Chapter 7 Taxation: Criteria for evaluating revenue options “Taxes are the price we pay for civilization” , Supreme Court Justice Oliver Wendell Holmes Lecture Outline:  Overview of taxation in the United States  Standards for tax policy  Taxes and Externalities

Principles underlying taxation Private firms raise revenues through voluntary exchange for goods and services with consumers Ideally, taxes exist to provide services where the private market is expected to fail to produce these goods and services Because of the incentive to free-ride when public goods are produced, government uses coercive payments (taxes) to collect revenues Tax policy then distributes the cost of paying for these goods and services across society

Government Revenue Sources of government revenue in the United States income tax, purchase or sales tax, property ownership or transfer Revenues from charging for services (user fees, etc.) and others sources (lotteries, interest on investments, royalties, etc.) account for a small percent of govt. funds Special revenues, such as payroll tax on employees for social security are allocated for specific uses only

Most economically advanced countries use a general sales tax, US is unique in relying primarily on an income tax Taxation policies are a direct result of the political organization of federalism (division of political power and responsibilities among different units of government) Since sales tax has been the revenue source for local governments, Federal govt. has had to look elsewhere Similarly, land property taxes would have disproportionally burdened larger states at the expense of smaller states Thus the reliance is on “direct taxation”, taxation on income rather than use of that income

Where does the US stand in terms of taxation? Compare the US rate of taxation to that of other industrial counties (table 7-3) Generally, the tax burden is low when compared to other nations. 28.9% compared to average of 38.4% among industrial nations. (Low of 16% with Mexico, and High of 52% in Sweden). Ranks among bottom tier with Turkey, Mexico, Korea and Japan

US relies heavier on personal income and corporate than most Heavier on property taxes And less on goods and services or sales taxes About average in terms of amounts paid toward social security

Tax Policy Standards Politics of taxation tends to be avoidance of the cost, while complaining when not receiving the benefit Public opinion alone (and indeed direct democracy) would tend to produce very inefficient policies “Don’t tax you, don’t tax me, tax that fellow behind the tree” (Sen. Russell Long)

Where income tax dollars are spent

General taxation principles Since taxation removes funds from private decision-makers, whose incentives to make purchasing decisions are directly tied to the benefits they receive from those decisions (and are therefore “efficient”), toward public decision-makers, whose incentives are tied to broad organizational and political goals unrelated to the goods and services the use of those funds provide (and are therefore less “efficient”), any taxation represents a burden on the private economy. However without some taxation public goods and service would not be provided So the trick, is to design tax policies that gain revenue from the private sector that do not unduly burden the economy

Four principles that guide taxation in a market economy 1. Equity 2. Revenue consequences 3. Collection costs 4. Economic efficiency

1. Equity While logical to say taxes should be distributed fairly, defining fairness of the tax burden is rather difficult Do you think the tax system in this country is fair? Write how you would define a “fair” taxation system

Two general equity principles  1) Benefits Received - defined according to the taxpayers’ benefits form or usage of a public service  2) Ability to Pay - defined according to taxpayers’ capacity to bear the burden

Benefits received approach Benefits received approach mimics the private market The higher the payment the greater the benefit When govt. sells a service, citizens pay a user fee (ex: toll roads, gas tax to pay for roads, ammo tax to pay for wildlife management) Avoids wasteful over-production when goods are produced at lower than market prices Does not over-subsidize some goods at the expense of other users Avoids anti-tax sentiments

Problems with benefits received approach Pure public goods do not provide an easy way to match benefits with costs Does not allow re-distributive policies  Whether redirecting funds from the wealth to the disadvantaged Ex: CA Proposition 63  Or in allowing equal access to nationally produced benefits Ex: Determining the admittance costs to national parks

Ability-to-pay approach Argues that regardless of service the greatest burden should be placed on those who can most easily bear the cost Maintains that the types of goods provided by govt. and the market are fundamentally different and need to be supplied differently Distribution of benefits should be provided by concerns of equity and fairness

Problems with the ability-to-pay approach Difficult to determine actual individual level demand without corresponding cost Over-supply of some types of goods

Horizontal and vertical equity Horizontal refers to equal treatment of taxpayers who have equal capability to pay taxes Taxes may not be horizontally fair when they vary by individual preference and taste, or when one sector of the economy has reduced tax burden (ex: fastfood tax, tax breaks for high risk investors)

Vertical equity Refers to the relative tax burden paid by individuals with different capabilities to pay taxes Question is how should tax payments differ among high and low income earners

Tax structures can then be categorized as: Proportional – effective tax rates are the same among all groups (10% across all income levels) Progressive – higher rates are applied to higher incomes Regressive – effective tax rates are higher for lower income groups and lower for higher income groups

How much do Americans make? US Income Pyramid As Percent of PopulationIncome 1.2 % $ 719, % 11.9 % 23.6 % 22.6 % 22.5 % $ 276,000 $ 188,000 $ 132,000 $ 53,000 $ 35, % $ 21,000 As Percent of Income 20 % % 22.7 % $ 8,400

How much do Americans pay?

Who really pays? The entity to which a tax burden has been assigned, may be able to shift the tax The impact may not coincide with the incidence because of tax shifting While law define the impact, market forces determine the actual incidence Typically applies to business taxes

Business replies to tax burdens three ways: 1. Forward shifting: the business increases prices to consumers 2. Backward shifting: reduces the price paid for resources purchased (wages to employees and for raw materials) 3. Absorption: returns a lower profit to its owners

Shifting has a similar impact Citizens are also consumers of goods and producers of labor and material for producing those goods Individual consumers either they pay a higher purchase price when business tax increases Or receive lower prices for the goods and services they provided to business employers (labor, raw material, etc.) All taxes are ultimately borne by individuals

If all taxes are ultimately paid by individuals, then why tax businesses? 1. Politically more palatable 2. Taxes can be designed to pay for costs they produce to society but do not account for in their decision-making Examples would include high consumption of service (utilities, public safety, court systems) & externalities (environmental damage, pollution, undesirable social or health effects)

3. It is also less costly in terms of collection Since additional costs will be shifted to consumers, easier to tax the product a the point of sale, than collect from individuals after purchase (ex: luxury taxes) 4. Finally, since all consumers will bear the burden, it may shift tax paying responsibilities to individual outside a specific political jurisdiction

2. Revenue Consequences Tax is only worthwhile if it produces revenues at a socially acceptable rate Tax revenue equation:  Tax yield (R) = Tax rate (t) times tax base (B) R=t * B  Simple linear relationship  If total individual income is 200 million and tax rate is 1%, then yield is 2 million.  So if we increase the rate to 4% the yield is 4 million, right?

Economic impact of taxes on revenues Linear relationship fails to include reaction to taxpayer If increase tax burden, less incentive to earn higher incomes and some taxpayers may leave the taxing area Tax base will also be determined by the tax rate So the effective tax base is R=t*B(t)

Effect of economic growth on revenue potential As an economy grows, so do the demands for government services (both at the micro and macro level) Local economies need to provide more infrastructure and utilities, law enforcement and effective court systems, and more demand for re-distributive policies

Some types of taxes are better able to match revenue raising capabilities with economic growth The relationship between a 1% change in income to a population and the percent change in revenue is expressed as “elasticity”

Tax-Income Elasticities Personal income tax1.75 Corporate tax1.1 General property tax0.87 General sales tax1.0 Motor fuel tax0.73 Tobacco tax0.26

3. Collection costs Costs of collection reduce the amount available to use toward goods and services Lower the complexity of a tax system, the lower the cost of collection Tradeoffs exist between equity and collection costs

4. Economic Efficiency Taxes always have some effect on economic efficiency, distort incentives and change behavior Creates a “tax wedge”, difference in before and after tax price Some argue that the best a tax can do is remain neutral and impact the economy as little as possible Others maintain that taxes can be used to alter incentives to produce favorable market outcomes (such as reducing the generation of externalities)

Types of activities taxed and their effects Work vs. leisure activities – high taxes on overtime will reduce the incentive to work more and induce an incentive to choose more leisure time Business operations – firms will organize activities around tax code. (Ex: inventory clearances). Location – high taxes causes consumers to purchase those items in neighboring areas (liquor, cigarettes, etc.). And businesses to serve mobile consumers locate to gain those customers. Personal management – since professional conventions are tax-deductible, most conferences tend to locate at resorts Investment decisions – investments choices are made on after-tax profits and may direct funds to different types of projects (ex: toward municipal bonds)

Loss to an economy caused by a tax can be minimized by: 1. Keeping tax rates low (have broad, diverse tax systems) 2. Avoiding different tax rates on similar products 3. Avoiding taxes in markets where buyers and/or sellers react dramatically to changes in price

Local Taxes and Economic Development State and local governments have incentives to use tax policies to attract investments for jobs and revenue Competition makes taxes critical policy variable for impacting local development

Questions regarding how much tax policy really influences development 1. Taxes have a small effect on interregional locations of economic activities. Total tax burden is less important than the specific burden for particular businesses. 2. Within a region taxes have a larger effect 3. Local govts. May offer additional incentives: abatements, exemptions, credits, etc.

Importance of transparency Because taxation in a democracy relies on some basic level of public compliance, it is important that people know what happens to the taxes they pay The greater the transparency, the greater the level of compliance and lower the collection costs

Elements of transparency Adoption Administration Compliance requirements Payment amount

Taxes and externalities Emission taxes Indirect taxes on goods and services