1. © 2007 Thomson South-Western

2. “In this world nothing is certain but death and taxes.”... Benjamin Franklin 0 20 40 60 80 100 Taxes paid in Ben Franklin’s time accounted for 5 percent of the average American’s income. 1789

3. © 2007 Thomson South-Western “In this world nothing is certain but death and taxes.”... Benjamin Franklin 0 20 40 60 80 100 1789 Today Today, taxes account for up to a third of the average American’s income.

4. © 2007 Thomson South-Western Table 1: Central Government Tax Revenue as a Percentage of GDP Source: World Development Report 1998/99

5. © 2007 Thomson South-Western Figure 1 Government Revenue as a Percentage of GDP State and local Federal 0 Revenue as Percent of GDP Total government 1902 1922 1927 1913 1932 1940197019801990200019501960 35 30 25 20 15 10 5

6. © 2007 Thomson South-Western The Federal Government The U.S. federal government collects about two-thirds of the taxes in our economy. The largest source of revenue for the federal government is the individual income tax. Individual Income Taxes The marginal tax rate is the tax rate applied to each additional dollar of income. Higher-income families pay a larger percentage of their income in taxes.

7. © 2007 Thomson South-Western The Federal Government The Federal Government and Taxes Payroll Taxes: tax on the wages that a firm pays its workers. Social Insurance Taxes: taxes on wages that is earmarked to pay for Social Security and Medicare. Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic beverages. Tariffs

8. © 2007 Thomson South-Western Source: Economic Report of the President, 2005, Table B-81. Table 2 Receipts of the Federal Government: 2004

9. © 2007 Thomson South-Western The Federal Government Federal Government Spending Government spending includes transfer payments and the purchase of public goods and services. Transfer payments are government payments not made in exchange for a good or a service. Transfer payments are the largest of the government’s expenditures.

10. © 2007 Thomson South-Western Federal Government Spending: 2004 Social Security, 22% Defense, 20% Income Security (Food Stamps, “Welfare”) 15% Medicare, 12% Health, incl. Medicaid 10% Net Interest, 7% Other, 15%

11. © 2007 Thomson South-Western Table 4 Spending of the Federal Government: 2004 Source: Economic Report of the President, 2005, Table B-81.

12. © 2007 Thomson South-Western The Federal Government Financial Conditions of the Federal Budget A budget deficit occurs when there is an excess of government spending over government receipts. Government finances the deficit by borrowing from the public. A budget surplus occurs when government receipts are greater than government spending. A budget surplus may be used to reduce the government’s outstanding debts. Cutting taxes or increasing spending will increase budget deficits.

13. © 2007 Thomson South-Western The Demographic and Fiscal Challenge

14. © 2007 Thomson South-Western The Demographic and Fiscal Challenge

15. © 2007 Thomson South-Western State and Local Government State and local governments collect about 40 percent of taxes paid.

16. © 2007 Thomson South-Western Source: Economic Report of the President, 2005, Table B-86. Table 5 Receipts of State and Local Governments: 2002

17. © 2007 Thomson South-Western Source: Economic Report of the President, 2005, Table B-86. Table 6 Spending of State and Local Governments: 2002

18. © 2007 Thomson South-Western Criteria for Good Tax System Design Policymakers have two objectives in designing a tax system: 1.Efficiency 2.Equity Efficient tax systems minimize the total cost to taxpayers of raising a given amount of tax revenue. Equitable tax systems are FAIR.

19. © 2007 Thomson South-Western TAXES AND EFFICIENCY One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

20. © 2007 Thomson South-Western TAXES AND EFFICIENCY The Cost of Taxes to Taxpayers –The tax payment itself –Deadweight losses –Administrative burdens

21. © 2007 Thomson South-Western Deadweight Losses Because taxes distort incentives, they create deadweight losses. The DEADWEIGHT LOSS of a tax is its cost to taxpayers in excess of the amount of revenue raised by the government. Examples: Reduced incentives to work. Constructing tax shelters. Avoiding taxed activities (e.g. going to Pennsylvania to grocery-shop).

22. © 2007 Thomson South-Western Administrative Burdens Complying with tax laws creates additional deadweight losses. Taxpayers lose additional time and money documenting, computing, and avoiding taxes over and above the actual taxes they pay. The administrative burden of any tax system is part of the inefficiency it creates. Administrative Burden is part (but only part) of the DWL.

23. © 2007 Thomson South-Western TAXES AND EQUITY Equity means FAIRNESS. How should the burden of taxes be divided among the population? How do we evaluate whether a tax system is fair?

24. © 2007 Thomson South-Western TAXES AND EQUITY Two Principles of Tax Equity: –Benefits principle –Ability-to-pay principle $

25. © 2007 Thomson South-Western Tax Equity: The Benefits Principle The benefits principle: People should pay taxes based on the benefits they receive from government services. An example is a gasoline tax: Tax revenues from a gasoline tax are used to finance our highway system. People who drive the most also pay the most toward maintaining roads.

26. © 2007 Thomson South-Western Tax Equity: The Ability-to-Pay Principle The ability-to-pay principle: People who are more able to pay taxes should pay more. The ability-to-pay principle leads to two corollary notions of equity. 1.Vertical Equity: People with higher ability to pay should pay more. 2.Horizontal Equity: People with the same ability to pay should pay the same.

27. © 2007 Thomson South-Western Tax Equity: The Ability-to-Pay Principle Vertical Equity: People who can pay more taxes, should pay more taxes. Should they pay a higher rate, or just a higher dollar amount?

28. © 2007 Thomson South-Western Tax Equity: The Ability-to-Pay Principle Vertical Equity and Alternative Tax Systems A proportional tax is one for which high-income and low-income taxpayers pay the same fraction of income. A regressive tax is one for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers. A progressive tax is one for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers.

29. © 2007 Thomson South-Western Table 7 Three Tax Systems

30. © 2007 Thomson South-Western Tax Equity: The Ability-to-Pay Principle Horizontal Equity: People who have the same ability to pay, should pay the same. Troublesome Details: Family income, or individual income? Adjust for the number of children? Adjust for wealth? Adjust for local cost of living? Adjust for differences in health? Age?

31. © 2007 Thomson South-Western Marginal Tax Rates versus Average Tax Rates The average tax rate is total taxes paid divided by total income. Average tax rates primarily indicate equity. The marginal tax rate is the extra taxes paid on an additional dollar of income. Marginal tax rates primarily indicate efficiency.

32. © 2007 Thomson South-Western Table 3 Federal Income Tax Rates (Single): 2004

33. © 2007 Thomson South-Western Calculating Income Tax Simple Tax Table: Taxable Incomes of at least... But no more than... Pay a Marginal Tax Rate of... $0$20,00010% $20,001$50,00020% $50,000 -50% What is the marginal rate on an income of $100,000? What is the average rate on an income of $100,000?

34. © 2007 Thomson South-Western 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. Is it Efficient? Is it Equitable?

35. © 2007 Thomson South-Western Table 7 Three Tax Systems

36. © 2007 Thomson South-Western Source: Congressional Budget Office. Figures are estimates for 2005. Dollar figures are expressed in 2001 dollars.Congressional Budget Office Table 8 The Burden of Federal Taxes

37. © 2007 Thomson South-Western CASE STUDY: Horizontal Equity and the “Marriage Tax” Tax law treats a married couple as a single taxpayer. When a couple gets married, they stop paying taxes as individuals and start paying taxes as a family. “Married filing jointly” tax table has lower taxes for each level of total income, but. If each has a similar income, their total tax liability rises when they get married (40% of couples, according to CBO) If their incomes are very different, their total tax bill falls when they get married (50% of couples).

38. © 2007 Thomson South-Western CASE STUDY: Equity and the “Marriage Tax” Example: Suppose Jack and Jill each have a salary of $72,000 per year. According to 2005 tax tables: Single: Pay about $14,500 each, total tax $29,000. Married filing jointly: Pay a tax of about $30,000. Marriage Tax = $1000 Example: Suppose Jill makes $144,000 and marries Jack, an artist. According to 2005 tax tables: Single: Jill pays about $35,000, Jack pays $0 income tax. Married: Jill pays about $30,000 income tax. Marriage Subsidy = $5000 Is this system equitable? Is it efficient?

39. © 2007 Thomson South-Western CASE STUDY: Equity and the “Marriage Tax” Principles: 1.Two married couples with the same income should pay the same tax. 2.Marriage should not change your tax bill 3.A person or family with no income should pay no taxes. 4.Higher incomes should pay higher proportion of their income in tax. It’s impossible to satisfy all four of these principles at the same time. Only a proportional tax satisfies the first 3 principles Taxing people as individuals violates principle #1.

40. © 2007 Thomson South-Western CASE STUDY: Efficiency and the “Marriage Tax” How does a “Marriage Tax” Affect Actions? 1.If you pay a higher tax when married (40% of couples who have fairly equal salaries), you will be less likely to get married. (DWL) 2.The current system penalizes equal earners, and subsidizes stay-at-home moms relative to working moms. The “marriage tax” reduces the opportunity cost of one partner staying at home and raising the kids, relative to working and using day-care. Eliminating the “marriage tax” encourages two-earner families that use daycare. Which effect is bigger? 1 or 2? Are taxes more likely to affect your decision to marry, or your decision to work?

41. © 2007 Thomson South-Western Tax Incidence and Tax Equity Who bears the burden of taxes (tax incidence) is central to evaluating tax equity. Flypaper Theory of Tax Incidence: The burden of a tax, like a fly on flypaper, sticks wherever it first lands. The flypaper theory isn’t true. For example, the burden of corporate taxes falls primarily on stockholders, not the corporations themselves.