Taxes: Equity versus Efficiency Chapter 32 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

The Size Distribution of Income Size distribution of income: The way total personal income is divided up among households or income classes Income share: The proportion of total income received by a particular group

Cumulative Percentage Cumulative Percentage of People The Lorenz Curve 10 20 30 40 50 60 70 80 90 100 Inequality gap Absolute equality Cumulative Percentage of Income Actual distribution B C 27.5 A 3.6 Cumulative Percentage of People

The Federal Income Tax Federal income tax is meant to be progressive Progressive tax: A tax system in which tax rates rise as incomes rise This is achieved by imposing increasing marginal tax rates on higher incomes Marginal tax rate: The tax rate imposed on the last (marginal) dollar of income

Loopholes People with high incomes can avoid high taxes by claiming large exemptions and deductions These may violate the following principles of Vertical equity: Principle that people with higher incomes should pay more taxes Horizontal equity: Principle that people with equal incomes should pay equal taxes

Nominal vs. Effective Tax Rates The gap between the nominal tax rate and the effective tax rate is a reflection of loopholes in the tax code

Tax-Induced Misallocations Tax loopholes not only foster inequity but encourage inefficiency Tax preferences induce resource shifts into tax-preferred activities Some feel the federal income tax promotes both inequity and inefficiency

Payroll, State, and Local Taxes The federal income tax is only one of many taxes the average taxpayer must pay Sales taxes and property taxes are both regressive Regressive tax: A tax system in which tax rates fall as incomes rise

Tax Incidence Tax incidence: Distribution of the real burden of a tax The burden of property taxes is reflected in higher rents Landlords tend to pass along property taxes Tenants pay higher rents because of this

Incidence of a Payroll Tax Quantity of Labor Wage Rate S + tax Supply of labor Payroll taxes reduce wages and employment w1 w0 w2 Demand for labor L1 L0

The Impact of Transfers The government completes the redistribution process by transferring income to consumers Income transfers: Payments to individuals for which no current goods or services are exchanged, for example, Social Security, welfare, and unemployment benefits

The Costs of Greater Equality The greatest potential cost of moving toward greater income equality is reduced incentives Absolute income equality breaks the market link between effort and reward The argument for preserving income inequalities is anchored in a concern for productivity

The Benefits of Greater Equality Arguments for greater equality include: The present degree of inequality is more than necessary to maintain work incentives Low-income earners might work harder if incomes were distributed more fairly Resources might be allocated more efficiently if greater equality achieved via tax simplification

Taxes: Equity versus Efficiency End of Chapter 32 McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.