Distribution • Once goods are produced, the FOR WHOM question must be answered. • Should the market decide? • Should government intervene? • The market would strive for efficiency and reward producers according to their value in production. • The government would strive for greater equity– that is, a more equal distribution.
Distribution • Some participants in the market are wildly successful and earn millions. Others are unsuccessful and must go without many amenities. • The market generates inequalities in income distribution. • Should the government intervene to redistribute some income? • If so, how should it do that?
Distribution • The tax system is the government’s main lever to redistribute income. • Taxes affect both production and distribution. • There is a potential trade-off between equity and efficiency.
Learning Objectives • 33-01. Know how the U.S. tax system is structured. • 33-02. Know what makes taxes more or less progressive. • 33-03. Know the nature of the equity-efficiency trade-off.
What Is Income? • Personal income is the amount earned and received by households before taxes are paid. • Some households get in-kind income: goods and services received directly (not via a market transaction). • Measuring income by different means causes some distortions in year-to-year comparisons.
What Is Income? • A family is declared to be “poor” if their money income is below a certain threshold. • Counting this way, there has been no progress in the War on Poverty since it started in 1965. • There are more “poor” today than in 1965. • If we add in-kind income, there are fewer “poor” today than in 1965, indicating modest progress.
What Is Income? • We also must consider the distribution of wealth (the market value of assets owned). • Wealth is a stock of potential purchasing power. • Wealth tends to be distributed less equally than income.
The Distribution of Income • We divide households into quintiles (fifths or 20% of households) according to their income. • The bowed Lorenz curve shows that the income share of the lowest fifth is 3.4% and the top fifth has half of the total income.
The Distribution of Income • The diagonal line shows what the distribution would be if there were complete equality. • 20% of households would receive 20% of income. • The greater the area between the Lorenz curve and the diagonal, the more inequality exists.
The Distribution of Income • The area under the diagonal of the Lorenz curve is represented by the Gini coefficient. • The higher the Gini coefficient, the greater the inequality of income. • Large inequality, to some, represents market failure. • Income distribution is “unfair.” • The government should intervene by levying taxes on the “rich” and making transfer payments to the “poor.”
The Federal Income Tax • Efficiency concerns. • The federal income tax is progressive. • It imposes higher tax rates on high incomes than on low incomes. • The marginal tax rate increases as incomes rise. • Marginal tax rate: the tax rate imposed on the last (marginal) dollar of income. • Higher-income earners find themselves in higher tax brackets. • The goal of progressive tax rates is to reduce inequality.
The Federal Income Tax • Efficiency concerns. • Progressive taxes reduce inequality but also affect efficiency. • Since marginal tax rates increase as income increases, the progressive tax system punishes success. • It is a disincentive to work more, produce more, or invest more. • The implication is that rising marginal tax rates can contribute to a decrease in total output.
The Federal Income Tax • Equity concerns. • In theory, a progressive tax system taxes the “rich” heavily and distributes the proceeds to the “poor.” • In reality, the system is not so progressive. • The tax code applies only to “taxable” income, not all income. To arrive at taxable income, deduct all • Exemptions. • Itemized deductions. • Other tax breaks in the tax code (“loopholes”).
The Federal Income Tax • Equity concerns. • As a result, many high-income earners can reduce their taxable income greatly and pay little tax. • Some pay less tax than people with lower incomes. • The bulk of taxes are paid by the “middle class,” not the “rich.” • There are two equity considerations: • Vertical equity: people with higher incomes should pay more taxes than people with lower incomes. • Horizontal equity: people with equal incomes should pay equal taxes.
The Federal Income Tax • Equity concerns. • As a result of loopholes, there is a distinction between nominal tax rates and effective tax rates. • Nominal tax rate: taxes paid divided by taxable income. • Effective tax rate: taxes paid divided by total income. • The gap between nominal and effective tax rates reflects the loopholes in the tax code.
The Federal Income Tax • Resource misallocations. • Tax loopholes alter the mix of outputs. • Tax-preferred activities receive more resources, and heavily taxed activities receive fewer resources. • The resulting mix of output could be inferior to the mix that a pure market outcome would generate, and therefore could be characterized as government failure.
The Federal Income Tax • A shrinking tax base. • Loopholes shrink the tax base. • As the base of taxable income shrinks, the average tax rate must increase to maintain the same tax revenue. Tax revenue = Average tax rate X Tax base
Payroll, State, and Local Taxes • Sales and property taxes. • These are major sources of revenue for state and local government. • Both taxes are regressive because the tax rate falls as income rises. • This imposes a proportionally larger burden of the tax on lower-income earners.
Payroll, State, and Local Taxes • Sales and property taxes. • Tax incidence: where the real burden of a tax falls. • Sales tax incidence: • At lower incomes, earners spend all of their income, which is subject to sales tax. • At higher incomes, earners do not pay sales tax on income not spent, but saved.
Payroll, State, and Local Taxes • Sales and property taxes. • Property tax incidence: • Income going to housing is higher for low-income earners, who primarily rent rather than own. • Property tax is reflected in higher rents.
Payroll, State, and Local Taxes • Payroll taxes. • Social Security payroll tax is the second-largest source of federal tax revenue. • Workers pay this tax on earnings up to $106,800. • Thus the tax is regressive. Higher-income earners pay no tax on income above that level. • Half of the tax is paid by employers. This is an added business cost, which is a disincentive to hire.
Taxes and Inequality • Despite rampant loopholes, the income tax system ends up being progressive. • Note that the top 50% earn 88% of income and pay 97% of taxes, while the bottom 50% earn 12% of income and pay 3% of taxes.
Taxes and Inequality • When state and local taxes are taken into account, however, the tax system as a whole ends up being nearly proportional. • Proportional tax system: the percentage of income going to taxes is the same no matter what the income. • The redistribution process is completed by the government transferring income to favored segments of society. We will look at this in the next chapter.
What Is Fair? • Everyone has an opinion about how to answer this question. • Costs of greater equality. • Incentives to work hard are reduced. • The willingness to produce is reduced. • The link between effort and reward is weakened. • The argument for preserving some inequity is to maintain productivity. • There is a trade-off between efficiency and equality.
What Is Fair? • There is a trade-off between efficiency and equality. • The benefits of greater equality. • Low-income earners might work harder if incomes were more fairly distributed. • Low incomes subject their earners to poor health, malnutrition, and inadequate educational opportunities. • Loopholes distort economic incentives. Simplify the tax code and resources would be more efficiently allocated.