Understanding Taxes: Types, Economic Impact, and Principles

Chapter 14.1 Learning Target: Analyze the ways in which the government generates revenue Student Success Criteria: Students can explain various types of taxes and how they work

Economic Impact of Taxes • Governments levy (charge) many different kinds of taxes. The purpose of taxes is to pay for the running of all levels of the government. As the government adds to the services it provides – taxes increase to pay for those services.

Resource Allocation • Taxes influence the economy in different ways and are not always paid by the party being taxed • If a tax is placed on a good or service in a factory – the factory passes on that tax to the consumer – how? By raising the price of the product they make.

Resource Allocation • People react to this price increase – they buy less • If sales drop enough – the factory will cut back on production • What factor of production is always the first to be impacted? • They also purchase less of the materials needed to make their product – which is what factor of production?

Behavior Adjustment • If the government wants to encourage or discourage behaviors – they can do so through taxes • Home ownership is something the government encourages – so home owners can deduct interest on their mortgage and property taxes • Other debt (credit cards, auto loans, boat loans) is not encouraged – so you cannot deduct the interest on those.

Behavior Adjustment • A sin tax– is a high tax placed on goods that the government wants to discourage. What goods might have a sin tax? • It is important that a sin tax is uniform from city to city or state to state – or else people will simply go elsewhere to avoid the tax.

Income Redistribution • The government collects taxes to pay for things like national defense, roads, schools and courts among other things. • Unfortunately the government also has to deal with problems of poverty, discrimination, an aging population and so on so taxes can impact the distribution of income. • Some people benefit more from the government and pay little while others pay substantial amounts and get little DIRECTLY.

Productivity and Growth • If taxes get too high – people might decide not to try any harder to earn more money – because they would lose too much of it to taxes. This has never really happened – but the economic argument is that it is possible that IF taxes got too high – productivity and the desire to increase your income by working harder would go down.

Incidence of a Tax • So who really pays the tax? • If the tax is indirect – at least a portion of it can be passed on to the consumer. If the tax is added to a regulated utility – and the utility is not allowed to raise prices – then the company would have to absorb the tax and earn lower revenues.

Incidence of a Tax • So who really pays the tax? • If the tax is direct then only the consumer can pay. A good example of this is the fee for your license. If the state raises the tax – you must pay it.

Incidence of a Tax • Elasticity is a microeconomic concept. Goods that are elastic are goods consumers can easily choose not to buy and so an increase in the price might cause reduced sales – in that case the producer pays the tax and reduces her profits • Inelastic products have the consumer bearing the burden. These are items consumer MUST have or think they must have.

Characteristics and Types of Taxes Some taxes will always be needed – but we want them to be three things: equitable, simple and efficient.

Equity – Is it fair? While people will generally never agree on what is fair – most agree that tax loopholes are not fair. Loopholes are opportunities given to some people to allow them to pay less tax. The fewer exceptions, deductions and exemptions there are – the more the tax is seen as equitable or fair

Simplicity – do people understand how the tax works? • Sales taxes are simple – easy to compute and understand plus the merchant takes care of collecting them. • Individual income taxes are complex. The IRS(Internal Revenue Service) collects these taxes and sends out the forms you need to complete your tax return.

Efficiency – Are they easy to collect? • Income taxes – while not necessarily equitable or simple – are generally considered efficient. They are taken directly out of your pay and once a year (at tax time) you can adjust what you pay through filing an income tax return. • There are taxes that are not as efficient (tolls on roads and bridges). The tax also has to generate enough of a return to make it worth the trouble. • The new Michigan process for paying user fees for state park use is an attempt to make that tax more efficient.

Two Principles of Taxation

Benefit Principle • The idea is that if you benefit from a government good or service – you should pay in proportion to that benefit. Gas taxes work this way – you pay every time you fill up. • Problems – those who benefit from government services are usually the least able to pay • It is hard to figure out who all the beneficiaries are – a good road benefits the driver (who pays for it through gas taxes) but also the businesses on the road benefit.

Ability to Pay Principle • We can’t always figure out who or how much people benefit from government spending…do we all benefit from poor people getting food stamps? How? • People with higher incomes feel the effect of taxes LESS – than people with lower incomes

Three Types of Taxes

Proportional Taxes • Proportional Tax – same tax rate no matter how much you make (Medicare) Why not SS? (because it is capped) The average tax rate is the same for everyone.

Progressive Taxes • Higher tax on higher income (income tax) So you have a progressively higher marginal tax rate as you go from bracket to bracket.

Regressive Taxes • Higher percentage rate of taxation on lower incomes (state sales tax – if I make 9.7 million dollars a year – as the Centerfielder does – it is unlikely that I spend 30% of my income on things that have sales tax. If I am a teacher making $54,700 – I probably spend even more than 30% of my income on taxable goods – which means I spend a higher percentage of my income on things that are taxed – the impact is greater.)

Alternative Tax Approaches

Flat Tax • Aproportional tax on individual income after a threshold has been met. So those below that threshold would not pay anything.

Flat Tax • Good that it eliminates loopholes and time spent on preparing taxes BUT the deductions (loopholes) encourage certain behaviors that the government wants to encourage – like donating to charities and buying houses. Many of the deductions benefit middle income earners (child tax credit, education credits, etc.)

Flat Tax Problems • No one really knows what the flat tax would need to be to replace the current revenue. One estimate of 23% would put many middle income workers in a higher marginal tax rate because their deductions would be eliminated. The burden for lower income families that were above poverty but well below paying at 23% would be disastrous. • Flat taxes have never been done so there is no way to know what impact it will have on the economy

The Value Added Tax (VAT) • The government taxes consumption (sales tax at the national level) rather than income. • VAT – at every stage of manufacturing a tax is added (based on the value of that step of the operation.) With services, every time let’s say a lawyer worked on your case – the VAT would be added to the hourly rate. It is invisible to the consumer (with the exception of knowing the VAT rate. In the UK it is 20%.) Benefits are numerous because like a sales tax – it is all done at the point of sale and collected, sent by the business owner.

Tax Reform of 1981 • Biggest change in the tax code in the US – done by Reagan. Reduced the top bracket from 70 to 50 percent. It has been lowered more since. Also reduced the number of tax brackets.

Tax Reform: 1986, 1993 • Taxes were seen to benefit the wealthy with many paying no taxes at all due to loopholes. Strengthened the alternative minimum tax • Alternative minimum tax – the minimum rate everyone must pay on income regardless of deductions • All of the tax reductions began to show as increased deficit spending. Two tax brackets were added 35 and 39.6.

Tax Reform 1997 • In 1997 the government had an increase in tax revenue due to the two new tax brackets and the closing of some loopholes. Politicians decided to reduce the capital gains tax which only benefitted people wealthy enough to invest. These changes actually complicated the tax code even more.

Tax Reform in 2001 • The surplus created during Clinton’s time in office was “sent back to the people. Left alone – these surpluses would have continued through 2010 and paid down debt, paid back the SS trust fund or funded new gov’t spending BUT…no – he cut taxes

Tax Reform in 2001 continued… • Tax brackets were adjusted, a 10% bracket created and other brackets lowered with the 35% rate now the highest bracket to be done in 2006. It also was to eliminate the estate tax by 2010. We’ll talk about that later – it really only impacts the super rich that are really stupid and don’t take care of this before they die.

Tax Reform in 2003 • Slow economic growth made Bush reduce the highest brackets NOW – no waiting for 2006 • For the poor people the amount of money you could make and stay in the 10% bracket was increased (so you don’t bump into a higher bracket for a bit longer) • Child tax credit increased • Capital gains reduced AGAIN to 15% • Results – MORE DEFICIT SPENDING.

The “Permanent” Tax cuts of 2011 • A pesky little recession (the biggest in history) stopped the tax cuts from being permanent.

Tax Reform in 2013 • Top two tax brackets added. The only thing that is certain in life is death and taxes and in the US – that taxes will always be changing – stay tuned.

Tax Reform in 2018 • All the brackets changed • Changes overwhelmingly favor those making over $750,000 per year • Many loopholes for middle class were eliminated • State and local taxes can only be deducted up to $10,000. For states like NY and CA where state property taxes are very very high – this is a huge change and people will be paying more tax.

Chapter 14.2 Learning Target: Analyze the consequences of various tax strategies Student Success Criteria: Students can explain the impact of various budget policies

Establishing the Federal Budget

Fiscal Year • A 12 month planning period – Oct to Oct, kind of like a school year.

Executive Formulation • The president uses the OMB (office of management and budget) to prepare his budget. This must be sent to Congress by the first Monday in February.

Congressional Action • Congress breaks the bill down into 12 categories and assigns them to House subcommittees. The budget always goes to the House first. All budgets must come from the House. Each committee prepares an appropriations bill that funds part of the federal government. All the writing, changing, etc. takes place in the subcommittee. Once approved it moves on.

Congressional Action • Next the bill goes to the House Appropriations Committee. If they vote favorably it goes to the whole House to vote on. • The Senate gets the House bill next • Approve it • Change it • Make one of their own • The whole Senate must approve of the Senate bill

Congressional Action • If the Senate and House versions are different – it now goes to a Conference committee to work out the differences. • Meanwhile – the CBO (Congressional Budget Office) is pricing it all out • Once the joint committee has an agreed upon bill – it goes back to the full House and full Senate to be voted on.

Final Approval • If both the House and Senate approve – it goes to the president for signing • Very likely looks nothing like his original • Can veto – but….unlikely • If no agreement in time – the Congress can pass a continuing budget resolution – an agreement to continue funding at last years rate

Terms • Budget deficit – spending more than revenues • Budget surplus – revenues exceed spending • Internal Revenue Service (IRS) – the branch of the US Treasury responsible for collecting taxes. The 16th Amendment allowed for income taxation.

Totem Pole of Taxes • Form groups of three • 1st hour = 5 groups • 2nd hour = 9 groups with one group of 4 • 5th hour = 8 groups with one group of 2 • You will be making 3 totem poles • Show examples

Totem Pole of Taxes • Using book pages • 414 – 416 for federal • 423-425 for state • 427-428 for local • Create three totem poles that visually show where the government gets its revenue. The highest revenue source should be at the top and the other sources below in order of the amount of revenue gained. (See examples in class) • Best totem poles will be hung in the room and get 5 extra credit experience points. • Skip to slide 57

Where the Federal Government Gets Money • Individual Income Taxes • Collected through the payroll withholding system which requires employers to automatically deduct income taxes from paychecks and send that to the IRS. • To guard against inflation – the highest dollar amount in each tax bracket is indexed or raised every year by the rate of inflation.

Where the Federal Government Gets Money • Borrowing • When the government spends more than it takes in – they have to borrow to pay for everything in the budget. More borrowing done today than ever before. • Increased spending on Social Security and Medicare • Unfunded spending on wars since 9/11 • Passage of tax decreases • Lower revenues due to unemployment and under employment during and since Great Recession

Understanding Taxes: Types, Economic Impact, and Principles