0 chapter 12 the design of the tax system chap 12: design of the tax system
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CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 1
Chap 12: Design of the Tax System
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CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 2
Introduction
One of the Ten Principles from Chapter 1: A government can sometimes improve market outcomes.
• providing public goods
• regulating use of common resources
• remedying the effects of externalities
To perform its many functions, the govt raises revenue through taxation.
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CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 3
U.S. Tax Revenue (% of GDP)
0%
5%
10%
15%
20%
25%
30%
35%
40%
1940 1950 1960 1970 1980 1990 2000
State and local Federal
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Central Govt Revenue (% of GDP)
France 39%
United Kingdom 34
Germany 29
Brazil 20
United States 19
Canada 18
Russia 17
Pakistan 15
Indonesia 15
Mexico 13
India 10
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Receipts of the U.S. Federal Govt, 2004
TaxAmount (billions)
Amount per person
Percent of Receipts
Individual income taxes $ 809 $2,753 43%
Social insurance taxes 733 2,494 39
Corporate income taxes 189 643 10
Other 149 507 8
Total $1,880 $6,397 100%
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Receipts of State & Local Govts, 2002
TaxAmount (billions)
Amount per person
Percent of Receipts
Sales taxes $ 324 $1,102 19%
Property taxes 279 949 17
Individual income taxes 203 690 12
Corporate income taxes 28 95 2
From federal govt 361 1,228 21
Other 490 1,667 29
Total $1,685 $5,733 100%
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Marginal vs. Average Tax Rates
average tax rate
• total taxes paid divided by total income
• measures the sacrifice a taxpayer makes
marginal tax rate
• the extra taxes paid on an additional dollar of income
• measures the incentive effects of taxes on work effort, saving, etc.
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CHAPTER 12 THE DESIGN OF THE TAX SYSTEM 8
Deadweight Losses One of the Ten Principles:
People respond to incentives.
Recall from Chapter 8: Taxes distort incentives, cause people to allocate resources according to tax incentives rather than true costs and benefits.
The result: a deadweight loss. The fall in taxpayers’ well-being exceeds the revenue the govt collects.
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Income vs. Consumption Tax
Some economists advocate taxing consumption instead of income.
• would restore incentive to save
• better for individuals’ retirement income security and long-run economic growth
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Income vs. Consumption Tax
Consumption tax-like provisions in the U.S. tax code include Individual Retirement Accounts, 401(k) plans.
• People can put a limited amount of saving into such accounts.
• The funds are not taxed until withdrawn at retirement.
Europe’s Value-Added Tax (VAT) is like a consumption tax.
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Administrative Burden
The time and money people spend to comply with tax laws.
http://www.pbs.org/newshour/bb/congress/forbes_flat_tax.html
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marginal tax rateaverage tax rateincome
0%10%$40,000
0%20%$20,000
A lump-sum tax is the same for every person
Example: lump-sum tax = $4000/person
Lump-Sum Taxes
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A lump-sum tax is the most efficient tax:
• causes no deadweight loss does not distort incentives, as a person’s decisions have no tax consequences
• minimal administrative burdenno need to hire accountants, keep track of receipts, etc.
Yet, not used because perceived as unfair:
• in dollar terms, the poor pay as much as the rich
• relative to income, the poor pay much more than the rich
Lump-Sum Taxes
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The Benefits Principle
Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt services
Example: Gasoline taxes
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The Ability-To-Pay Principle
Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden
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Vertical Equity Vertical equity: the idea that taxpayers with a
greater ability to pay taxes should pay larger amounts
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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 Tax Systems
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U.S. Federal Income Tax Rates: 2005
On taxable income…
the tax rate is…
0 – $7,300 10%
7,300 – 29,700 15%
29,700 – 71,950 25%
71,950 – 150,150 28%
150,150 – 326,450 33%
Over $326,450 35%
The U.S. has a progressive income tax.
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Steve Forbes endorses Giuliani& talks about taxes.
http://www.youtube.com/watch?v=FyrqjaadA-o&mode=user&search
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Horizontal Equity
Horizontal equity: the idea that taxpayers with similar abilities to pay taxes should pay the same amount
Problem: Difficult to agree on what factors, besides income, determine ability to pay.
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1A1A: : Taxes and MarriageTaxes and Marriage
The income tax rate is 25%. The first $20,000 of income is excluded from taxation. Tax law treats a married couple as a single taxpayer.
Sam and Diane each earn $50,000.
i. If Sam and Diane are living together unmarried, what is their combined tax bill?
ii. If Sam and Diane are married, what is their tax bill?
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1A1A: : AnswersAnswers
If unmarried, Sam and Diane each pay 0.25 x ($50,000 – 20,000) = $7500
Total taxes = $15,000 = 15% of their joint income.
If married, they pay 0.25 x ($50,000 – 20,000) = $20,000or 20% of their joint income.
The $5000 increase in the tax bill is called the “marriage tax” or “marriage penalty.”
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1B1B: : Taxes and MarriageTaxes and Marriage
The income tax rate is 25%. For singles, the first $20,000 of income is excluded from taxation. For married couples, the exclusion is $40,000.
Harry earns $0. Sally earns $100,000.
i. If Harry and Sally are living together unmarried, what is their combined tax bill?
ii. If Harry and Sally are married, what is their tax bill?
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AA CC TT II VV E LE L EE AA RR NN II NN G G 1B1B: : AnswersAnswers
If unmarried, Harry pays $0 in taxes. Sally pays0.25 x ($100,000 – 20,000) = $20,000
Total taxes = $20,000 = 20% of their joint income.
If married, they pay 0.25 x ($100,000 – 40,000) = $15,000or 15% of their joint income.
The $5000 decrease in the tax bill is called the “marriage subsidy.”
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Marriage Taxes and Subsidies
In current U.S. tax code,
• couples with similar incomes are likely to pay a marriage tax
• couples with very different incomes are likely to receive a marriage subsidy
Many have advocated reforming the tax system to be neutral with respect to marital status…
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Marriage Taxes and Subsidies
Ideally, a tax system would have these properties:
• Two married couples with the same total income pay the same tax.
• Marital status does not affect a couple’s tax bill.
• A person/family with no income pays no taxes.
• High-income taxpayers pay a higher fraction of their incomes than low-income taxpayers.
However, designing a tax system with all four of these properties is mathematically impossible.
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Tax Incidence and Tax Equity Recall: The person who bears the burden is not
always the person who gets the tax bill.
Example: A tax on fur coats
• May appear to be vertically equitable
• But furs are a luxury, with very elastic demand
• The tax shifts demand away from furs, hurting the people who produce furs (who probably are not rich)
Lesson: When evaluating tax equity, must take tax incidence into account.
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Who Pays the Corporate Income Tax?
When the govt levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer.
The burden of the tax ultimately falls on people.
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CONCLUSION: The Trade-Off Between Efficiency and Equity
The goals of efficiency and equity often conflict:
• E.g., lump-sum tax is the least equitable but most efficient tax.
Political leaders differ in their views on this tradeoff.
Economics
• can help us better understand the tradeoff
• can help us avoid policies that sacrifice efficiency without any increase in equity