 12 12 13 13

14. Financial Conditions of the Federal Budget
Budget Deficit
Situation where the expenses of the budget are greater than the revenues.
Government finances the deficit by borrowing from the public.
Budget Surplus
Situation where the revenues are greater than the expenses. Used to pay outstanding debts. 13 14 13 14 14 13

15. The Provincial Government: Revenue9 9 14 14 15 15

16. The Provincial Government: Spending9 9 15 15 16 16

17. Local Governments: Municipalities and School Boards
Spending
Education
Protection of People and Property
Other
Receipts
Property Taxes
Transfers
Other 14 16 15 17 17 16

18. Quick Quiz!
What are the two most important sources of tax revenue for the federal government?
What are the three most important expenditures for provincial governments? 15 16 17 18 18 17

19. Overview Financial Overview of the Canadian Government
Taxes and Efficiency
Taxes and Equity
Conclusion 2 8 15 15 8 8 19 19 30 8

20. Taxes and Efficiency
The aim of a tax system is to raise revenue for the government. Two objectives of designing a tax system:
Efficiency
Equity
A tax system is more efficient if it can raise the same amount of revenue at a smaller cost to the taxpayers. 16 17 18 20 20 18

21. Related Costs of Taxes to Taxpayers
The costs of taxes to taxpayers:
The tax payment itself
Transfer of money from taxpayer to government.
Deadweight losses
Administrative burdens
Again, an efficient tax system is one which minimizes these costs. 17 18 19 21 21 19

22. Deadweight Loss of Taxation
When a tax is levied on buyers, the demand curve shifts downward by the size of the tax...
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. 18 19 20 22 22 20

23. Administrative & Compliance Costs
Administrative Costs include:
Collection and enforcement expenses.
Compliance costs include:
The time spent in early spring filling out forms.
Payment for tax experts in assisting the taxpayer in filing tax returns.
The cost to the taxpayer is greater than the actual tax payment made. 19 20 21 23 23 21

24. The Goal of an Efficient Tax System
An efficient tax system is one that imposes small deadweight losses and small administrative and compliance burdens.
Suggested strategies to enhance efficiency include:
simplifying the tax system
broader based taxes 20 21 22 24 24 22

25. Alternative Tax Rates
Efficiency and equity of income taxes leads to three notions of tax rates:
Average Tax Rate...
...is total taxes paid divided by total income
Marginal Tax Rate...
...is the extra taxes paid on an additional dollar of income
Lump-Sum Tax Rate...
...everyone owes the same amount of tax 21 22 23 25 25 23

26. Quick Quiz! What is meant by the efficiency of a tax system?
What can make a tax system inefficient? 22 23 24 26 26 24

27. Overview Financial Overview of the Canadian Government
Taxes and Efficiency
Taxes and Equity
Conclusion 2 8 15 15 8 8 27 27 30 8

28. Ability-to-pay Principle
Taxes and Equity
How should the burden of taxes be divided among the population?
How do we evaluate whether a tax system is fair?
Benefits Principle
Ability-to-pay Principle 23 24 25 28 28 25

29. Taxes and Equity: Benefits Principle
“People should pay taxes based on the benefits they receive from government services.”
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. 24 25 26 29 29 26

30. Taxes and Equity: Ability-to-pay Principle
“Taxes should be assigned based on an individual’s ability to shoulder the tax burden.”
Two notions of equity:
Vertical Equity
Horizontal Equity 25 26 27 30 30 27

31. “Differently situated individuals should be treated differently.”
Vertical Equity
“Differently situated individuals should be treated differently.”
Example: People with higher incomes should pay more than people with lower incomes.
Alternative Tax Systems:
Proportional
Regressive
Progressive 26 27 28 31 31 28

32. “Would require people of like incomes to pay the same amount of tax.”
Horizontal Equity
“Would require people of like incomes to pay the same amount of tax.”
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. 27 28 29 32 32 29

33. Taxes and Equity
The difficult part of tax policy is to balance the sometimes conflicting nature of the efficiency and equity goals.
The study of who bears the burden of taxes is central to evaluating tax equity. This is called Tax Incidence. 28 29 30 33 33 30

34. Quick Quiz!
Explain the benefits principle and the ability-to-pay principle.
What are vertical equity and horizontal equity?
Why is studying tax incidence important in determining equity in a tax system? 29 30 31 34 34 31

35. Overview Financial Overview of the Canadian Government
Taxes and Efficiency
Taxes and Equity
Conclusion 2 8 15 15 8 8 35 35 30 8

36. Conclusion: The tradeoff between equity and efficiency
Equity and efficiency are the two most important goals of the tax system. But often these goals conflict.
Many proposed changes in the tax laws increase efficiency while reducing equity, or increase equity while reducing efficiency. 30 31 32 36 36 32

37. Overview Financial Overview of the Canadian Government
Taxes and Efficiency
Taxes and Equity
Conclusion 2 8 15 15 8 8 37 37 30 8