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Taxation Slide 2 Objectives of This Lecture Discuss the economics and nature of taxes. An unbiased approach. Assist students to see that: Taxation is a complicated issue. There is no such thing as a best tax. Question: How do we pay for public goods? Slide 3 Taxation: A Brief History Matthew, the tax collector. Tax farming. Tax collectors = sinners. The French: An important cause of the French revolution. Contributed to the downfall of Napoleon. The English: After the Glorious Revolution, Parliament stripped the King of the right to tax. The wig and powder tax. The United States: The Boston tea party make is a coffee drinking nation. Our constitution specifically states who has the right to tax. The Whiskey Rebellion. Slide 4 Slide 5 Adam Smiths Maxims of Taxation Source: Smith, Adam, The Wealth of Nations, The Modern Library, 2000, pp 888-890 Slide 6 Smiths Maxims of Taxation (No.1) The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state. The expense of government to the individuals of a great nation, is like the expense of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. Slide 7 Smiths Maxim of Taxation (No. 2) The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought to be clear and plain to the contributor, and to every other person. Where it is otherwise, every person subject to the tax is put more or less in the power of the tax- gatherer, who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some present or perquisitie to himself. Slide 8 Smiths Maxim of Taxation (No. 3) Every tax ought to be levied at the time, or in the manner, in which it is most likely to be convenient for the contributor to pay it. A tax upon the rent of land or of houses, payable at the same term at which such rents are usually paid, is levied at the time when it is most for the likely to be convenient for the contributor to pay; or when he is most likely to have the wherewithal to pay. Taxes upon such consumable goods as are articles of luxury, are all finally paid by the consumer, and generally in a manner that is very convenient for him. Slide 9 Smith Maxims of Taxation ( No. 4) Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what is brings into the public treasury of the state. Slide 10 Smiths Additional Comment An injudicious tax offers a great temptation to smuggling. But the penalties of smuggling must rise in proportion to the temptation. The law, contrary to all the principles of justice, first creates the temptation, and then punishes those who yield to it; and it commonly enhances the punishment too in proportion to the very circumstances which ought certainly to alleviate it, the temptation to commit the crime. Slide 11 Tax Features Smiths Tax Philosophy: Equality. Certainty. Convenience of payment. Economy of collection. Modern Tax Philosophy: Is distribution of the tax burden fair? Are taxes designed to minimize frictions or distortions? Is the system understandable to the payers? Is the tax system operated at as low a cost as possible? Slide 12 What Do We Tax Income. Wages. Interest and dividends. Consumption. Sales tax. Excise tax. Wealth. Property (Personal and real). Capital gains. Inheritance. Slide 13 What Do We Tax - Continued Tax base: The measure of value on which a tax is levied. ( Page 377 in text.) Examples: All income after deductions above X amount. Federal income tax. The value of your home. County real estate tax. The value of your automobile. Personal property tax. Slide 14 Principles of Taxation The goal of economic efficiency. The benefits received principle. The ability to pay principle. The horizontal and vertical equity principles. The progressive and regressive tax concepts. The goal of attaining social objectives. Slide 15 Taxes and Economic Efficiency A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises. Excess burden is the efficiency loss to the economy that results from a tax causing a reduction in the quantity of a good produced. Do high taxes discourage the start of new businesses? Do high taxes encourage people to leave the formal labor force? Do high taxes alter incentives to work, save, or invest? A tax that is neutral with respect to economic decisions is preferable to one that distorts economic dedcisions. Slide 16 Tax Efficiency & Tax Burden We begin with a common supply and demand diagram. Slide 17 Tax Efficiency and Tax Burden, Cont. When we include the tax on the item the supply curve shifts left and the price increases. Slide 18 Tax Efficiency and Tax Burden, Cont. Slide 19 Slide 20 With the new higher price and the lower quantity demanded, we see that producers are producing less and receiving a lower price. Therefore, high taxes lead to lower production. Slide 21 Benefits Received Principle A theory of fairness holding that taxpayers should contribute to government (in the form of taxes) in proportion to the benefits that they receive from public expenditures. ( Page 381 ) Examples; Toll roads and bridges. Federal highway trust fund. Landing fees at an airport. The tax side and the expenditure side are connected. Problem: How does society pay for public goods? Slide 22 Ability to Pay Principle A theory of taxation that holds that citizens should bear tax burdens in line with their ability to pay. The tax side and the expenditure side are viewed separately. Slide 23 Ability To Pay Principle - Continued Regressive tax ( Page 379 in text.): A tax whose burden, expressed as a percentage of income, falls as income increases. Example: A retail sales tax. Progressive tax ( Page 378 in text. ): A tax whose burdens, expressed as a percentage of income, increases as income increases. Example: Individual income tax. Proportional tax ( Page 378 in text.) A tax whose burden is the same proportion of income for all households. Example: A flat tax. Slide 24 Ability To Pay Principal - Continued Horizontal equity ( Page 387 in text.): The principle of horizontal equity holds that those with equal ability to pay should bear equal tax burden. Vertical equity ( Page 387 in text.) The principle of vertical equity holds that those with greater ability to pay should pay more. Slide 25 Social Goals and Taxation There are citizens who believe that one of the legitimate purposes of a tax system is to promote social goals. Redistribution of income. John Maynard Keynes. Franco Modigliani. Promote economic growth. Deduction of mortgage interest on income taxes. Deductions for number of children on income taxes. Sin taxes. Liquor taxes. Tobacco taxes. Slide 26 Features of an Income Tax A tax on income. A tax on flow. Generally considered progressive. Contains both horizontal and vertical equity. An ability to pay tax. Generally considered to be anti-growth since tax payers are taxed twice. Types: Federal tax: A marginal tax above a certain level. Missouri Tax: Marginal to a point and then proportional. City of St. Louis: A proportional tax. Slide 27 Marginal Tax Rates Single Tax Payer 2005 Rates Slide 28 Average Tax Rate Slide 29 Features of Real Estate Taxes A tax on stock. A tax on wealth. There is vertical equity: Those who have the most pay the most. There is no horizontal equity: The tax is not uniform city to city. It is an ability-to-pay tax. Is it regressive? Lower income households pay a larger percentage of their income. However, studies show that upper income people pay a higher percentage of their income on housing that do lower income people. Slide 30 Slide 31 Keynesian Rate/Receipts Curve Slide 32 Laffer Rate/Receipts Curve Slide 33 Slide 34 Supply Side Tenets of Taxation Beyond some point, high marginal tax rates on personal income can reduce peoples willingness to work. High marginal tax rates discourage people from investing in education and improving their work related skills. High marginal tax rates encourage people to work in the underground economy. (Source: Page 331, McKenzie, Richard B., Macroeconomics, Houghton Mifflin Co, 1986) Slide 35 Slide 36 When Do Tax Cuts Matter (Chapter 14 in the Readings Book) Slide 37 When Do Tax Cuts Matter The concept of marginal utility: As a general rule, people maximize their own utility: They make choices that maximize their satisfaction. They look at the marginal cost and marginal benefit. They consider what is happening today as well as what they believe will happen in the future. Slide 38 When Do Tax Cuts Matter Therefore: Temporary tax cuts have temporary benefits. Any change in behavior will be short lived. If the income tax is cut for next year but not the year after: > People will work hard next year, but not the next year after that. Permanent tax cuts affect peoples futures, and they pick up on that. => Permanent tax cuts affect peoples utility, and, therefore, their behavior. Slide 39 Cairo Egypt, picture taken 1-6-10 Slide 40 Hausers Law In 1993, William Kurt Hauser, a San Francisco economist, said, No matter what the tax rates have been, in post war America tax revenues have remained at about 19.5% of GDP. The data show that the tax yield has been independent of marginal tax rates over this period, but tax revenue is directly proportional to GDP. The implication, based on actual data, is that if the government wants to increase tax revenue, we need to increase GDP. Note the difference between tax avoidance and tax delinquency. Slide 41 Hausers Law, Cont. Slide 42