1. The Design of the Tax System E conomics P R I N C I P L E S O F N. Gregory Mankiw Chapter 12

2. THE DESIGN OF THE TAX SYSTEM 1 Introduction  One of the Ten Principles from Chapter 1: A government can sometimes improve market outcomes.  Providing public goods  Regulating use of common resources  Remedying the effects of externalities  To perform its many functions, the government raises revenue through taxation.  Lessons about taxes from earlier chapters:  A tax on a good reduces the market quantity  The burden of a tax is shared between buyers and sellers) (impact of elasticity)  A tax causes a deadweight loss.

3. Our Role in Funding the Government  We authorize the government, through the Constitution and elected officials, to raise money through taxes.  Must originate in the House (Ways and Means)  House-Senate-President  Taxation is the primary way that the government collects money.  Without revenue, or income from taxes, government would not be able to provide goods and services.

4. Power and Limits of Taxation The Power to Tax  Article 1, Section 8, Clause 1 of the Constitution grants Congress the power to tax.  The Sixteenth Amendment (introduced 1909, ratified 1913) gives Congress the power to levy an income tax.  Great Depression  Social Security Act (1935) and the Internal Revenue Service (IRS)  Administrative agency of the Dept. of Treasury  Headquarters in DC, 7 regional offices  Main functions are to collect income taxes and enforce tax laws  WWII Limits on the Power to Tax 1. The purpose of the tax must be for “the common defense and general welfare.” 2. Federal taxes must be the same in every state. 3. The government may not tax exports.

5. Types of Taxes  Individual Income Taxes  Social Security Taxes  This program is funded by the Federal Insurance Contributions Act (FICA). Most of the FICA taxes you pay go to Social Security, or Old- Age, Survivors, and Disability Insurance (OASDI)  Medicare Taxes  Medicare is a national health insurance program that helps pay for health care for people over 65 and for people with certain disabilities. Medicare is also funded by FICA taxes.  Unemployment Taxes  Unemployment taxes are collected by both federal and state governments.  Other Taxes  Excise Taxes  Estate Taxes  Gift Taxes  Import Taxes

6. How the Money Comes In: Revenue

7. THE DESIGN OF THE TAX SYSTEM 6 Receipts of the U.S. Federal Govt, 2007 Tax Amount (billions) Amount per person Percent of receipts Individual income taxes$ 1164$3,48245.3% Social insurance taxes8702,79533.9 Corporate income taxes3701,18014.4 Other165572 6.4 Total$2,568$8,030100.0%

8. Tax Structures  Proportional Taxes  A proportional tax is a tax for which the percentage of income paid in taxes remains the same for all income levels.  Progressive Taxes  A progressive tax is a tax for which the percent of income paid in taxes increases as income increases.  Regressive Taxes  A regressive tax is a tax for which the percentage of income paid in taxes decreases as income increases.

9. What is a “good” tax?  Simplicity  Tax laws should be simple and easily understood.  Economy  Government administrators should be able to collect taxes without spending too much time or money.  Certainty  It should be clear to the taxpayer when the tax is due, how much is due, and how it should be paid.  Equity  The tax system should be fair, so that no one bears too much or too little of the tax burden.

10. Spending Categories Mandatory Spending  Money that lawmakers are required by law to spend  Interest payments on the national debt  “Entitlement” programs (Social Security, Medicare and Medicaid)  Makes up almost 2/3 of federal budget  Problem because Congress and the President cannot control much of spending. Discretionary Spending Money that government planners can choose how to spend. Defense Education Training Environmental cleanup National parks and monuments Scientific research

13. Federal Spending Ron Paul on Government Spending I.O.U.S.A. Clip

14. THE DESIGN OF THE TAX SYSTEM 13 U.S. Tax Revenue (% of GDP)

15. THE DESIGN OF THE TAX SYSTEM 14 Total Government Revenue (% of GDP) Sweden50% France45 United Kingdom37 Germany36 Canada36 Russia32 Brazil30 United States28 Japan27 Mexico20 Chile19 China15 India14

16. THE DESIGN OF THE TAX SYSTEM 15 Receipts of State & Local Govts, 2007 Tax Amount (billions) Amount per person Percent of receipts Sales taxes$305.1$1,01024.1% Property taxes401.31,32931.7 Individual income taxes291.796623.0 Corporate income taxes58.01924.6 Other211.770116.7 Total$1,268$4,197100.0%

17. THE DESIGN OF THE TAX SYSTEM 16 Taxes and Efficiency  One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers.  The costs to taxpayers include:  the tax payment itself  deadweight losses  administrative burden

18. THE DESIGN OF THE TAX SYSTEM 17 Deadweight Losses  One of the Ten Principles: People respond to incentives.  Taxes distort incentives, cause people to allocate resources according to tax incentives rather than true costs and benefits.  The result: a deadweight loss. The fall in taxpayers’ well-being exceeds the revenue the government collects.

19. THE DESIGN OF THE TAX SYSTEM 18 Income vs. Consumption Tax  The income tax reduces the incentive to save:  If income tax rate = 25%, 8% interest rate = 6% after-tax interest rate.  The lost income compounds over time.  Some economists advocate taxing consumption instead of income.  Would restore incentive to save.  Better for individuals’ retirement income security and long-run economic growth.

20. THE DESIGN OF THE TAX SYSTEM 19 Income vs. Consumption Tax  Consumption tax-like provisions in the U.S. tax code include Individual Retirement Accounts, 401(k) plans.  People can put a limited amount of saving into such accounts.  The funds are not taxed until withdrawn at retirement.

21. THE DESIGN OF THE TAX SYSTEM 20 Administrative Burden  Includes the time and money people spend to comply with tax laws  Encourages the expenditure of resources on legal tax avoidance  e.g., hiring accountants to exploit “loopholes” to reduce one’s tax burden  Is a type of deadweight loss  Could be reduced if the tax code were simplified but would require removing loopholes

22. THE DESIGN OF THE TAX SYSTEM 21 Marginal vs. Average Tax Rates  Average tax rate  total taxes paid divided by total income  measures the sacrifice a taxpayer makes  Marginal tax rate  the extra taxes paid on an additional dollar of income  measures the incentive effects of taxes on work effort, saving, etc.

23. THE DESIGN OF THE TAX SYSTEM 22 Marginal tax rateAverage tax rateIncome 0%10%$40,000 0%20%$20,000  A lump-sum tax is the same for every person  Example: lump-sum tax = $4000/person Lump-Sum Taxes

24. THE DESIGN OF THE TAX SYSTEM 23 A lump-sum tax is the most efficient tax:  Causes no deadweight loss Does not distort incentives.  Minimal administrative burden No need to hire accountants, keep track of receipts, etc. Yet, perceived as unfair:  In dollar terms, the poor pay as much as the rich.  Relative to income, the poor pay much more than the rich. Lump-Sum Taxes

25. THE DESIGN OF THE TAX SYSTEM 24 Taxes and Equity  Another goal of tax policy: equity – distributing the burden of taxes “fairly.”  Agreeing on what is “fair” is much harder than agreeing on what is “efficient.”  Yet, there are several principles people apply to evaluate the equity of a tax system.

26. THE DESIGN OF THE TAX SYSTEM 25 The Benefits Principle  Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt services  Tries to make public goods similar to private goods – the more you use, the more you pay  Example: Gasoline taxes  Amount of tax paid is related to how much a person uses public roads

27. THE DESIGN OF THE TAX SYSTEM 26 The Ability-To-Pay Principle  Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden  Suggests that all taxpayers should make an “equal sacrifice”  Recognizes that the magnitude of the sacrifice depends not just on the tax payment, but on the person’s income and other circumstances  a $10,000 tax bill is a bigger sacrifice for a poor person than a rich person

28. THE DESIGN OF THE TAX SYSTEM 27 Three Tax Systems  Proportional tax: Taxpayers pay the same fraction of income, regardless of income  Regressive tax: High-income taxpayers pay a smaller fraction of their income than low-income taxpayers  Progressive tax: High-income taxpayers pay a larger fraction of their income than low-income taxpayers

29. THE DESIGN OF THE TAX SYSTEM 28 200,000 100,000 $50,000 % of income tax % of income tax % of income taxincome 3060,000 2525,000 20%$10,000 Progressive 2550,000 2525,000 25%$12,500 Proportional 2040,000 2525,000 30%$15,000 Regressive Examples of the Three Tax Systems

30. THE DESIGN OF THE TAX SYSTEM 29 U.S. Federal Income Tax Rates: 2007 On taxable income… the tax rate is… 0 – $7,82510% 7,825 – 31,85015% 31,850 – 77,10025% 77,100 – 160,85028% 160,850 – 349,70033% Over $349,70035% The U.S. has a progressive income tax.

31. CHAPTER SUMMARY  In the U.S., the most important federal revenue sources are the personal income tax, social insurance payroll taxes, and the corporate income tax. The most important state and local taxes are the sales tax and property tax.  The efficiency of a tax system refers to the costs it imposes on taxpayers beyond their tax payments. One cost is the deadweight loss caused by the distortion of incentives from taxes. Another is the administrative burden of complying with tax laws. 30

32. CHAPTER SUMMARY  The equity of a tax system refers to its fairness. The benefits principle suggests that it is fair for people to be taxed based on the amount of government benefits they receive. The ability-to- pay principle suggests that it is fair for people to pay taxes based on their ability to handle the burden.  The U.S. has a progressive tax system, in which high income taxpayers face a higher average tax rate than low income taxpayers. 31

33. CHAPTER SUMMARY  When evaluating the equity of a tax system, it is important to consider tax incidence, as the distribution of tax burdens is not the same as the distribution of tax bills.  Policymakers often face a tradeoff between the goals of efficiency and equity in the tax system. Much of the debate over tax policy arises because people give different weights to these two goals. 32