1. Principles of Taxation
Chapter 2
Tax Policy Issues: Standards for a Good Tax

2. Tax Policy Issues The Standards for a Good Tax
Income and Substitution Effects
Equity Issues
Tax Rate Structure

3. “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

4. 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 meet what four objectives?

5. Tax Policy Issues - Sufficiency
A Sufficient Tax
When is a tax sufficient?
Forecasting revenue:
______forecast - assume base stays the same.
_________forecast - estimate change in base due to change in rate. Income versus substitution effects help predict change in base.

6. Tax Policy Issues - Sufficiency
Income versus Substitution Effects
Taxpayers often modify their behavior in reaction to increased tax rates. These behavioral changes result in either an income effect or substitution effect. They are summarized below
Remember tax = _____* ______
What effect on behavior does a change in either rate or base have? (See IR 1)

7. Tax Policy Issues - Sufficiency
Income Effect: Taxpayers react to rate increases by _________ their income-producing activities to maintain the same disposable income experienced before the tax rate increase. In other words, taxpayers work harder to maintain the same economic status.
See Q5

8. Tax Policy Issues - Sufficiency
Substitution Effect: Taxpayers react to rate increases by ____________the amount of income producing activities. In other words, an hour of leisure is worth more than an additional hour of labor.
Theoretically, the income effect is more powerful for __________-income taxpayers and the substitution effect is more compelling to __________-income taxpayers.
Other examples: married women?
See Q6

9. Tax Policy Issues - Convenience
A Convenient Tax
When is a tax convenient?
from the Government’s Viewpoint? Q10
from the Taxpayer’s Viewpoint? Q11

10. 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.

11. Tax Policy Issues - Equity
A tax is fair if:
the taxpayer has the Ability to Pay the tax.
Define Horizontal Equity
Define Vertical Equity

12. Tax Policy Issues - Equity
Horizontal Equity
Achieving horizontal equity depends heavily on the tax base definition.
Tax “loopholes” vary across taxpayers. (IR2)
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?

13. Tax Policy Issues Vertical Equity
What should rate structure look like?
The ongoing policy issue is usually not whether rich should paying 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.

14. Tax Policy Issues - Equity
A regressive tax structure is one for which the rate of tax paid ____________with an increase in tax base.
Assume a tax rate structure for which John Smith who earns $20,000 pays a tax of $2,000 and John Jones earns $40,000 pays a tax of $3,000.
John Smith’s average tax rate is ______% ($____/$_______) while John Jones’s is ___% ($____/$_______). The rate structure meets the strict standards of vertical equity $_____>$_____. Is John Jones is paying an amount consistent with his “ability to pay?”

15. Tax Policy Issues - Equity
Proportional Rate Structure levies a tax that is the _______ percentage of income regardless of tax base amount.
Assume a rate structure for which John Smith with income of $20,000 pays $2,000 in tax and John Jones with $40,000 of income pays $4,000.
John Smith’s and John Jones’s average tax rates are both _____%. However, based on the theory of the declining marginal utility of income John Smith’s tax burden is a greater hardship than John Jones’s .
A proportional rate structure is often referred to as a “flat tax.”
See Q14

16. Tax Policy Issues - Equity
Progressive Rate Structure levies a tax, which as a proportion of income, increases as income increases.
Assume a rate structure for which John Smith with income of $20,000 pays a tax of $2,000 and John Jones with income of $40,000 pays a tax of $4,400.
John Smith’s average tax rate is ___% and John Jones’s is ___%.
Whether the tax burden is now equitable is a question that is still unanswered.

17. Tax Policy Issues - Equity
Vertical Equity
Examine data from prior class exercise. How much did your opinions vary?
How does the class’ average tax burden for individuals A B C and D compare with current income tax rates?

18. Tax Policy Issues Tax Rate Structure
Average Tax Rate = The tax rate on income determined by dividing tax paid by an income measure. Income measures selected are usually 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.
Let’s look at tax rates at front of the book:
Single person earns $150,000. MTR? ATR?
Married couple earns $150,000. MTR? ATR?