1 of 45 copyright © 2010 pearson education, inc. publishing as prentice hall · economics · r....

1 of 45Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

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CHAPTER18

Public Choice,Taxes, and the Distribution of Income

Fernando Quijano

Prepared by:

When Barack Obama became president

in January 2009, he proposed a number of

changes to the tax system.


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18.1 Public Choice

Define the public choice modeland explain how it is used to analyze government decision making.

18.2 The Tax System

Understand the tax system inthe United States, including the principles that governments use to create tax policy.

18.3 Tax Incidence Revisited: The Effect of Price Elasticity

Understand the effect of price elasticity on tax incidence.

18.4 Income Distribution and Poverty

Discuss the distribution of income in the United States and understand the extent of income mobility.

Chapter Outline and Learning Objectives

CHAPTER

Public Choice,Taxes, and the Distribution of Income

18


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Public choice model A model that applies economic analysis to government decision making.

Public Choice, Taxes, andthe Distribution of Income


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Public Choice

POLICY LENA DAVID KATHLEEN

Cancer research 1st 2nd 3rd

Mass transit 2nd 3rd 1st

Border security 3rd 1st 2nd

VOTES OUTCOME

Cancer research versus mass transit Cancer research wins

Mass transit versus border security Mass transit wins

Border security versus cancer research Border security wins

How Do We Know the Public Interest?Models of Voting

The Voting Paradox

Table 18-1

The Voting Paradox

Define the public choice model and explain how it is used to analyze government decision making.

18.1 LEARNING OBJECTIVE


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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.

The Voting Paradox

Public Choice

How Do We Know the Public Interest? Models of Voting




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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


The Median Voter Theorem




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FIGURE 18-1



Public Choice


The median voter theorem states that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle. In this case, David is in the political middle because two voters want to spend more on breast cancer research than he does and two voters want to spend less. In any vote between a proposal to spend $2 billion and a proposal to spend a different amount, a proposal to spend $2 billion will win.




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Rent seeking 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.

Government Failure?

Rent seeking

Logrolling and Rational Ignorance

Public Choice Define the public choice model and explain how it is used to analyze government decision making.



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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.

Regulatory Capture

Government Failure?




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Although government regulation can clearly provide important benefits to consumers, we need to take into account the costs of regulations.

Economics can help policymakers devise regulations that provide benefits to consumers that exceed their costs.

Is Government Regulation Necessary?




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• Individual income taxes.

• 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 SystemUnderstand the tax system in the United States, including the principles that governments use to create tax policy.



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FIGURE 18-2

Federal, State, and Local Sources of Revenue, 2008

An Overview of the U.S. Tax System



Individual income taxes are the most important source of revenue for the federal government, and social insurance taxes are the second most important source. State and local governments receive the most revenue from sales taxes. State and local governments also receive large transfers from the federal government, in part to help pay for federally mandated programs. Many local governments depend on property taxes to raise most of their tax revenue.


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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.

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.

Progressive and Regressive Taxes




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INCOME TAX RATE

0 to $8,350 10%

$8,351 to $33,950 15

$33,951–$82,250 25

$82,251–$171,550 28

$171,551–$372,950 33

Over $372,950 35

ON MATT’S . . . MATT PAYS TAX OF . . .

first $8,350 of income $ 835

next $25,600 of income 3,840

next $48,300 of income 12,075

last $17,750 of income 4,970

His total federal income tax payment is $21,720

Table 18-2

Federal Income Tax Brackets and Tax Rates for Single Taxpayers, 2009

Table 18-3

Federal Income Tax Paid on Taxable Income of $100,000

Progressive and Regressive Taxes




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Which Groups Pay the Most in Federal Taxes?

INCOME CATEGORY

PERCENTAGEOF TOTAL

INCOME EARNED(1)

PERCENTAGE OF TOTAL FEDERAL

TAXES PAID(2)

ALL FEDERAL TAXES PAIDAS A FRACTION OF INCOME

(AVERAGE FEDERAL TAX RATE)

(3)

Lowest 20% 4.0% 0.1% – 0.3%

Second 20% 9.2 4.0 7.9

Third 20% 14.9 12.0 14.5

Fourth 20% 20.8 19.9 17.2

Highest 20% 51.3 64.0 22.5

Total 100.0% 100.0% 18.0%

Highest 1% 15.4 22.2 26.0

Makingthe

Connection

YOUR TURN: Test your understanding by doing related problem 2.9 at the end of this chapter.

Understand the tax system in the United States, including the principles that governments use to create tax policy.



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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.

%7.21100000,100$

720,21$

Marginal and Average Income Tax Rates



For example, in Table 18-3, Matt had a marginal tax rate of 28 percent

because that is the rate he paid on the last dollar of his income. But his average tax

rate was:


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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 Corporate Income Tax




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COUNTRY TAX IN 2000 TAX IN 2008

France 37% 33%

Germany 52 30

Ireland 24 13

Italy 41 31

Japan 42 41

Spain 35 30

Sweden 28 28

United Kingdom 30 28

United States 40 40

Table 18-4

Corporate Income Tax Rates around the World

International Comparison of Corporate Income Taxes




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me • The goal of economic efficiency

• The ability-to-pay principle

• The horizontal-equity principle

• The benefits-received principle

• The goal of attaining social objectives

Evaluating Taxes

In selecting which taxes to use, governments take into account the following goals and principles:




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FIGURE 18-3

The Efficiency Loss from a Sales Tax

Evaluating TaxesThe Goal of Economic Efficiency



A sales tax increases the cost of supplying a good, which causes the supply curve to shift up from S1 to S2.

Without the tax, the equilibrium price of the good is P1, and the equilibrium quantity is Q1.

After the tax is imposed, the equilibrium price rises to P2, and the equilibrium quantity falls to Q2. After paying the tax, producers receive P3.

The government receives tax revenue equal to the green-shaded rectangle. Some consumer surplus and some producer surplus become tax revenue for the government,

and some become deadweight loss, shown by the yellow-shaded triangle. The deadweight loss is the excess burden of the tax.


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Excess burden A measure of the efficiency loss to the economy that results from a tax having reduced the quantity of a good produced; also known as the deadweight loss.

The Goal of Economic EfficiencyEvaluating Taxes




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Should the United StatesShift from an Income Taxto a Consumption Tax?

Would a consumption tax be more efficient than an income tax?

Makingthe

Connection


Understand the tax system in the United States, including the principles that governments use to create tax policy.


Under the income tax, households pay taxes on all income earned. Under a consumption tax, households pay taxes only on the part of income they spend.


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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 Ability-to-Pay Principle

Evaluating Taxes




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According to the benefits-received principle, 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 Benefits-Received Principle

Evaluating Taxes




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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





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FIGURE 18-4The Effect of Elasticity on Tax Incidence

Tax Incidence Revisited: The Effect of Price Elasticity

When demand is more elastic than supply, consumers bear less of the burden of a tax. When supply is more elastic than demand, firms bear less of the burden of a tax.

D1 is inelastic between point A and point B, and D2 is elastic between point A and point C.

With demand curve D1, a 10-cents-per-gallon tax raises the equilibrium price from $3.00 (point A) to $3.08 (point B), so consumers pay 8 cents of the tax, and firms pay 2 cents.

With D2, a 10-cents-per-gallon tax on gasoline raises the equilibrium price only from $3.00 (point A) to $3.02 (point C), so consumers pay 2 cents of the tax.

Because in this case producers receive $2.92 per gallon after paying the tax, their share of the tax is 8 cents per gallon.




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Do Corporations Really Bear theBurden of the Federal CorporateIncome Tax?

Will she be paying part of Apple’s corporate income tax when she buys an iPhone?

Makingthe

Connection




Most economists agree that some of the burden of the corporate income tax is passed on to consumers in the form of higher prices.


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The Effect of Price Elasticity on the Excess Burden of a Tax

Solved Problem 18-3

YOUR TURN: For more practice, do related problems 3.5 and 3.6 at the end of the chapter.



When demand is less elastic, the excess burden of a tax is smaller than when demand is more elastic.


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ANNUAL INCOME PERCENTAGE OF ALL HOUSEHOLDS

$0–$14,999 13.2%

$15,000–$24,999 11.6

$25,000–$34,999 10.7

$35,000–$49,999 14.1

$50,000–$74,999 18.2

$75,000–$99,999 11.9

$100,000 and over 20.2

Table 18-5

The Distribution of Household Income in the United States, 2007

Income Distribution and Poverty

Measuring the Income Distribution and Poverty




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How Has the Distribution of Income Changed over Time?

YEAR LOWEST 20% SECOND 20% THIRD 20% FOURTH 20% HIGHEST 20%

2007 3.4% 8.7% 14.6% 23.4% 49.7%

1990 3.9 9.6 15.9 24.0 46.6

1980 4.3 10.3 16.9 24.9 43.7

1970 4.1 10.8 17.4 24.5 43.3

1960 3.2 10.6 17.6 24.7 44.0

1950 3.1 10.5 17.3 24.1 45.0

1936 4.1 9.2 14.1 20.9 51.7

Table 18-6






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Poverty line A level of annual income equal to three times the amount of money necessary to purchase the minimum quantity of food required for adequate nutrition.

The Poverty Rate in the United States





Poverty rate The percentage of the population that is poor according to the federal government’s definition.


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FIGURE 18-5

Poverty in the United States, 1960–2007




The poverty rate in the United States declined from 22 percent of the population in 1960 to 11 percent in 1973. Over the past 30 years, the poverty rate has fluctuated between 11 percent and 15 percent of the population.




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All people 12.5%

Female head of family, no husband present (all races) 28.3

Blacks 24.5

Hispanics 21.5

Asians 10.2

White, not Hispanic 8.2

Married couple 4.9

Table 18-7

Poverty Rates Vary across Groups, 2007







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For most people, the most important factor of production they own is their labor. Therefore, the income they earn depends on how productive they are and on the prices of the goods and services their labor helps 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.

Explaining Income Inequality

Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility.



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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.

Gini coefficientA

A B




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FIGURE 18-6

The Lorenz Curve and Gini Coefficient


Showing the Income Distribution with a Lorenz Curve



Because the Lorenz curve for 1980 is closer to the line of perfect equality than the Lorenz curve for 2007, we know that income was more equally distributed in 1980 than in 2007. In panel (b), we show the Gini coefficient. The closer the Gini coefficient is to 1, the more unequal the income distribution.


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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


Each column represents one quintile—or 20 percent—of households, arranged by their incomes in 1996. Reading up the column, we can see where the households that started in that quintile in 1996 ended up in 1999. Only 62 percent of the households that were in the bottom quintile of income in 1996 were still in the bottom quintile in 1999. Only 66 percent of the households that were in the top quintile of income in 1996 were still in the top quintile in 1999.Note: Incomes are in 1999 dollars to correct for the effects of inflation.




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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.

YOUR TURN: For more practice, do related problem 4.7 at the end of the chapter.

Are Many Individuals Stuck in Poverty?

Solved Problem 18-4 Discuss the distribution of income in the United States and understand the extent of income mobility.



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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.

The Effect of Taxes and Transfers

Problems in Measuring Poverty and the Distribution of Income




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Table 18-8

Income Inequality around the World

COUNTRY LOWEST 20% HIGHEST 20% RATIO

Bolivia 1.5% 63.0% 42.0

Paraguay 2.4 61.9 25.8

Brazil 2.8 61.1 21.8

Chile 3.8 60.0 15.8

United states 3.4 49.7 14.6

Thailand 6.3 49.0 7.8

United kingdom 6.1 44.0 7.2

Ireland 7.4 42.0 5.7

France 7.2 40.2 5.6

Canada 7.2 39.9 5.5

South Korea 7.9 37.5 4.7

Germany 8.5 36.9 4.3

Norway 9.6 37.2 3.9

Japan 10.6 35.7 3.4

Income Distribution and Poverty around the World




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Table 18-9

Poverty in Sub-Saharan Africa Is Much Greater Than Elsewhere in the World

PERCENTAGE OF THE POPULATION IN POVERTY

REGION 1970 2000

World 20.2% 7.0%

East Asia 32.7 2.4

China 32.0 3.1

South Asia 30.3 2.5

Middle East and North Africa 10.7 0.6

Latin America 10.3 4.2

Sub-Saharan Africa 35.1 48.8

Income Distribution and Poverty around the World




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AN INSIDE LOOK at Policy Should the Government Use a Tax on Soda to

Pay For an Overhaul of Health Care?>>

AN INSIDE LOOK at Policy

A tax decreases the supply of sugary soft drinks. The amount of revenue raised by the tax depends on the elasticity of the demand and the elasticity of supply of the drinks.


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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

Poverty rate

Progressive tax

Public choice model

Regressive tax

Rent seeking

Tax incidence

Voting paradox

KEY TERMS

1 of 45 copyright © 2010 pearson education, inc. publishing as prentice hall · economics · r....

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income distribution

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