Taxes Chapter 12 Issues of Efficiency and Equity

Policymakers have two objectives in designing a tax system... Ê Efficiency Ë Equity

Taxes are inefficient due to: uDeadweight losses: cause lower consumption and lower production of goods uMarginal income tax rates may cause people to work less uAdministrative burdens

Taxes and Efficiency uOne tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. uAn efficient tax system is one that imposes the smallest deadweight losses and administrative burdens possible.

Lump-Sum Taxes A lump-sum tax is a tax that is the same amount for every person, regardless of earnings or any actions that the person might take. Lump-sum taxes therefore have less dead-weight loss.

Consumption Taxes (Sales tax) Interest income from savings is taxed at the same rate as income earned from working. This may discourage some people from saving. To counter low savings rate some economist propose replacing our income tax with a national consumption(sales tax). This would eliminate the disincentive to work and save that marginal tax rates may cause.

Taxes and Equity uHow should the burden of taxes be divided among the population? uHow do we evaluate whether a tax system is fair?

Principles of Taxation u Benefits principle u Ability-to-pay principle $

Benefits Principle u The benefits principle is the idea that people should pay taxes based on the benefits they receive from government services. u An example is a gasoline tax: u Tax revenues from a gasoline tax are used to finance our highway system. u People who drive the most also pay the most toward maintaining roads.

Ability-to-Pay Principle u The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden. u The ability-to-pay principle leads to two corollary notions of equity. u Vertical equity-those with greater ability should contribute a greater amount u Horizontal equity- those with similar ability should pay similar amounts

Vertical Equity and Alternative Tax Systems uA proportional tax is one for which high-income and low-income taxpayers pay the same fraction of income. uA regressive tax is one for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers. uA progressive tax is one for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.

Three Tax Systems

Horizontal Equity u Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amounts. u For example, two families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.