P R I N C I P L E S O F

1. P R I N C I P L E S O F FOURTH EDITION 0 The Design of the Tax System 12

2. In this chapter, look for the answers to these questions: 0 • What is the structure of U.S. taxes, and what are the largest sources of tax revenue? • What are the efficiency costs of taxes, and what special role does the marginal tax rate play? • How can we evaluate the equity of a tax system? • What are the major issues today with the present federal income tax? CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

3. U.S. Tax Revenue (% of GDP) 0 CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

4. Receipts of the U.S. Federal Govt, 2004 0 CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

5. Receipts of State & Local Govts, 2002 0 CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

6. Taxes and Efficiency 0 • One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers. • The costs to taxpayers include: • the tax payment itself • deadweight losses (Taxes distort incentives, cause people to allocate resources according to tax incentives rather than true costs and benefits.) • administrative burden CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

7. Administrative Burden 0 • includes the time and money people spend to comply with tax laws • encourages the expenditure of resources on legal tax avoidance • e.g., hiring accountants to exploit “loopholes” to reduce one’s tax burden • is a type of deadweight loss • could be reduced if the tax code were simplified but would require removing loopholes, politically difficult CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

8. Marginal vs. Average Tax Rates 0 • 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. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

9. Income taxes with multiple tax rates • Consider this tax: Tax rates vary with income as follows: • Income less than $20K – no tax. • Income from $20K-50K – taxed at 20% • Income above 50K – taxed at 40%. What is the average and marginal tax rates for someone earning 80K? Comment on this statement by someone making $150K: “I bitterly resent the government taking 40% of every dollar I earn.” CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

10. Lump-Sum Taxes 0 A lump-sum tax is the same for every person and is the most efficient tax: • causes no deadweight lossdoes 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 CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

11. Taxes and Equity 0 • Another goal of tax policy: equity – distributing the burden of taxes “fairly.” Views differ widely on what is fair and equitable. • Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt services This provides little guidance as most citizens share equally in the benefits of the federal government. • Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden -- suggests that all taxpayers should make an “equal sacrifice” CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

12. Ability to pay: what is “equal sacrifice”? 0 • Ability-to-pay principle: recognizes that the magnitude of the sacrifice depends not just on the tax payment, but on the person’s income and other circumstances; is a $10,000 tax bill a bigger sacrifice for a poor person than a rich person • Vertical equity: the idea that taxpayers with a greater ability to pay taxes should pay larger amounts • Is a proportionate tax equal sacrifice? CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

13. Three Tax Systems 0 • Proportional tax: taxpayers pay the same fraction of income, regardless of income • Regressive tax: high-income taxpayers pay a smaller fraction of their income than low-income taxpayers • Progressive tax: high-income taxpayers pay a larger fraction of their income than low-income taxpayers CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

14. The U.S. Federal Tax System • The federal tax system relies on progressive taxes, with marginal taxes increasing at higher income tax “brackets”. • The definition of income and taxable income is extremely complex, reflecting a host of social objectives that are reflected in the tax code: • Some types of economic activity are not fully taxed -- deductions reducing ‘taxable income’. • Taxation of business income includes complex rules. • Personal taxes reflect complex objectives that favor home ownership, child care, charitable giving, etc. • Special tax provisions reduce the tax base, hence requiring that marginal tax rates be higher. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

15. Structure of Federal Income Tax CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

16. Deductions in the Federal Tax Code • Each taxpayer is allowed a deduction from income, in calculating “adjusted gross income” on which you pay tax (either “Standard” or “Itemized” deduction. • Deductions affect taxpayers differently. The tax savings of a deduction depend on your income level (marginal tax rate). • HH A earns $150K and is in the 28% bracket. Its tax savings of $30K of mortgage interest is .28($30K) = $8,400. • HH B earns $25K and is in the 15% bracket. Its tax savings of $8K mortgage interest: .15($8K) = $1,200. • Deductions make the tax system less progressive! CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

17. Largest Tax Expenditures (tax provisions that reduce taxable income) 2007 CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

18. Major Income Tax Policy Decisions • World War II - 1981: Very high marginal tax rates in WWI declining to 50% top rate in 1970’s. • 1981, Pres. Reagan: Cut taxes by increasing brackets dramatically and allowing tax shelters (top rate 50%). • 1986: Broadened tax base by disallowing many shelters and deductions; lowered marginal rates (15, 28, 31%). • 1993, Pres. Clinton: Raised all marginal tax rates up, highest at 39.6% for income over $250K. Much more progressive tax code. • 2001,2003, Pres. Bush: Reduced marginal rates and cut taxes on dividends, capital gains, and estates. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

19. U.S. Federal Income Tax Rates: 2005 0 The U.S. has a progressive income tax. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

20. Burden of Federal taxes, 2005 CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

21. Present Tax Debate • 2001 tax reductions and govt. spending have created huge federal deficit. Most tax reductions expire in 2010, implying massive tax hike then! Will taxes be increased, and what will be the structure of tax changes? • Alternative Minimum Tax: A tax provision designed to tax highest income households by taking away their deductions and taxing at flat rate of 28% above a set income threshold. Because threshold is not indexed, millions of middle/upper middle class taxpayers now confronted with this tax! Eliminating the AMT would be a tax cut and hence a still bigger federal deficit. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

22. Long Term Fiscal Imbalances • Sunset of the 2001/2003 tax reductions in 2010 will increase taxes about $350 billion/year. • Repealing the Alternative Minimum Tax will cost about $50-75 billion/year • Extending the current estate tax law will cost about $50 billion/year. • Federal budget expenditures explode upward after 2015 due to Medicare costs of retirees. • Social Security Trust Fund increases until 2015 then gradually spent down-- insufficient by 2045. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

23. Income vs. Consumption Tax 0 • The income tax reduces the incentive to work, earn, and to save and invest: (eg. If income tax rate = 25%, 8% interest rate = 6% after-tax interest rate) • Some economists advocate taxing consumption instead of income. • would restore incentive to earn, invest, and save • would impose a tax burden on persons now evading the income tax by dealing in cash • Equity issue: consumption taxes pose a greater burden on lower income households. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

24. Who Pays the Corporate Income Tax? 0 • 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. • Suppose govt levies a tax on car companies • owners receive less profit, may respond over time by shifting their wealth out of the car industry • the supply of cars falls, car prices rise, car buyers are worse off • demand for auto workers falls, wages fall, workers are worse off CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

25. CHAPTER SUMMARY 0 • In the U.S., the most important federal revenue sources are the personal income tax, social insurance payroll taxes, and the corporate income tax. The most important state and local taxes are the sales tax and property tax. • The efficiency of a tax system refers to the costs it imposes on taxpayers beyond their tax payments. One cost is the deadweight loss caused by the distortion of incentives from taxes. Another is the administrative burden of complying with tax laws. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

26. CHAPTER SUMMARY 0 • The equity of a tax system refers to its fairness. The benefits principle suggests that it is fair for people to be taxed based on the amount of government benefits they receive. The ability-to-pay principle suggests that it is fair for people to pay taxes based on their ability to handle the burden. • The U.S. has a progressive tax system, in which high income taxpayers face a higher average tax rate than low income taxpayers. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

27. CHAPTER SUMMARY 0 • When evaluating the equity of a tax system, it is important to consider tax incidence, as the distribution of tax burdens is not the same as the distribution of tax bills. • Policymakers often face a tradeoff between the goals of efficiency and equity in the tax system. Much of the debate over tax policy arises because people give different weights to these two goals. CHAPTER 12 THE DESIGN OF THE TAX SYSTEM