1. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 18 Public Choice, Taxes, and the Distribution of Income

2. 2 of 44 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Should the Government Use the Tax System to Reduce Inequality? 18.1Define the public choice model and explain how it is used to analyze government decision making. 18.2Understand the tax system in the United States, including the principles that governments use to create tax policy. 18.3Understand the effect of price elasticity on tax incidence. 18.4Discuss the distribution of income in the United States and understand the extent of income mobility. Learning Objectives Tax laws affect economic incentives and economic activity and can also affect fairness.

3. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 44 Public choice model A model that applies economic analysis to government decision making. Public Choice, Taxes, and the Distribution of Income

4. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 44 Public Choice POLICYLENADAVIDKATHLEEN Cancer research1st2nd3rd Mass transit2nd3rd1st Border security3rd1st2nd Learning Objective 18.1 How Do We Know the Public Interest? Models of Voting The Voting Paradox Table 18-1 The Voting Paradox VOTESOUTCOME Cancer research versus mass transitCancer research wins Mass transit versus border securityMass transit wins Border security versus cancer researchBorder security wins

5. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 44 Learning Objective 18.1 Voting paradox The failure of majority voting to always result in consistent choices. Arrow impossibility theorem A mathematical theorem that holds that no system of voting can be devised that will consistently represent the underlying preferences of voters. Public Choice How Do We Know the Public Interest? Models of Voting The Voting Paradox

6. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 44 Learning Objective 18.1 Median voter theorem The proposition that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle. Public Choice How Do We Know the Public Interest? Models of Voting The Median Voter Model

7. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 44 Learning Objective 18.1 FIGURE 18-1 The Median Voter Theorem Public Choice How Do We Know the Public Interest? Models of Voting The Median Voter Model

8. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 44 Learning Objective 18.1 Rent seeking The attempts by individuals and firms to use government action to make themselves better off at the expense of others. Logrolling refers to the situation where a member of Congress votes to approve a bill in exchange for favorable votes from other members on other bills. Because becoming informed on an issue may require time and effort and the economic payoff is often low, some economists argue that many voters are rationally ignorant of the effect of rent-seeking legislation. Public Choice Government Failure? Rent seeking Logrolling and Rational Ignorance

9. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 44 Learning Objective 18.1 One way in which the government intervenes in the economy is by establishing a regulatory agency or commission that is given authority over a particular industry or type of product. However, because the firms being regulated are significantly affected by the regulatory agency’s actions, the firms have an incentive to try to influence those actions. In extreme cases, this influence may lead the agency to make decisions that are in the best interests of the firms being regulated, even if these actions are not in the public interest. Public Choice Government Failure? Regulatory Capture

10. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 44 Learning Objective 18.1 Although government regulation can clearly provide important benefits to consumers, we need to take the costs of regulations into account. Economics can help policymakers devise regulations that provide benefits to consumers that exceed their costs. Public Choice Is Government Regulation Necessary?

11. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 44 Individual income taxes. Learning Objective 18.2 Social insurance taxes. Sales taxes. Property taxes. Excise taxes. However the size of government and the types of activities it engages in are determined, government spending has to be financed. The government primarily relies on taxes to raise the revenue it needs. These are the most widely used taxes: The Tax System

12. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 44 Learning Objective 18.2 FIGURE 18-2 Federal, State, and Local Sources of Revenue, 2006 The Tax System An Overview of the U.S. Tax System

13. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 44 Learning Objective 18.2 FIGURE 18-2 Federal, State, and Local Sources of Revenue, 2006 (continued) The Tax System An Overview of the U.S. Tax System

14. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 44 Regressive tax A tax for which people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. Learning Objective 18.2 Progressive tax A tax for which people with lower incomes pay a lower percentage of their income in tax than do people with higher incomes. The Tax System Progressive and Regressive Taxes

15. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 44 INCOMETAX RATE 0 to $7,82510% $7,826 to $31,85015 $31,851–$77,10025 $77,101–$160,85028 $160,851–$349,70033 Over $349,70035 Learning Objective 18.2 Table 18-2 Federal Income Tax Brackets and Tax Rates for Single Taxpayers, 2007 ON MATT’S...MATT PAYS TAX OF... first $7,825 of income$ 782.50 next $24,025 of income3,603.75 next $45,250 of income11,312.50 last $22,900 of income6,412.00 His total federal income tax payment is$22,110.75 Table 18-3 Federal Income Tax Paid on Taxable Income of $100,000 The Tax System Progressive and Regressive Taxes

16. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 44 Learning Objective 18.2 Which Groups Pay the Most in Federal Taxes? Making the Connection INCOME CATEGORY PERCENTAGE OF TOTAL INCOME EARNED (1) PERCENTAGE OF TOTAL FEDERAL INDIVIDUAL INCOME TAXES PAID (2) PERCENTAGE OF TOTAL FEDERAL TAXES PAID (3) Lowest 20% 2.4% – 1.2% 0.4% Second 20% 6.2 – 1.7 2.1 Third 20% 11.2 3.1 7.4 Fourth 20% 19.5 13.117.0 Highest 20% 61.1 86.773.0 Total 100.0% Highest 1% 19.3 36.127.1 INCOME CATEGORY FEDERAL INCOME TAXES PAID AS A FRACTION OF INCOME (1) ALL FEDERAL TAXES PAID AS A FRACTION OF INCOME (2) Lowest 20% –5.0% 3.4% Second 20% −2.8 7.3 Third 20% 2.814.4 Fourth 20% 6.818.8 Highest 20% 14.525.9 All income categories 10.2%21.7% Highest 1% 19.330.4

17. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 44 Learning Objective 18.2 Marginal tax rate The fraction of each additional dollar of income that must be paid in taxes. Average tax rate Total tax paid divided by total income. The Tax System Marginal and Average Income Tax Rates

18. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 44 Learning Objective 18.2 The federal government taxes the profits earned by corporations under the corporate income tax. Some economists argue that if the purpose of the corporate income tax is to tax the owners of corporations, it would be better to do so directly by taxing the owners’ incomes rather than by taxing the owners indirectly through the corporate income tax. The Tax System The Corporate Income Tax

19. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 44 Learning Objective 18.2 COUNTRYTAX IN 2000TAX IN 2006 France37%33% Germany5238 Ireland2413 Italy4137 Japan4241 Spain35 Sweden28 United Kingdom30 United States40 Table 18-4 Corporate Income Tax Rates around the World The Tax System International Comparison of Corporate Income Taxes

20. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 44 Learning Objective 18.2 The goal of economic efficiency The ability-to-pay principle The horizontal-equity principle The benefits-received principle The goal of attaining social objectives The Tax System Evaluating Taxes In selecting which taxes to use, governments take into account the following goals and principles:

21. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 44 Learning Objective 18.2 FIGURE 18-3 The Efficiency Loss from a Sales Tax The Tax System Evaluating Taxes The Goal of Economic Efficiency

22. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 44 Learning Objective 18.2 Excess burden The efficiency loss to the economy that results from a tax causing a reduction in the quantity of a good produced; also known as the deadweight loss. The Tax System Evaluating Taxes The Goal of Economic Efficiency

23. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 44 Learning Objective 18.2 Should the United States Shift from an Income Tax to a Consumption Tax? Making the Connection Would a consumption tax be more efficient than an income tax?

24. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 44 Learning Objective 18.2 The ability-to-pay principle holds that when the government raises revenue through taxes, it is fair to expect a greater share of the tax burden to be borne by people who have a greater ability to pay. The Horizontal-Equity Principle The horizontal-equity principle states that people in the same economic situation should be treated equally. The Tax System Evaluating Taxes The Ability-to-Pay Principle

25. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 44 Learning Objective 18.2 According to the benefits-received principle, those people who receive the benefits from a government program should pay the taxes that support the program. The Goal of Attaining Social Objectives Taxes intended to discourage certain activities are sometimes referred to as “sin taxes.” The Tax System Evaluating Taxes The Benefits-Received Principle

26. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 44 Learning Objective 18.3 Tax incidence The actual division of the burden of a tax between buyers and sellers in a market. Tax Incidence Revisited: The Effect of Price Elasticity Don’t Let This Happen to YOU! Remember Not to Confuse Who Pays the Tax with Who Bears the Burden of the Tax

27. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 44 Learning Objective 18.3 FIGURE 18-4 The Effect of Elasticity on Tax Incidence Tax Incidence Revisited: The Effect of Price Elasticity

28. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 44 Learning Objective 18.3 Do Corporations Really Bear the Burden of the Federal Corporate Income Tax? Making the Connection Who really bears the burden of the taxes Apple pays?

29. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 44 Solved Problem 18-3 The Effect of Price Elasticity on the Excess Burden of a Tax Learning Objective 18-3

30. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 44 Learning Objective 18.4 ANNUAL INCOMEPERCENTAGE OF ALL HOUSEHOLDS $0–$14,99914.7% $15,000–24,99912.4 $25,000–34,99911.4 $35,000–49,99914.9 $50,000–74,99918.4 $75,000–99,99911.1 $100,000 and over17.2 Table 18-5 The Distribution of Household Income in the United States, 2005 Income Distribution and Poverty Measuring the Income Distribution and Poverty

31. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 44 Learning Objective 18.4 How Has the Distribution of Income Changed Over Time? YEARLOWEST 20%SECOND 20%THIRD 20%FOURTH 20%HIGHEST 20% 2005 3.4% 8.6% 14.6% 23.0% 50.4% 19903.99.615.924.046.6 19804.310.316.924.943.7 19704.110.817.424.543.3 19603.210.617.624.744.0 19503.110.517.324.145.0 19364.19.214.120.951.7 Table 18-6 Income Distribution and Poverty Measuring the Income Distribution and Poverty

32. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 44 Learning Objective 18.4 Poverty line A level of annual income equal to three times the amount of money necessary to purchase the minimal quantity of food required for adequate nutrition. Income Distribution and Poverty Measuring the Income Distribution and Poverty The Poverty Rate in the United States

33. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 44 Learning Objective 18.4 FIGURE 18-5 Poverty in the United States, 1960–2005 Income Distribution and Poverty Measuring the Income Distribution and Poverty The Poverty Rate in the United States

34. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 44 Learning Objective 18.4 Poverty rate The percentage of the population that is poor according to the federal government’s definition. All people 12.6% Female head of family, no husband present (all races)31.1 Blacks24.9 Hispanics21.8 Asians11.1 White, not Hispanic8.3 Table 18-7 Poverty Rates Vary across Groups, 2005 Income Distribution and Poverty Measuring the Income Distribution and Poverty The Poverty Rate in the United States

35. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 44 Learning Objective 18.4 For most people, the most important factor of production they own is their labor. Therefore, the income they earn will depend on how productive they are and on the prices of the goods and services their labor helps to produce. Many people own other factors of production, such as capital in the form of stock in corporations. Ownership of capital is not equally distributed. The tax system does not seem to have played a major role in recent changes in income inequality. Earning an income is also subject to good and bad fortune. Income Distribution and Poverty Explaining Income Inequality

36. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 44 Learning Objective 18.4 Income Distribution and Poverty Showing the Income Distribution with a Lorenz Curve Lorenz curve A curve that shows the distribution of income by arraying incomes from lowest to highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis.

37. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 44 Learning Objective 18.4 FIGURE 18-6 The Lorenz Curve and Gini Coefficient Income Distribution and Poverty Showing the Income Distribution with a Lorenz Curve

38. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 44 Learning Objective 18.4 Income Distribution and Poverty Problems in Measuring Poverty and the Distribution of Income Income Mobility in the United States FIGURE 18-7 Income Mobility in the United States, 1996–1999

39. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 39 of 44 Solved Problem 18-4 Are Many Individuals Stuck in Poverty? Learning Objective 18-4 Evaluate the following statement: Government statistics indicate that 12 percent of the population is below the poverty line. The fraction of the population in poverty has never dropped below 10 percent. Therefore, more than 10 percent of the population must cope with very low incomes year after year.

40. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 40 of 44 Learning Objective 18.4 Because individuals with low incomes are more likely to receive transfer payments and other benefits from the government than are individuals with high incomes, the distribution of income is more equal if we take these benefits into account. Income Distribution and Poverty Problems in Measuring Poverty and the Distribution of Income The Effect of Taxes and Transfers

41. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 41 of 44 Learning Objective 18.4 Table 18-8 Income Inequality around the World LOWEST 20%HIGHEST 20%RATIO BOLIVIA 1.5% 63.0% 42.0 BOTSWANA2.270.3 32.0 BRAZIL2.662.1 23.9 CHILE3.362.2 18.8 UNITED STATES3.450.4 14.8 THAILAND6.349.0 7.8 UNITED KINGDOM6.144.0 7.2 IRELAND7.442.0 5.7 FRANCE7.240.2 5.6 CANADA7.239.9 5.5 SOUTH KOREA7.937.5 4.7 GERMANY8.536.9 4.3 NORWAY9.637.2 3.9 JAPAN10.635.7 3.4 Income Distribution and Poverty Income Distribution and Poverty around the World

42. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 42 of 44 Learning Objective 18.4 Table 18-9 Poverty in Sub-Saharan Africa Is Much Greater Than Elsewhere in the World PERCENTAGE OF THE POPULATION IN POVERTY REGION19702000 World20.2%7.0% East Asia32.72.4 China32.03.1 South Asia30.32.5 Middle East and North Africa10.70.6 Latin America10.34.2 Sub-Saharan Africa35.148.8 Income Distribution and Poverty Income Distribution and Poverty around the World

43. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 43 of 44 An Inside LOOK Balancing Flexible Markets and a Government Safety Net The Grand Bargainer PERCENTILES BY AGI199920002001200220032004 2004 SHARE OF AGI EARNED BY TAXPAYERS IN THIS CATEGORY 2004 AGI LEVEL FOR THIS CATEGORY Top 1%36.1837.4233.8933.7134.2736.8919.00$328,049 Top 555.4556.4753.2553.8054.3657.1333.45137,056 Top 1066.4567.3364.8965.7365.8468.1944.3599,112 Top 2583.5484.0182.9083.9083.8884.8666.1360,041 Top 5096.0096.0996.0396.5096.5496.7086.5830,122 Bottom 50 4.00 3.91 3.97 3.50 3.46 3.3013.42<30,122

44. Chapter 18: Public Choice, Taxes, and the Distribution of Income © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 44 of 44 Arrow impossibility theorem Average tax rate Excess burden Lorenz curve Marginal tax rate Median voter theorem Poverty line K e y T e r m s Poverty rate Progressive tax Public choice model Regressive tax Rent seeking Tax incidence Voting paradox