Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 12: Taxation: Design of the Tax System

M. Cary LeaheyManhattan College

Fall 2012

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Goals

• Review of the US tax system—where does the money come from?• Evaluation of the efficiency and equity of the US tax system• Introduction of new concepts of horizontal/vertical equity, etc.

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Introduction • Taxes are needed to fund the “proper” role of government, such as• providing public goods• regulating common resources• remedying the effects of externalities• Review of what we learned in earlier chapters• Tax and subsidies are need to deal with negative and positive

externalities.• A tax reduces the quantity of that good while a subsidy promotes

that quantity.• The tax burden is shared between the buyers and sellers with the

shares determined by the elasticies of demand and supply.• Deadweight loses (DWL) arise and the benefits of the tax usually fall

short of the losses. The size of the DWL is a measure of tax efficiency.

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A look at U.S. taxation

• Examination over history to see how much if has changed• International comparison• Comparison of the differences in sources of taxes between federal

and states/localities

• Taxes since 1929• Paying for WWI meant that taxes jumped sharply to their 20% to

25% share of the early 1960s. Mild upward drift since then. Significant (Federal) tax reductions since 2001

• Taxes tend to mover procyclically, falling in downturns and rising in recessions. Taxes tend to rise and fall faster than income, as they are modestly progressive (more on this later).

• Across nations, the US is in the middle of the pack with taxes about 30% of GDP. The high is Sweden at nearly 50% and the low in India and China at 15%

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Government receipts since 1960

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35

30

25

20

15

10

5

0

Taxes as a Percent of GDP(Percent)

TotalFederalS&L

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The federal tax system

• The next slide indicates that the bulk of federal revenue comes from individual taxes, with income taxes (39%) a bit less than taxes for social insurance (Social Security and health, 41%).

• Corporate taxes (13%) are a declining share of total receipts• Other taxes, mainly excise, were the workhorses in the 18th and 19th

centuries are now very small (9%)• Most households (nearly 90%) pay some form of payroll (income

and social insurance taxes)• A little more than 50% pay income taxes, as Romney well knows.

Receipts of the Federal government, 2010Q3

TaxAmount (billions)

Amount per person

Percent of receipts

Individual income taxes $ 886 $2,869 36.7%

Social insurance taxes 992 3,215 41.1

Corporate income taxes

314 1,016 13.0

Other 224 726 9.3

Total $2,416 $7,827 100.0%

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The state and local government tax system

• The next slide indicates that state and local revenue is more equally distributed between income (27%), property (33%), and sales taxes (32%).

• Sales taxes are small part of Federal taxes, one of the reasons there has been talk for decades about introducing a US sales (VAT) tax (more on this later).

• Property taxes are levied by the localities to pay for education.

Receipts of state/local governments, 2010Q3

TaxAmount (billions)

Amount per person

Percent of receipts

Sales taxes $432.0 $1,399 32.4%

Property taxes 437.8 1,418 32.8

Individual income taxes 262.9 852 19.7

Corporate income taxes 91.1 295 6.8

Other 111.0 360 8.3

Total $1,335 $4,323 100.0%

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Taxes and efficiency

• A tax system is more efficient if it raises the same amount of revenue at a lower cost to taxpayers.

• Costs of taxation• the actual tax payment• administrative burden• deadweight loses• Deadweight loses (DWL) is the result that usually taxes reduce the

well being of tax payers more than the revenue it provides.• Taxes are a wedge in market behavior and distort incentives,

causing DWLs.

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Income versus consumption taxes

• Income tax reduces incentives at save and to work• Income taxes reduce income to workers.• Income taxes reduce the return to savers.

• Consumption taxes would tax spending not income• No distortion on decisions to work or investment• Equity issue: only people paying taxes are those that work. Richie

Rich’s investment income would not be touched; only his spending.

• Some aspects of the Federal tax system mimic consumption taxes• Reduced taxes on investment income and saving

• Consumption (sales/VAT) taxes predominately in Europe.• US only country in G7 without a VAT• But would it replace income taxes-so left with a smaller income tax

but yet another tax. So we have two not one major tax systems.

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Administrative burdens or costs

• Compliance time and costs• Resources allocated to tax avoidance• Rich peoples’ armies of accountants/lawyers

• Simpler tax cost could reduce those costs• Loopholes there for a reason and hard to eliminate because of the

iron triangle

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Marginal versus average tax rates

• Marginal tax rates – the ones that “count”• Tax paid on the incremental dollar of income• Measures incentives effects as they exist on the margin of

decisions

• Average tax rates• The total tax paid relative to income• For the well-to-do can be much lower than the marginal tax rate. • Average tax rates in US are 18% to 20% while the top marginal tax

rate is 35%.

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Lump sum taxes

• Lump sum (head or poll) tax is the same tax per person

• This is the most efficient tax• with no deadweight losses• no distortion of incentives

• Minimal administrative burdens

• But perceived as unfair (Thatcher’s demise)• Poor the same s the rich and relative to income poor pay much

more than the rich.

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Taxes and equity

• Equity is another worthy goal of taxation to distribute burden of taxes “fairly”

• Agreeing on fair is much harder than what is efficient.• Three notions of fairness• Benefits principle• Taxes should vary with the benefits received• Makes public goods more like private goods: more use, more

pay• Examples: gasoline taxes• Ability to pay principle• Higher incomes should shoulder a large burden as the taxes

involve a smaller sacrifice than to those of lower incomes• Vertical equity• Follows from ability to pay as those with more income should pay

proportionately more taxes.

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Taxes and equity

• Notion of equity leads to three categories of tax systems• Proportional tax system• Taxpayers pay the same fraction, regardless of income• Regressive• Taxpayers pay a smaller fraction of income as income increases• Progressive• Taxpayers pay a larger fraction of income as income increases

200,000

100,000

$50,000

% of income

tax% of

incometax

% of income

taxincome

3060,000

2525,000

20%$10,000

Progressive

2550,000

2525,000

25%$12,500

Proportional

2040,000

2525,000

30%$15,000

Regressive

Examples of the three pay systems

U.S. Federal income tax rates: 2010

On taxable income…

the tax rate is…

0 – $8,375 10%

8,376 – 34,000 15%

34,001 – 82,400 25%

82,401 – 171,850 28%

171,851 – 373,650 33%

Over $373,650 35%

The U.S. has a progressive income

tax. But the progressivity has fallen dramatically in the last 35 years.

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Horizontal equity

• Notion of that similar incomes with similar abilities to pay should pay similar taxes

• But figuring out ability to pay, beyond examining income, is messy.• One notable example is the marriage penalty.• Two individuals in one hose olds with equal incomes may more tax

if they are married since income is taxed according to total household income (At one time some couples would divorce at tax time, use the savings to pay for a spring vacation, and then remarry.)

• Current US system penalizes two income earners of similar incomes who are married but subsidizes a couple with greatly uneven incomes.

• No tax system can achieve both vertical and horizontal equity in the case of marriage.

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Tax incidence and tax equity

• Remember the person who bears the burden does not always pay the tax bill.

• Example of the luxury tax on yachts or even fur coats• A tax on fur coats• Is vertically equitable• But with the demand for fur coats price elastic.• The tax shifts away from the rich who spend money on other

luxuries onto the producers of the fur coats who are unlikely to be well off.

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Tax incidence and the who pays the corporate income tax

• Corporations are people too.• A tax on corporations ultimately falls on people, as the corporation is

really a tax collector for those who receive income from the corporation.

• For example a tax on automakers• Workers receive less profit and may eventually shift wealth out of

the industry.• A smaller industry means reduced supply, care prices rise, and

buyers are worse off.• Reduced output means reduced wages as demand for labor falls

and workers are worse off.• Not that this case may have some virtue if the auto industry

promotes pollution so society needs to reduce the private market equilibrium quantity to the lower socially optimal one.

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Flat taxes

• Flat tax is a tax system in which the marginal tax rate is the same for all taxpayers.

• Operationally, income below a socially approved minimum is untaxed. The higher the threshold or minimum, the more progressive the flat tax.

• benefits are ;• Reduced distortions• Reduced administrative costs (taxes done on a postcard)

• Costs are • Transition from existing system• Violations of approved notions of equity

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Conclusion: equity and efficiency

• Efficiency and equity goals can conflict• For example, the lump sum tax is the most efficient but most unfair

tax.• Policymakers differ on this tradeoff• Economics has a role• to better understand the tradeoffs• to avoid policies that reduce efficiency without increasing equity

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Summary

• We introduced a host of new concepts as well as a review of the US tax system

• The US tax system finds that federal taxes are dominated by income taxes on households while state and local govt taxes are more equally distributed between income, property and sales taxes.

• Efficiency of the tax system refers to the costs imposed beyond the revenues raised. One measure is the DWL of the distortions.

• Equity of the tax system refers to fairness which is harder to agree upon that efficiency. The benefits principle refers to those that benefit more pay more in taxes. Ability to pay refers to the ability to handle the burden. The US has a progressive tax system in which higher incomes pay a higher proportion in taxes.

• Tax incidence can mean that those who bear the tax burden may not ultimately pay the taxes.

• Policymakers face the tradeoff between goals of efficiency and equity. Notions of horizontal and vertical equity may conflict (example of the marriage tax).