Tax Policy Issues: Standards for a Good Tax Chapter 2 Tax Policy Issues: Standards for a Good Tax

“The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the least possible amount of hissing.” Jean Baptiste Colbert

Tax Policy Issues Standards for a Good Tax In theory every tax can and should be evaluated on a set of basic standards. In general a tax should be: Sufficient to raise necessary government revenues Convenient to administer and to pay Efficient in economic terms Fair to taxpayers required to pay

Tax Policy Issues - Sufficiency A Sufficient Tax A tax is sufficient if: it generates enough funds to pay for the public goods and services provided by the government levying the tax. Forecasting revenue: Static forecast - assume base stays the same. Dynamic forecast - estimate change in base due to change in rate.

Tax Policy Issues - Sufficiency Income versus Substitution Effects Taxpayers modify their behavior in reaction to increased tax rates. These behavioral changes result in either a income effect or substitution effect. Income Effect: Tax increase ==> base increase / Tax decrease ==> base decrease Work to keep after-tax income the same. Substitution Effect: Tax increase ==> base decrease / Tax decrease ==> base increase Substitute between labor and leisure. Theoretically, the income effect is more powerful for lower-income taxpayers and the substitution effect is more compelling to higher-income taxpayers.

Tax Policy Issues - Convenience A Convenient Tax A tax is convenient if: Government’s View the tax is easy to administer, easy to understand, and offers few opportunities for noncompliance. Taxpayer’s View the tax is easy to pay, easy to determine, and requires minimal time to comply.

Tax Policy Issues - Efficiency A tax is efficient if: judged by the classical standard of efficiency, it does not distort the market, create suboptimal allocation of goods and services, or modify taxpayer behavior. judged by Keynesian standards it is an effective fiscal policy tool for regulating the economy.

Tax Policy Issues - Equity A tax is fair if: the taxpayer has the Ability to Pay the tax. it enhances Horizontal Equity persons with the same ability to pay the tax should owe the same amount of tax. it enhances Vertical Equity persons with greater ability to pay owe more than persons with a lesser ability to pay.

Tax Policy Issues - Equity Horizontal Equity Achieving horizontal equity depends heavily on the tax base definition. Tax ‘loopholes’ vary across taxpayers. A simple but unpopular solution is to eliminate all tax preferences. This solution would likely increase the current systems’ horizontal equity but at the expense of the economic or social benefits derived from income producing activities that tax preferences are designed to promote. Examples?

Tax Policy Issues Vertical Equity What should rate structure look like? The ongoing policy issue is usually not whether rich should pay more taxes than poor, but how much more is appropriate. The definition of how much “more” is, may result in a tax rate structure that is regressive, proportional, or progressive.

Tax Policy Issues - Equity Regressive: tax rate decreases as tax base increases. Smith pays $2,000 tax (10%) on income of $20,000 and Jones pays $3000 tax (5%) on income of $60,000. Proportional = flat tax rate Smith pays $2000 tax (10%) on income of $20,000, and Jones pays $6000 tax (10%) on income of $60,000. Progressive: tax rate increases as tax base increases. Smith pays $2000 tax (10%) on income of $20,000, but Jones pays 12,000 (20%) on income of $60,000.

Tax Policy Issues Tax Rate Structure Average Tax Rate = total tax paid by tax base (typically gross income or taxable income) Marginal Tax Rate = The rate of tax applied to the next dollar of taxable income. In a progressive rate structure this rate increases as income levels increase. In a proportionate rate structure average and marginal rates are the same.