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McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Taxes: Equity vs. Efficiency
Taxes: Equity vs. EfficiencyChapter 33Chapter 33
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What Is Income?
There are several ways to measure income.
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Personal Income
Personal income (PI) is income received by households before payment of personal taxes.
Personal income is not a complete measure of income.
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Personal Income
Many goods and services are distributed directly as in-kind income.
In-kind income - Goods and services received directly, without payment in a market transaction.
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Wealth
The distribution of wealth is also important in determining access to goods and services.
Wealth - the market value of assets.
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Wealth
Wealth represents a stock of potential purchasing power.
Income statistics tell us how this year’s flow of purchasing power (income) is being distributed.
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The Size Distribution of Income
Size distribution of income is the way total personal income is divided up among households or income classes.
Income share is the proportion of total income received by a particular group.
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The Lorenz Curve
The Lorenz curve is a graphic illustration of the cumulative size distribution of income.
It contrasts complete equality with the actual distribution of income.
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The Lorenz Curve
The greater the area between the Lorenz curve and the diagonal, the more inequality exists.
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The Lorenz Curve
The ratio of the shaded are in the Lorenz curve to the area of the triangle formed by the diagonal is called the Gini coefficient.
The Gini coefficient is a mathematical summary of inequality based on the Lorenz curve.
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The Lorenz Curve
Cumulative Percentage of People
Cu
mu
lativ
e P
erce
nta
ge
of I
nco
me
27.5
3.610 20 30 40 50 60 70 80 90 1000
1020
405060708090
100
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Inequality gap
Absolute equality
Actual distributionB
C
A
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The Call for Intervention
To many people, large and increasing inequality represents a form of market failure.
Market failure – An imperfection in the market mechanism that prevent optimal outcomes.
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The Call for Intervention
The government redistributes market income by levying taxes on the rich and providing transfer payments to the poor.
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The Federal Income Tax
The federal income tax is designed to be progressive.
Progressive tax - A tax system in which tax rates rise as incomes rise.
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The Federal Income Tax
Progressivity is achieved by imposing increasing marginal tax rates on higher incomes.
Marginal tax rate - The tax rate imposed on the last (marginal) dollar of income.
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Progressive Taxes
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Changes in Marginal Tax Rates
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Efficiency Concerns
A progressive tax system raises concerns about efficiency.
High marginal tax rates may reduce the incentive to work, produce, or invest.
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Tax Elasticity
The tax elasticity of supply summarizes how market participants respond to higher tax rates.
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Tax Elasticity
The tax elasticity of supply is the percentage change in quantity supplied divided by the percentage change in tax rates.
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Equity Concerns
Critics raise questions about how well the federal income tax promotes equity.
What appears to be a progressive tax structure in theory turns out to be a lot less progressive in practice.
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Loopholes
The progressive tax rates described in the tax code apply to taxable income, not to all income.
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Loopholes
The purpose of itemized deductions is to encourage specific economic activities and reduce potential hardships.
People with high incomes can avoid high taxes by claiming large exemptions and deductions.
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Loopholes
These deductions may violate the principles of vertical or horizontal equity.
Vertical equity – Principle that people with higher incomes should pay more taxes.
Horizontal equity – Principle that people with equal incomes should pay equal taxes.
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Nominal vs. Effective Tax Rates
The nominal tax rate is calculated by dividing taxes paid by taxable income.
income taxable
paid taxrate tax Nominal
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Nominal vs. Effective Tax Rates
The effective tax rate is calculated by dividing taxes paid by total income.
income economic total
paid taxrate tax Effective
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Nominal vs. Effective Tax Rates
The gap between the nominal tax rate and the effective tax rate is a reflection of loopholes in the tax code.
It is also the source of vertical and horizontal inequities.
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Tax-Induced Misallocations
Tax loopholes not only foster inequity but encourage inefficiency as well.
Tax preferences induce resource shifts into tax-preferred activities.
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A Shrinking Tax Base
As deductions, exemptions, and credits accumulate, the tax base shrinks.
The tax base is the amount of income or property directly subject to nominal tax rates.
Tax revenue = average tax rate X tax base
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The 1986 Tax Reform Act
The basic features of the Tax Reform Act (TRA) of 1986 included:
Loophole closing.
Reductions in marginal tax rates.
Fewer tax brackets.
Tax relief for the poor.
Shift from personal to corporate taxes.
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Base Broadening
The elimination or reduction of scores of tax preferences increased the tax base by almost 25 percent.
By doing so, the TRA eliminated many sources of vertical and horizontal inequities.
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Rate Reductions
By broadening the tax base, the TRA made it possible to reduce tax rates.
The cut in the top tax rate from 50 to 28 percent was intended to stimulate a greater supply of labor and capital.
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1990 and 1993 Tax Increases
Some criticized the 1986 TRA reforms as a giveaway to the rich.
The 1990 and 1993 tax increases resulted in creating five tax brackets instead of three.
The top marginal tax rate was raised to 39.6 percent and the tax system became more progressive.
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The Bush Tax Cuts (2001-2010)
President Bush made tax cuts his top priority after he was elected.
Reduce marginal tax rates to encourage more production.
Provide tax incentives to encourage more education, saving, and family development.
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Reduced Marginal Rate
The highest marginal tax rate was reduced to 35 percent.
The lowest marginal rate was lowered from 15 to 10 percent.
This increased the disposable income of low-income workers to increase their incentive to work.
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New Loopholes
Education incentives – to encourage more education, the act provided a $3,000 tax credit for college tuition.
Family incentives – to encourage marital stability, the act reduced the marriage penalty and to help defray the cost of raising children, the child tax credit was increased.
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New Loopholes
Saving incentives – to encourage saving, the act of 2001 raised the limit on retirement savings accounts and phased out the estate tax.
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Payroll, State, and Local Taxes
The federal income tax is only one of many taxes the average taxpayer must pay.
We gauge tax burdens in relation to people’s incomes.
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Sales and Property Taxes
Sales taxes and property taxes are both regressive.
A regressive tax – a tax system in which tax rates fall as incomes rise.
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Sales and Property Taxes
Sales taxes and property taxes are regressive because poor people pay a larger percentage of their income on these taxes than do the rich people.
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Tax Incidence
Tax incidence is the distribution of the real burden of a tax.
The burden of property taxes is reflected in higher rents.
Landlords tend to pass along to tenants any property taxes they must pay.
People who rent apartments pay higher rents because of property taxes.
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Payroll Taxes
Labor demand reflects the marginal revenue product (MRP) of labor.
Marginal revenue product (MRP) – The change in total revenue associated with one additional unit of input.
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Payroll Taxes
MRP sets a limit to the wage an employer is willing to pay.
Fewer workers are employed and the net wage is reduced when a payroll tax is imposed.
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Quantity of Labor (labor-hours per time period)
Wag
e R
ate
(dol
lars
per
hou
r)Incidence of a Payroll Tax
S + tax
0 L1 L0
w1
w0
w2
Supply of labor
Demand for labor
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Taxes and Inequality
The regressivity of the Social Security payroll tax and of many state and local taxes offsets most of the progressivity of the federal income tax.
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A Proportional System
When all is said and done, the tax system as a whole ends up being nearly proportional.
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Income Tax Shares
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The Impact of Transfers
The government completes the redistribution process by transferring income to consumers.
Income transfers are payments to individuals for which no current goods or services are exchanged.
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What Is “Fair”?
To many people, the apparent ineffectiveness of the tax-transfer-system to redistribute income is a mark of government failure.
Government failure – Government intervention that fails to improve market outcomes.
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The Costs of Greater Equality
The argument for preserving income inequalities is anchored in a concern for productivity.
The greatest potential cost of moving toward greater income equality is reduced incentives.
Absolute income equality breaks the market link between effort and reward.
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The Benefits of Greater Equality
The arguments for greater equality focus on incentives:
The present degree of inequality is more than necessary to maintain work incentives.
Low-income earners might work harder if incomes were distributed more fairly.
Resources might be allocated more efficiently if greater equality was achieved via tax simplification.
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A Flat Tax?
Flat tax is a single-rate tax system.
The key features of a flat tax include:Replace the current system of multiple tax brackets and rates with a single tax rate that would apply to all taxable income.
Eliminate all deductions, credits and most exemptions.
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Simplicity
A major attraction of the flat tax is its simplicity.
The current 1600-page tax code would be scrapped.
All 437 IRS tax forms would be replaced by a single postcard-sized form.
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Fairness
The flat tax would eliminate horizontal and vertical inequities.
Some progressivity could also be preserved with a flat tax by offering personal exemptions.
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Efficiency
Proponents of a flat tax claim it enhances efficiency as well as equity.
With a simplified flat tax, all the labor resources used to prepare tax returns could be put to uses that are more productive.
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The Critique
As proposed by Dick Armey, the flat tax would not apply to all income.
Income on savings and investments would not be taxed so that saving, investment and economic growth is encouraged.
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The Critique
This proposal creates vertical and horizontal inequities.
Someone receiving $1 million in interest and dividends could escape all income taxes, while a family earning $50,000 would have to pay.
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The Critique
The transition to a flat tax would entail a wholesale reshuffling of wealth and income.
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Taxes: Equity vs. Efficiency
Taxes: Equity vs. Efficiency
End of Chapter 33End of Chapter 33
