1. The Design of the Tax System12
The Design of the Tax System

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

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

4. 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?

5. 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

6. Total government tax revenue as a percentage of GDP1
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%

7. 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

8. 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

9. 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%

10. The federal income tax rates: 20073
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.

11. Spending of the federal government: 20074
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%

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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%

22. 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

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

24. Spending of state and local governments: 20056
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%

25. 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

26. 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

27. 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

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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

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

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

39. 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

40. 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

41. 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

42. 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%

43. 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

44. 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

45. 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

46. 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?

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

48. 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?

49. 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.

50. 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.

51. 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.

52. 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. $ e. $12

53. 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.

54. 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.