Chapter 18

1. Chapter 18 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

2. The Level and Types of Taxation • Taxes • As share of GDP • By Local, state, and federal government • Constant for 40 years • Average tax rate • Ratio of taxes to income

3. Figure 1 Taxes as a percentage of gross domestic product

4. The Level and Types of Taxation • Progressive tax • Average tax rate • Rises as income rises • Proportional tax • Average tax rate • Same - all income levels • Regressive tax • Average tax rate • Falls as income rises

5. The Level and Types of Taxation • Marginal tax rate • Fraction – each additionaldollar of income • Paid in taxes • Direct taxes • Levied directly on people • Federal government • Indirect taxes • Levied on specific economic activities • State & local government

6. Federal Tax System • Personal income tax • Levied on income • Individual • Family • Progressive rate • Corporate income tax • Excise taxes

7. Figure 2 Sources of Federal Revenue

8. Federal Tax System • Personal income tax • Employers – withhold income taxes • From payroll • To U.S. Treasury • Progressive • 6 basic marginal rates • Specific tax brackets

9. Table 1 Federal personal income tax rates in 2007 for A married couple filing jointly

10. Federal Tax System • Tax loopholes • Special provision in tax code • Reduces taxation - below normal rates • Municipal bonds – tax exempt • Income – not taxable • Homeowners – tax deduction • Sum of money – subtracted • Taxable income

11. Federal Tax System • Tax loopholes • Encourage particular patterns of behavior • Favor particular types of people • Benefit the rich • Erode - progressivity of income tax

12. Federal Tax System • Payroll tax • Levied on earnings from work • 8% by employer • 8% by employee • Subject to upper limits • Above limit: marginal payroll tax rate = 0 • Regressive

13. Federal Tax System • Corporate income tax • Levied on profits of corporations • After expenditures – deducted • Excise taxes • Sales tax • Levied on purchases • Specific good or service • Aimed – discourage consumption

14. Federal Tax System • Social Security System • Raises funds – payroll tax • Pays Social Security benefits – retirees • Pay-as-you-go system • Problems • Growth in real wages – slowed • Social Security benefits – grow rapidly • Slow population growth • More retirees • Higher life expectancy • Falling retirement age

15. State and Local Tax System • Sales and excise tax • Purchases of goods & services • Some exceptions • 5-8% • Property tax • Levied - assessed value of taxable property • Houses • Office buildings

16. Figure 3 Sources of State and Local Revenue

17. State and Local Tax System • Fiscal federalism • System of grants • From one level of government • To the next • Grants from federal government • To state government • To local government • Grants from state government • To local government

18. The Concept of Equity in Taxation • Taxes – judged • Equity criteria • Efficiency criteria • Horizontal equity • Equally situated individuals • Taxed equally • Vertical equity • Differently situated individuals • Taxed differently

19. Table 2 Three alternative income-tax plans

20. The Concept of Equity in Taxation • Ability-to-pay principle of taxation • People - greater ability to pay taxes • Should pay higher taxes • Benefits principle of taxation • People who derive benefits from a service • Should pay taxes • That finance it

21. The Concept of Efficiency in Taxation • Economic efficiency • Make someone better off • Make no one worse off • Taxes • Introduce inefficiencies • Efficient taxation • Least amount of inefficiency • For given tax revenue

22. The Concept of Efficiency in Taxation • Burden of a tax • Amount – given to taxpayer • Just as well off • With tax • Without tax • Normally, exceeds revenue • Raised by tax • Measured accurately by revenue collected • If: tax – no change in economic behavior

23. The Concept of Efficiency in Taxation • Excess burden of a tax • Amount • Burden of tax > paid tax • Induce people – change behavior • Inefficiencies • Total burden = • = Tax collections + Excess burden

24. The Concept of Efficiency in Taxation • Different marginal tax rates • Different income-earning activities • Economic choice – distorted • Less efficiency

25. Shifting the Tax Burden: Tax Incidence • Incidence of a tax • Allocation of burden of the tax • To specific individuals / groups • Tax shifting • Economic reactions to a tax • Prices & outputs – change • Shift part of burden of tax • Onto others

26. Figure 4 The incidence of an excise tax S0 S1 D Tax = $ 1,000 $40,600 40,000 Rise in price = $600 Price of an SUV, Including Tax B A S0 S1 D Number of SUVs

27. Shifting the Tax Burden: Tax Incidence • Incidence of excise tax • More inelastic demand • Consumer - larger tax share • More inelastic supply • Supplier – larger tax share • Incidence of payroll tax • Excise tax on employment of labor • Same • Levied on employer • Levied on employee

28. Figure 5 An extreme case of tax incidence S0 D S1 Tax = $ 1,000 $41,000 40,000 Rise in price = $1,000 Price of an SUV, Including Tax S0 S1 D Number of SUVs

29. Figure 6 Another extreme case of tax incidence S D $40,000 Price of an SUV, Including Tax S D Number of SUVs

30. When Taxation can Improve Efficiency • Some taxes • Introduce economic inefficiencies • May be good social policy • Help achieve a goal • Change economic behavior • May lead to efficiency gains

31. Equity, Efficiency, and Optimal Tax • Ideal tax • Raise revenues for government • Reflect society’s views - equity in taxation • Induce no changes in economic behavior • No excess burden • Doesn’t exist • Comprehensive personal income tax • With few loopholes • Small excess burden