19 Taxation and Resource Allocation The taxing power of the government must be used to provide revenues for legitimate government purposes. It must not

19

Taxation and Resource Allocation

The taxing power of the government must be used to provide revenues for legitimate government purposes. It must not be used to regulate the economy or bring

about social change.RONALD REAGAN

● The Level and Types of Taxation

● The Federal Tax System

● The State and Local Tax System

● The Concept of Equity in Taxation

● The Concept of Efficiency in Taxation

● Shifting the Tax Burden: Tax Incidence

● The Level and Types of Taxation

● The Federal Tax System

● The State and Local Tax System

● The Concept of Equity in Taxation

● The Concept of Efficiency in Taxation

● Shifting the Tax Burden: Tax Incidence

ContentsContents

Copyright © 2003 South-Western/Thomson Learning. All rights reserved.

● When Taxation Can Improve Efficiency

● Equity, Efficiency, and the Optimal Tax

● When Taxation Can Improve Efficiency

● Equity, Efficiency, and the Optimal Tax

ContentsContents


Copyright© 2003 Southwestern/Thomson Learning. All rights reserved.

The Level and Types of TaxationThe Level and Types of Taxation

● Average tax rates have been roughly constant over the past two decades, at both the federal and the state and local levels.

● Taxes can be classified in terms of whether they are progressive, proportional, or regressive.

● Average tax rates have been roughly constant over the past two decades, at both the federal and the state and local levels.

● Taxes can be classified in terms of whether they are progressive, proportional, or regressive.

FIGURE 19-1 Taxes as Percentage of GDP

FIGURE 19-1 Taxes as Percentage of GDP


2001

2000 1995

State and local government

22

20

18

16

14

12

10

8

6

4

1985 1980 1975 1970 1965 1960 1955 1950 1945 1940 1935 1930 1990

Federal government

2

Pe

rce

nta

ge

of

GD

P

0

FIGURE 19-2 The Tax Burden in Selected Countries, 2000

FIGURE 19-2 The Tax Burden in Selected Countries, 2000


Ta

x R

ev

en

ue

s a

s a

Pe

rce

nta

ge

of

GD

P

United States Japan Switzerland Germany

Netherlands Sweden Italy United Kingdom 0

10

20

30

40

50

27.1 29.0

35.9 37.7 37.8

41.8 42.9

53.3 60



● Progressive tax = the fraction of income paid in taxes rises as a person’s income increases

● Proportional tax = this fraction is constant

● Progressive tax = the fraction of income paid in taxes rises as a person’s income increases

● Proportional tax = this fraction is constant



● Regressive tax = the fraction of income paid to the tax collector declines as income rises

● The marginal tax rate, not the average tax rate, most directly affects economic incentives.

● Regressive tax = the fraction of income paid to the tax collector declines as income rises

● The marginal tax rate, not the average tax rate, most directly affects economic incentives.



● Direct taxes are levied directly on people; primary examples are income taxes and inheritance taxes.

● Indirect taxes are levied on particular activities, such as buying gasoline, using the telephone, or owning a home.

● Direct taxes are levied directly on people; primary examples are income taxes and inheritance taxes.

● Indirect taxes are levied on particular activities, such as buying gasoline, using the telephone, or owning a home.


The Federal Tax SystemThe Federal Tax System

● The principal federal taxes, in descending order of revenue, are: ♦ The personal income tax

♦ The payroll tax

♦ The corporate income tax

♦ Excise taxes

● The principal federal taxes, in descending order of revenue, are: ♦ The personal income tax

♦ The payroll tax

♦ The corporate income tax

♦ Excise taxes

FIGURE 19-3 Sources of Federal Revenue

FIGURE 19-3 Sources of Federal Revenue


Individual income taxes

48.8%

Corporate income taxes 10.3%

Excise taxes 3.4%

All other 1.1% Payroll taxes (Social Security

taxes and contributions)

36.4%



● The Federal Personal Income Tax ♦ The personal income tax is generally

progressive, but with many loopholes.■Every tax loophole encourages particular patterns

of behavior and favors particular types of people.■Among the major tax loopholes are the exempt

status of municipal bond interest and tax benefits for homeowners.

● The Federal Personal Income Tax ♦ The personal income tax is generally

progressive, but with many loopholes.■Every tax loophole encourages particular patterns

of behavior and favors particular types of people.■Among the major tax loopholes are the exempt

status of municipal bond interest and tax benefits for homeowners.

TABLE 19-1 Federal Personal Income Tax Rates in 2001

TABLE 19-1 Federal Personal Income Tax Rates in 2001




● The Payroll Tax ♦ The proceeds of this tax are paid into “trust

funds,” such as Social Security, Medicare, and unemployment benefits.

♦ The payroll tax is highly regressive.

● The Payroll Tax ♦ The proceeds of this tax are paid into “trust

funds,” such as Social Security, Medicare, and unemployment benefits.

♦ The payroll tax is highly regressive.



● The Corporate Income Tax ♦ Tax applies only to profits, not to income;

wages, rents, and interest paid by corporations are deducted before the tax is applied.

♦ All large corporations currently pay a basic marginal tax rate of 35%.

♦ Since WWII, has accounted for a declining share of federal tax revenue--now just 12%.

● The Corporate Income Tax ♦ Tax applies only to profits, not to income;

wages, rents, and interest paid by corporations are deducted before the tax is applied.

♦ All large corporations currently pay a basic marginal tax rate of 35%.

♦ Since WWII, has accounted for a declining share of federal tax revenue--now just 12%.



● Excise Taxes ♦ a sales tax on the purchase of a particular good

or service

♦ Sales taxes are mainly reserved for state and local governments.

♦ A minor source of federal government revenue, some taxes seek to discourage consumption of a good, such as cigarettes, by raising its price.

● Excise Taxes ♦ a sales tax on the purchase of a particular good

or service

♦ Sales taxes are mainly reserved for state and local governments.

♦ A minor source of federal government revenue, some taxes seek to discourage consumption of a good, such as cigarettes, by raising its price.



● The Payroll Tax and the Social Security System♦ For the most part, Social Security is not a true

trust fund, but a pay-as-you-go transfer system.♦ For many years, this system managed to give

every generation of retirees more in benefits than it had contributed in payroll taxes.■Population growth■Wage growth

● The Payroll Tax and the Social Security System♦ For the most part, Social Security is not a true

trust fund, but a pay-as-you-go transfer system.♦ For many years, this system managed to give

every generation of retirees more in benefits than it had contributed in payroll taxes.■Population growth■Wage growth



● The Payroll Tax and the Social Security System♦ “Growth magic” stopped in the 1970s.

■Wage growth stopped.■Population growth slowed.■Life expectancy increased.■Retirement age fell.

♦ The burdens on the payers are increasing over time.

● The Payroll Tax and the Social Security System♦ “Growth magic” stopped in the 1970s.

■Wage growth stopped.■Population growth slowed.■Life expectancy increased.■Retirement age fell.

♦ The burdens on the payers are increasing over time.


The Federal Tax System The Federal Tax System

● The Payroll Tax and the Social Security System♦ Because of recent changes, the system is

currently building up a trust fund, but projections show that the fund will be depleted in less than 50 years.

♦ Eventually, taxes will have to rise and/or benefits will have to be cut.

● The Payroll Tax and the Social Security System♦ Because of recent changes, the system is

currently building up a trust fund, but projections show that the fund will be depleted in less than 50 years.

♦ Eventually, taxes will have to rise and/or benefits will have to be cut.


The State and Local Tax SystemThe State and Local Tax System

● State and local governments depend mostly on sales, excise and property taxes.

● Under the U.S. system of fiscal federalism, grants (often restricted) are made from higher to lower levels of government.

● The federal government is currently devolving increased funds and responsibilities to state governments.

● State and local governments depend mostly on sales, excise and property taxes.

● Under the U.S. system of fiscal federalism, grants (often restricted) are made from higher to lower levels of government.

● The federal government is currently devolving increased funds and responsibilities to state governments.

FIGURE 19-4 Sources of State and Local Revenue

FIGURE 19-4 Sources of State and Local Revenue


Income taxes

(personal and

corporate) 15.6%

All other 28.5%

Property taxes 16.7%

Sales and gross receipts taxes

20.3%

From federal government

18.9%


The Concept of Equity in TaxationThe Concept of Equity in Taxation

● The three principles are: ♦ Horizontal equity

♦ Vertical equity

♦ The benefits principle

● It is often difficult to apply these principles in real situations.

● The three principles are: ♦ Horizontal equity

♦ Vertical equity

♦ The benefits principle

● It is often difficult to apply these principles in real situations.



● Horizontal Equity♦ Horizontal equity = equally situated

individuals should be taxed equally

♦ The current tax code frequently violates this principle.

● Horizontal Equity♦ Horizontal equity = equally situated

individuals should be taxed equally

♦ The current tax code frequently violates this principle.



● Vertical Equity♦ Vertical equity = unequals should be treated

unequally

♦ Often translated into the ability-to-pay principle, according to which those most able to pay should pay the highest taxes

● Vertical Equity♦ Vertical equity = unequals should be treated

unequally

♦ Often translated into the ability-to-pay principle, according to which those most able to pay should pay the highest taxes

TABLE 19-2 Three Alternative Income-Tax Plans

TABLE 19-2 Three Alternative Income-Tax Plans




● Vertical Equity♦ Regressive taxes are generally thought to be

unfair.

♦ There is much less agreement about the relative merits of progressive versus proportional taxes.

● Vertical Equity♦ Regressive taxes are generally thought to be

unfair.

♦ There is much less agreement about the relative merits of progressive versus proportional taxes.



● The Benefits Principle♦ Benefits principle of taxation = those who

reap the benefits from government services should pay the taxes

● The Benefits Principle♦ Benefits principle of taxation = those who

reap the benefits from government services should pay the taxes


The Concept of Efficiency in TaxationThe Concept of Efficiency in Taxation

● Because most taxes induce changes in behavior, the burden of the tax exceeds the revenue generated with the result that an excess burden is created.

● In comparing two taxes that raise the same total revenue, the one that produces less excess burden is the more efficient.

● Because most taxes induce changes in behavior, the burden of the tax exceeds the revenue generated with the result that an excess burden is created.

● In comparing two taxes that raise the same total revenue, the one that produces less excess burden is the more efficient.

A SIMPLE TAX SCHEDULEA SIMPLE TAX SCHEDULE


Tax

$1,000 500

0

Car Type

Cadillac Catera Chrysler 300 Ford Escort


The Concept of Efficiency in TaxationThe Concept of Efficiency in Taxation

● Tax Loopholes and Excess Burden♦ When tax loopholes exist, economic choices

are distorted by tax considerations.

♦ This impairs economic efficiency.

● Tax Loopholes and Excess Burden♦ When tax loopholes exist, economic choices

are distorted by tax considerations.

♦ This impairs economic efficiency.


Shifting the Burden of Taxation: Tax IncidenceShifting the Burden of Taxation: Tax Incidence

● Incidence of a tax = an allocation of tax burden to specific individuals or groups

● Flypaper theory of tax incidence = theory that the tax burden always sticks where the government puts it♦ This theory is often wrong because the people

who pay a tax are often able to shift its burden to other people.

● Incidence of a tax = an allocation of tax burden to specific individuals or groups

● Flypaper theory of tax incidence = theory that the tax burden always sticks where the government puts it♦ This theory is often wrong because the people

who pay a tax are often able to shift its burden to other people.

FIGURE 19-5 The Incidence of an Excise Tax

FIGURE 19-5 The Incidence of an Excise Tax


Pri

ce o

f L

uxu

ry C

ars,

Incl

ud

ing

Tax

$40,000

$40,600

Number of Luxury Cars

Rise in price = $600

Tax = $1,000

S0

S0

S1

S1

D

D

B

A



● The Incidence of Excise Taxes♦ The incidence is determined not by who

physically pays the tax, but by the elasticities of supply and demand.

♦ The more inelastic the demand (supply), the larger is the share of the tax that consumers (producers) pay.

● The Incidence of Excise Taxes♦ The incidence is determined not by who

physically pays the tax, but by the elasticities of supply and demand.

♦ The more inelastic the demand (supply), the larger is the share of the tax that consumers (producers) pay.

FIGURE 19-6 An Extreme Case of Tax Incidence

FIGURE 19-6 An Extreme Case of Tax Incidence


S0

S0

S1

S1 Tax = $1,000

Pri

ce o

f L

uxu

ry C

ars,

Incl

ud

ing

Tax

$40,000

$41,000


Rise in price = $1,000

D

D

FIGURE 19-7 Another Extreme Case of Tax Incidence

FIGURE 19-7 Another Extreme Case of Tax Incidence


Pri

ce o

f L

uxu

ry C

ars,

Incl

ud

ing

Tax

$40,000


D

D

S

S



● The Incidence of the Payroll Tax♦ The incidence is the same whether it is levied

on employers or employees.

♦ Because the supply of labor is probably less elastic than the demand, the incidence falls mostly on workers.

● The Incidence of the Payroll Tax♦ The incidence is the same whether it is levied

on employers or employees.

♦ Because the supply of labor is probably less elastic than the demand, the incidence falls mostly on workers.


When Taxation Can Improve EfficiencyWhen Taxation Can Improve Efficiency

● Some taxes that change behavior are nevertheless good because: ♦ They help to achieve some other goal.

♦ They compensate for an inefficiency in the market. (See, for example, the discussion of pollution taxes in Chapter 20.)

● Some taxes that change behavior are nevertheless good because: ♦ They help to achieve some other goal.

♦ They compensate for an inefficiency in the market. (See, for example, the discussion of pollution taxes in Chapter 20.)


Equity, Efficiency and the Optimal TaxEquity, Efficiency and the Optimal Tax

● All taxes have some negative effects in terms of efficiency and equity.

● The comprehensive personal income tax with no loopholes is the best we can do.

● All taxes have some negative effects in terms of efficiency and equity.

● The comprehensive personal income tax with no loopholes is the best we can do.


The Pros and Cons of the Bush Tax CutsThe Pros and Cons of the Bush Tax Cuts

● First: Reduced marginal tax rates♦ improved economic efficiency

● Second: tax cuts skewed toward upper-brackets♦ con: why rich get large breaks?

♦ Pro: people who received largest breaks, paid most in taxes

● First: Reduced marginal tax rates♦ improved economic efficiency

● Second: tax cuts skewed toward upper-brackets♦ con: why rich get large breaks?

♦ Pro: people who received largest breaks, paid most in taxes

??


The Pros and Cons of the Bush Tax CutsThe Pros and Cons of the Bush Tax Cuts

● Third: large magnitude once phased in♦ government afford “generosity”?

♦ Bush argued surpluses justified but surpluses disappeared after Sept. 11

● Conclusion: It is public policy debate with plenty of room for reasonable people to disagree.

● Third: large magnitude once phased in♦ government afford “generosity”?

♦ Bush argued surpluses justified but surpluses disappeared after Sept. 11

● Conclusion: It is public policy debate with plenty of room for reasonable people to disagree.

??

Documents

19 Taxation and Resource Allocation The taxing power of the government must be used to provide revenues for legitimate government purposes. It must not