The Design of the Tax System 12 The Design of the Tax System

Would you give up a larger portion of your income for a higher standard of living in our country? Why or why not?

Why do we have taxes? Raise money for the government - main Adjust people’s behavior - secondary

Key Questions for Chapter 12 How does the government collect taxes? How does the government spend taxes? What are the two goals of the tax system? What are the costs of the tax system? What two principles govern tax equity?

Financial Overview of U.S. Government Government revenue As percentage of total income Increased as economy’s income has grown Government’s revenue from taxation has grown even more As a nation gets richer Government - takes a larger share of income in taxes

Total government tax revenue as a percentage of GDP 1 Total government tax revenue as a percentage of GDP Sweden France United Kingdom Germany Canada Brazil Russia United States Japan Mexico Chile China India 50% 45 37 36 36 30 32 28 27 20 19 15 14

Financial Overview of U.S. Government The federal government Collects about two-thirds of taxes Receipts Individual income tax - based on total income Marginal tax rate - applied to each additional dollar of income Payroll taxes - tax on wages “Social insurance taxes” – pay for Social Security and Medicare Corporate income tax - based on profit Other taxes: excise tax, estate tax, custom duties

Other Excise taxes on certain items Mostly gasoline, cigarettes, alcoholic drinks $3.90 on a carton of cigarettes Michigan – Beer: $0.20 Wine: $0.51 All per gallon Gas Tax: Federal $0.184 per gallon MI: $0.25

Receipts of the federal government: 2007 Tax Amount (billions) per person Percent of receipts Individual income taxes Social insurance taxes Corporate income taxes Other Total $1,163 870 370 165 $2,568 $3,851 2,881 1,225 546 $8,503 45% 34 14 7 100%

The federal income tax rates: 2007 3 The federal income tax rates: 2007 On taxable income… The tax rate is… Up to $7,825 From $7,825 to $31,850 From $31,850 to $77,100 From $77,100 to $160,850 From $160,850 to $349,700 Over $349,700 10% 15% 25% 28% 33% 35% This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on all the marginal tax rates up to his or her income level. For example, a taxpayer with income of $25,000 pays 10 percent of the first $7,825 of income, and then 15 percent of the rest.

Spending of the federal government: 2007 4 Spending of the federal government: 2007 Category Amount (billions) Amount per person Percent of spending Social Security National defense Medicare Income security Health Net interest Other Total $586 553 375 366 266 237 347 $2,730 $1,940 1,831 1,242 1,212 881 785 1,149 $9,040 21% 20 14 13 10 9 100%

Financial Overview of U.S. Government The federal government Spending Social Security: Transfer payments to the elderly National defense Medicare Other health spending Medicaid Spending on medical research

Financial Overview of U.S. Government The federal government Spending Income security - transfer payments to poor families Temporary Assistance for Needy Families (TANF) Food Stamp Net interest Other spending Federal court system; Space program Farm-support programs Salaries of members of Congress and the president

Financial Overview of U.S. Government The federal government Budget deficit Excess of government spending over government receipts Budget surplus Excess of government receipts over government spending

The fiscal challenge ahead 2013 budget deficit = $680 billion Long-term projections Government - spend vastly more than it will receive in tax revenue As a percentage of gross domestic product Taxes – constant Government spending - rise gradually and substantially

The fiscal challenge ahead Rise in government spending Social Security and Medicare Significant benefits for the elderly The elderly - growing percentage of overall population Medical advances and lifestyle improvements Increased life expectancy Fewer children Smaller families Labor force - growing more slowly Fewer workers paying taxes to support the government benefits that each elderly person receives

The fiscal challenge ahead Rise in government spending Rising cost of healthcare Medicare – healthcare to the elderly Medicaid – healthcare to the poor Medical advances New, better, and expensive ways to extend and improve our lives

The fiscal challenge ahead Handle spending increases Raise taxes - as a percentage of GDP Impose - great a cost on younger workers Reduce the promises now being made to the elderly of the future People - encouraged to take a greater role caring for themselves as they age Raising the normal retirement age People - more incentive to save during their working years

Financial Overview of U.S. Government State and local government Receipts Sales tax Percentage of total amount spent at retail stores Property taxes Percentage of estimated value of land and structures - paid by property owners Individual and corporate income taxes

Financial Overview of U.S. Government State and local government Receipts Funds from the federal government Other receipts Fees for fishing and hunting licenses; Tolls from roads and bridges Fares for public buses and subways

Receipts of state and local governments: 2005 Tax Amount (billions) per person Percent of spending Sales taxes Property taxes Individual income taxes Corporate income taxes From federal government Other Total $383 336 241 43 438 580 $2,021 $1,294 1,135 814 145 1,480 1,959 6,827 19% 17 12 2 22 28 100%

Financial Overview of U.S. Government State and local government Spending Education Public schools: kindergarten to high school Public universities Public welfare Transfer payment to the poor Highways Building and maintenance of roads

Financial Overview of U.S. Government State and local government Spending Other spending Libraries Police Garbage removal Fire protection Park maintenance Snow removal

Spending of state and local governments: 2005 6 Spending of state and local governments: 2005 Category Amount (billions) per person Percent of spending Education Public welfare Highways Other Total $689 367 124 834 $2,014 $2,328 1,240 419 2,817 $6,804 34% 18 6 42 100%

Taxes and Efficiency Policymakers - adopt a tax system Equity and efficiency Costs of taxes to taxpayers Tax payment itself Deadweight losses Result when taxes distort the decisions that people make Administrative burdens Taxpayers bear as they comply with the tax laws

Taxes and Efficiency Efficient tax system Deadweight losses Small deadweight losses Small administrative burdens Deadweight losses People respond to incentives Government – tax a good People buy less of it Taxes – distort incentives

Taxes and Efficiency Deadweight losses Reduction in economic well-being of taxpayers in excess of the amount of revenue raised by the government Inefficiency People allocate resources according to the tax incentive, not according to true costs and benefits

Taxes and Efficiency Deadweight losses Tax a good Consumer surplus – drops Tax revenue – increases Decrease in consumer surplus > increase in tax revenue

Should income or consumption be taxed? Taxes – Induce people to change their behavior Cause deadweight losses Make the allocation of resources less efficient Current tax system: Individual income tax Tax the amount of income that people earn Discourages people from working as hard Discourages people from saving Tax interest income Saving - much less attractive

Should income or consumption be taxed? Changing the basis of taxation Eliminate disincentive toward saving Consumption tax Tax the amount that people spend Income saved - not be taxed until the saving is later spent Not distort people’s saving decisions European countries Rely more on consumption taxes than does the US Value-added tax (VAT) Tax – collected in stages as the good is being produced

Taxes and Efficiency Administrative burden Time spent to fill out forms Time spent throughout the year keeping records for tax purposes Resources the government has to use to enforce the tax laws Tax lawyers and accountants Legal tax avoidance Resources devoted to complying with tax laws Can be reduced – simplify the tax laws

Taxes and Efficiency Marginal tax rates versus average tax rates Total taxes paid divided by total income Sacrifice made by a taxpayer Fraction of income paid in taxes Marginal tax rate The extra taxes paid on an additional dollar of income How much tax system distort incentives Determines the deadweight loss

Taxes and Efficiency Lump-sum taxes A tax that is the same amount for every person Most efficient tax possible- A person’s decisions do not alter the amount owed Doesn’t distort incentives Doesn’t cause deadweight losses Imposes a minimal administrative burden No equity

Taxes and Equity The benefits principle People should pay taxes based on the benefits they receive from government services Tries to make public goods similar to private goods A person who gets great benefit from a public good should pay more for it than a person who gets little benefit

Taxes and Equity The ability-to-pay principle Vertical equity Taxes should be levied on a person according to how well that person can shoulder the burden Vertical equity Taxpayers with a greater ability to pay taxes should pay larger amounts Richer taxpayers should pay more than poorer taxpayers

Taxes and Equity The ability-to-pay principle Vertical equity How much more should the rich pay? Proportional tax High-income and low-income taxpayers pay the same fraction of income Regressive tax High-income taxpayers pay a smaller fraction of their income than do low-income taxpayers Progressive tax High-income taxpayers pay a larger fraction of their income than do low-income taxpayers

Tax systems Proportional – Medicare tax Regressive – state sales tax Progressive – federal income tax

Trade-off between equity and efficiency What is fair is not always equal. Why?

7 Three tax systems Proportional tax Regressive tax Progressive tax Income Amount of tax Percent of income $ 50,000 100,000 200,000 $12,500 25,000 50,000 25% 25 $15,000 40,000 30% 20% $10,000 60,000 30

How the tax burden is distributed Do the wealthy pay their fair share of taxes? United States federal tax system Progressive tax system Families - ranked according to their income Five groups of equal size, “quintiles” The poorest quintile Average income = $15,900 Earns 4.0% of all income Taxes = 4.3% of income Pays 0.8% of all taxes

How the tax burden is distributed The richest quintile Average income = $231,300 Earns 55.1% of all income Taxes = 25.5% of income Pays 68.7% of all taxes The richest 1% Average income = over $1 million Earns 18.1% of all income Taxes = 31.2% of income Pays 27.6% of all taxes

How the tax burden is distributed Account for taxes and transfer payments Even greater progressivity Richest families Pays about 25% of income to the government, after transfers Poor families Receive more in transfers than they pay in taxes Average tax rate = negative 30%

Taxes and Equity The ability-to-pay principle Horizontal equity Taxpayers with similar abilities to pay taxes should pay the same amount Similar taxpayers Determine which differences are relevant for a family’s ability to pay and which differences are not U.S. income tax Special provisions that alter a family’s tax based on its specific circumstances

Taxes and Equity Tax incidence and tax equity Tax incidence Who bears the burden of taxes Central to evaluating tax equity Person who bears the burden a tax Not always the person who gets the tax bill from the government Taxes alter supply and demand Alter equilibrium prices Indirect effects

Who pays the corporate income tax? Who bears the burden of the corporate tax? People pay all taxes Tax on a corporation Corporation – more like a tax collector than taxpayer Burden of the tax ultimately falls on people Workers and customers bear much of the burden of the corporate income tax Popular - it appears to be paid by rich corporations

Key Questions for Chapter 12 Review How does the government collect taxes? How does the government spend taxes? What are the two goals of the tax system? What are the costs of the tax system? What two principles govern tax equity?

Why does the government collect taxes Why does the government collect taxes? Is there another way this purpose could be met?

Question 1 A recent increase in federal gasoline taxes was estimated to cause a $150 million reduction in the total surplus (consumer plus producer surplus) in the gasoline market. If tax revenues increased by $100 million, what is the deadweight loss associated with the tax? As a result of the tax, 10,000 people sold their cars and started riding their bicycles to work. How much of the burden of the deadweight loss is incurred by the bicycle riders?

The direct deadweight loss is $50 million The direct deadweight loss is $50 million. It is impossible to determine how much of the loss is borne by bicycle riders without more information. For example, some of the deadweight loss may be attributable to walkers or people who switched to public transportation.

Question 2 Lump-sum taxes are rarely used in the real world because: a. while lump-sum taxes have low administrative burdens, they have high deadweight losses. b. while lump-sum taxes have low deadweight losses, they have high administrative burdens. c. lump-sum taxes are often viewed as unfair because they take the same amount of money from both poor and rich. d. lump-sum taxes are very inefficient. e. lump-sum taxes are often viewed as unfair because they take more money from the poor than the rich.

Question 3 a. distort incentives to work. High marginal income tax rates: a. distort incentives to work. b. are used to encourage saving behavior. c. will invariably lead to lower average tax rate d. are not associated with deadweight loss e. are the cost of industrialization.

Question 4 Suppose Jim and Joan receive great satisfaction from their consumption of cheesecake. Joan would be willing to purchase only one slice and would pay up to $6 for it. Jim would be willing to pay $9 for his first slice, $7 for his second slice, and $3 for his third slice. The current market price is $3 per slice. How much consumer surplus does Joan receive from consuming her slice of cheesecake? a. zero b. $3 c. $6 d. $9 e. $12

Question 5 A tax system with little deadweight loss and a small administrative burden would be described as a. equitable. b. communistic. c. capitalistic. d. efficient. e. inefficient.

Question 6 If a poor family has three children in public school and a rich family has two children in private school, the benefits principle would suggest that a. the poor family should pay more in taxes to pay for public education than the rich family. b. the rich family should pay more in taxes to pay for public education than the poor family. the benefits of private school exceed those of public school public schools should be financed by property taxes. e. the poor family should not have to pay taxes, the rich family should pay the taxes.