CHAPTER 12, MICRO

What makes a tax system efficient?

A tax system system is efficient if it generates the most revenue at the lowest cost to taxpayers

What is a lump-sum tax?

A tax that is the same amount for every person regardless of their income

What are the costs of a tax to taxpayers?

1) Cost of the tax itself 2) Deadweight loss resulting from the tax 3) The administrative burdens of complying with tax laws

What are the most important taxes for state and local governments?

1) Property taxes make up 21% of total receipts. They are levied on property owners (% of estimated value of property). 2) Sales taxes are levied as a % of total money spent at retail stores (tax added to price of each purchased good). In some states, some goods might bc excluded from sales taxes (necessities). 3) Personal income taxes - similar to federal, but different rates (also dividend vs income, etc). 4) Excise taxes 5) Corporate income tax

What factors affect tax liability?

A higher number of dependents (mostly children) decreases tax liability; deductible expenses such as mortgage interest payments and charitable giving are subtracted from taxes; higher income brackets pay higher taxes (because marginal tax rate rises as income rises)

What are payroll taxes?

A payroll tax is a tax on wages. It is also called a social insurance tax because its revenue is used mostly to pay for Social Security (income-support for elderly mostly) and Medicare (government health program for elderly mostly). The tax incidence of payroll taxes are determined by the market - both the employer and the employee pay them, but it is largely taken out of an employee's wage.

Describe a successful tax system (2 objectives of taxation)

A tax system should be both efficient and equitable. Taxation should impose as small of a cost on society as possible, and the burden of taxes should be distributed fairly. This is not easy to achieve.

How much of all taxes paid goes to state and local governments in the US?

About a third - $2.5 trillion, or about $7600 per American on average.

How can the benefits principle be used to argue for antipoverty programs funded by taxes from the wealthy?

Antipoverty programs can be considered a public good in the sense that people may generally prefer to live in a society without poverty. If the wealthy place a higher dollar value on this public good (that is, living in a society without poverty) than the middle class (even if it is just because they have more to spend) then the benefits principle would suggest that they should be taxed more heavily to pay for these programs.

How does a lump-sum tax show the difference between average and marginal tax rates?

Because lump sum taxes result in drastically different average tax rates for people with different incomes, but the marginal tax rate is 0 for all taxpayers as no tax is owed on an additional dollar of income.

Explain Bush's views on taxation

Bush has similar views to Reagan and reduced the top tax rate to 35% in 2003

How are corporate profits taxed twice?

Corporations are taxed first upon earning any profit (corporate income tax) and then again when they use this profit to pay dividends to their share holders (personal income tax). Dividend income is taxed at a much lower rate than other types of income in part because of this double taxation.

Why do some taxes not create deadweight loss?

Corrective taxes (or Pigouvian taxes) levied to offset externalities do not create any deadweight loss because the resulting behavioural change is intentional and meant to correct existing market inefficiencies. Thus, it increases the well being of market participants by correcting externalities that would otherwise affect consumers. Corrective taxes also raise revenue which could be used to reduce taxes that do create deadweight loss.

Explain how some taxes create deadweight loss

Deadweight loss is the reduction in market participants' well-being in excess of the revenue raised for the government. Market participants' well being can be measured through consumer surplus - that is, the difference between how much they pay for a good and how much they would be willing to pay for it (or the value they place on it). If I place a value of $15 on a good that would usually sell for $13, I get a $2 consumer surplus. However, if a $3 tax is levied on that good, I would likely decide not to buy the good because its market price ($16) exceeds the value I attribute to it ($15). In this sense, the tax has distorted incentives because it is the tax incentives that are driving my behaviour rather than the actual costs and benefits of the good. The result of this is a reduction in my well being (i.e. the consumer surplus I receive) that is not offset by additional revenue for the government because I did not pay any tax. The reduction in my welfare is the deadweight loss of the tax. Deadweight loss occurs only when taxes change peoples' behaviour - when taxes reduce consumer surplus but the good is still purchased, the reduction in welfare is offset by an equivalent increase in government revenue.

Why do economists like consumption taxes but democrats don't?

Economists like consumption taxes because they do not distort incentives to work, save, and invest - only spending is being taxed, and so consumption taxes are better for economic growth. However, democrats do not like them because they are technically regressive in nature and do not redistribute income.

Why are lump-sum taxes rare in the real world?

Efficiency is not the only goal of the tax system - equity is another major goal of tax policy. A lump-sum tax takes the same amount of money from the rich and the poor, which most people would agree is unfair.

Which countries rely more on consumption taxes and which rely more on income taxes?

European countries tend to rely more on consumption taxes than the US, which relies more on personal income taxes. Many countries in Europe raise a lot of government revenue from VAT (value-added tax) which is like a retail sales tax but rather than being collected at by state governments like in the US, it is collected at each stage of production. Thus all sellers - suppliers, manufacturers, distributors, and retailers - collect VAT on taxable sales.

What other taxes make up a government's revenue?

Excise taxes (on gas, alcohol, cigarettes), estate taxes, customs duties, etc

What are other sources of income for state and local governments?

Funding from the federal government, fishing/hunting licenses, tolls, public transport fares, etc

Explain horizontal equity

Horizontal equity states that taxpayers with similar abilities to pay should contribute the same amount

When is it appropriate to measure taxation using the marginal tax rate and when is it appropriate to use the average tax rate?

If we are trying to gauge the sacrifice made by the taxpayer, then the average tax rate is more appropriate because it measures the overall fraction of one's income that is used up in paying taxes. However, if we are trying to gauge how the tax system distorts incentives, then the marginal tax rate is more effective. One of the principles of economics is that rational people think at the margin - by extension, it makes sense that when deciding whether to work more hours one would consider how much they would be taxed on the additional income they would make by doing so. Thus, it is the marginal tax rate that determines the deadweight loss of an income tax.

In what cases do taxes decrease efficiency?

In most cases, taxes cause deadweight loss - they reduce consumer and producer surplus which reduces economic well-being overall and decreases efficiency.

How is the gasoline tax justified using the benefits principle?

In some states, revenues from gasoline are used to build and maintain roads. The people who buy gasoline are the same people who use the roads, so using the money they are taxed on gasoline to maintain roads applies the benefits principle.

Explain the relationship between transfer payments and taxes

In some ways, transfer payments are the opposite of taxes because the flow of money goes from the government to households for the benefit of taxpayers. If we treat transfer payments as negative taxes, this substantially changes the distribution of the tax burden. While the average tax rates of high-income taxpayers are still from a quarter to a third of their income, that rate for low-income taxpayers is negative because most households in the bottom-most tax brackets receive more in transfers than they pay in taxes. Thus, to fully understand the progressivity of government policies, one must take into account both what people pay in taxes and what they receive in transfer payments.

What determines if two taxpayers are similar (and should hence pay similar taxes based on horizontal equity)?

Income is not the only factor that determines how much tax someone pays. Other factors such as how many dependents (mostly children) a family has - especially if they are going to college - and whether there are serious illnesses that result in high medical bills could also factor in. Tax breaks are given in some circumstances based on these very factors.

What inefficiencies stem from individual income tax?

Individual income tax discourages people from working as hard as they otherwise might. It can also discourage people from saving due to tax on interest income.

How can the benefits principle be used to argue for progressive taxation?

It can be argues that wealthy people benefit more from public services and hence should pay higher taxes according to the benefits principle. For example, it is wealthy citizens who benefit from police protection from theft as they have much more wealth to protect. This same argument can be used for many other services such as fire protection, national defense, and the court system.

What are examples of tax codes that give preferential treatment to specific types of behaviour?

One example is that the US federal tax code gives preferential treatment to investors in municipal bonds because Congress wanted to make it easier for state and local governments to borrow money.

What are examples of legal tax avoidance? Explain.

Many taxpayers, especially those in higher tax brackets, hire tax lawyers and accountants to fill out their tax forms and arrange their affairs in a way that reduced taxes owed through legal loopholes. Sometimes, these loopholes arise from ambiguities and omissions in tax laws - congressional mistakes - but more often they arise because Congress gives special treatment to specific types of behaviour.

How much of an average American's income is used up by (all) taxes?

More than a quarter; In the late 18th century, this number was less than 5%.

What do most economists think about increasing the top federal marginal tax to 70% but keeping the rest of the current tax code as is?

Most economists think that increasing the top federal marginal tax to a rate as high as 70% would not successfully increase aggregate government revenue without lowering economic activity.

Explain Obama's views on taxation

Obama once again emphasized vertical equity and increased the top marginal tax rate to about 40% in 2013

How do taxes distort incentives?

One of the principles of economics is that people respond to incentives. If the government taxes something, people will be incentivised to consume less of it and spend more of their income on other things (such as substitute goods). In this sense, taxes result in people allocating resources based on tax incentive instead of the true costs and benefits of the good or service they are purchasing. This creates an inefficiency which is the deadweight loss. However, this doesn't apply to taxes levied to combat externalities.

What is the largest source of revenue for the federal government?

Personal income tax (second is social insurance tax/payroll tax). Every family must report all its sources of income (wages, interest, dividends, profits) - this is their total income; tax liability (how much tax is owed) is based on total income);

How is the burden of a tax divided?

Regardless of whether the tax is levied on the buyers or the sellers, both buyers and sellers bear some proportion of the tax burden - the division of the burden of a tax depends on the elasticities of supply and demand in the market.

Why is a lump-sum tax the most efficient tax?

Since a person's decisions do not alter the amount owed (eg. their decision to work more or less isn't affected by tax rates), lump-sum taxes do not distort incentives and therefore do not cause deadweight loss. It is also very simple to compute the amount owed for a lump-sum tax (no need for accountants of tax lawyers), so the administrative burden of a lump-sum tax on taxpayers is also lower.

Why did Al Capone go to jail?

Tax Evasion (Benjamin Franklin: "in this world nothing is certain but death and taxes")

What are corporate income taxes?

Taxes levied on corporations based on their profits. Makes up a much smaller proportion of government revenue than personal income taxes and payroll taxes. Corporations have their own legal existences, separate from their owners.

How much tax does the US federal government collect?

The US federal government collects about 2/3 of the taxes in our economy - $3.6 trillion total, about $11,000 per American on average.

How has the US government's role changed over the past century?

The US government's role has grown substantially, as can be shown by the proportion of its total income that is constituted of taxes. This number was 7% in 1902, but has grown to 30% in recent years. As the economy's income has grown, the government's tax revenue has grown even more.

Which nations have higher tax burdens and vice versa?

The US has a low tax burden compared to most other advanced economies such as many European nations (Denmark, Sweden, France, > 40%). These nations have higher taxes to finance a more generous social safety net. Countries like Mexico have far lower taxes (< 20%).

What is the ability-to-pay principle? Explain.

The ability-to principle is another way to evaluate the equity of a tax system. It is the idea that taxes should be levied on a person according to how well that person can shoulder the burden. It is sometimes justified by the claim that all citizens should make an "equal sacrifice" to support the government. The magnitude of a person's sacrifice is measured by many factors in addition to the size of the tax - one's income and circumstances play a big role. A $1000 tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by a rich person.

What is tax incidence?

The actual division of the burden of a tax between buyers and sellers in a market. Tax incidence is central to evaluating tax equity because taxes don't only affect the people they are levied on - they have an impact on supply and demand, and by extension, equilibrium prices. Thus, who actually pays the tax might not be who the tax is levied on.

What comprises the administrative burden of taxation?

The administrative burden of any tax system involves the time spent filling out tax forms, the time spent keeping records for tax resources, and the resources the government uses to enforce the tax laws. The resources devoted to complying with tax laws are a type of deadweight loss as the government gets only the amount of taxes paid, but the tax payer loses not only this amount, but also the time and money spent documenting, computing, and avoiding taxes.

What is the marginal tax rate and how is it applied?

The amount of additional tax paid for every additional dollar of income earned. Tax rates differ for different income brackets, but each tax rate only applies to income within the associated range - not to a person's entire income. All income from $0 to $10,000 is taxed at 10% in the US, regardless of what your total income is. If you earn $40,000 a year, the first $10,000 will be taxed at a lower rate than the next $30,000.

What is the difference between average tax rate and marginal tax rate?

The average tax rate is total taxes paid divided by total income whereas the marginal tax rate is the amount by which taxes increase from an additional dollar of income.

What is the benefits principle? Explain.

The benefits principle is one way to evaluate the equity of a tax system. It is the idea that people should pay taxes based on the benefits they receive from government services. This principles likens public goods to private goods - just like someone who often goes to the movies has to spend more on movie tickets than someone who rarely goes to the movies, people who benefit more from public goods should pay more for them.

What is the consumption tax system?

The consumption tax system changes the basis of taxation by taxing the amount of their income that people spend rather than the amount they save. This wouldn't distort people's saving decisions. There are some existing tax provisions that reflect consumption tax like ideals such as Individual Retirement Accounts and 401(k) plans which are not taxed at all (including on interest) until the money is withdrawn at retirement. Many economists including Alan Greenspan who was the Chair of the Federal Reserve in 2005 have suggested that the US should move to a consumption tax system but such a transition would be challenging.

How does the corporate income tax provide a good example of the importance of tax incidence?

The corporation tax is popular among voters who want tax cuts and are eager for impersonal corporations to pick up the tab. However, the truth is that voters pay all taxes. When the government levies a tax on a corporation, the corporation is more like the tax collector than a taxpayer. The burden of the tax falls on the owners, customers, or workers of the corporation. Some economists believe that it is mostly the workers and customers who bear the burden of corporate income tax because while the owners will be hurt initially, they will respond to the tax over time. Since producing is less profitable, they invest less into capital (building new factories, etc) and instead invest their wealth in other ways (buying larger houses, building factories in other industries or other countries). With fewer factories, the supply will drop. This will result in higher prices and lower wages for the workers making the good.

Define deadweight loss

The deadweight loss of tax is the reduction in market participants' well-being in excess of the revenue raised for the government.

Which principle of economics relates to taxation?

The government can sometimes improve market outcomes (for example, when it remedies an externality, provides a public good, or regulates the use of a common resource); to do so, it needs revenue which it gets through taxation.

How would the average tax rate and marginal tax rate differ for someone who makes $60,000 and is taxed 20% on the first $50,000 but 50% on all income above $50,000?

The total tax paid here would be 20% of $50,000 (which is 0.2 x 50,000 = 10,000) + 50% of $60,000 - $50,000, or $10,000 (which is 0.5 x 10,000 = 5,000). 10,000 + 5,000 = 15,000, so $15,000 is the total tax paid. To calculate the average tax rate, we would divide this value by total income. 15,000/60,000 = 25%, so that is the average tax rate. However, if the taxpayer earned another dollar over their current income, they would be taxed at 50% - for each additional dollar, they'd owe the government $0.50. Thus, the marginal tax rate is 50%. Note: total tax as in total income tax, no other forms of tax included.

How is the tax burden distributed in the US?

There are seven federal tax brackets for the 2022 tax year. The lowest is 10% and the highest is 37% - the US federal tax system is progressive. What tax bracket a household falls into depends on its market income which includes all earnings from economic activity including salaries, business income, interest, capital gains, dividends, and pension benefits.

Explain the tax bill signed by Trump in 2017

This tax bill cut corporate tax from 35% to 21% because Trump's corporate advisers argued that the long-term effect of cutting this tax would be increased capital accumulation, productivity, and wages. Critics of the bill agreed that these growth effects would occur, but argued that they would be small and the main benefits of the corporate tax cut would still be the wealthy owners of the corporations.

What is the flypaper theory of tax incidence? Give an example to disprove it

This theory assumes that the burden of tax - like a fly on flypaper - sticks wherever it first lands. However, it is rarely valid as is agreed by most economists. For example, an example of this would be the argument that a tax on expensive fur coats is vertically equitable because most buyers of furs are wealthy. However, if the demand for fur coats is elastic because people can easily substitute other luxuries for furs, then a tax on furs will likely reduce sales of furs. In the end, to prevent losing sales to the point of making a loss and going out of business, the makers and sellers of furs will have to absorb more of the burden of tax than the wealthy buyers of the furs. Thus, the burden of tax isn't falling where it was first levied and it may not be so equitable because most workers who make furs are not wealthy.

What are transfer payments?

Transfer payments refer to money that flows from the government to households in the form of Social Security, unemployment benefits, Medicaid, SNAP benefits (food stamps), and housing assistance.

Explain Trump's views on taxation

Trump cut the top tax rate to 37% in 2018 and also cut corporate income tax

What are the two corollary principles of equity that the ability-to-pay principle leads to?

Vertical equity and horizontal equity

Explain vertical equity

Vertical equity states that taxpayers with a greater ability to pay should contribute a larger amount

Explain the difference between proportional, progressive, and regressive tax systems

Vertical equity states that taxpayers with a greater ability to pay should contribute a larger amount of money in taxes. These three tax systems are primarily concerned with the proportion of one's income that goes into tax. A proportional tax system taxes all taxpayers the same fraction of income (eg. taxpayers pay 25% regardless of income). In a progressive tax system, high-income taxpayers pay a higher fraction of their income in tax than lower-income taxpayers. In a regressive tax system, high-income taxpayers pay a smaller fraction of their income in tax than low-income taxpayers. Usually, all these systems show vertical equity because the absolute value paid by high-income tax payers is generally higher even if the fraction of their income paid is equal to or less than what is paid by lower-income taxpayers. Determining which one of these systems is the most equitable is difficult as equity is in the eye of the beholder.

Explain Bill Clinton's views on taxation

When Bill Clinton ran for president in 1992, he signed in a bill that raised the marginal tax rate of the richest Americans to about 40%. He argued that the rich were not paying their fair share and hence the current tax rates violated vertical equity.

Explain Ronald Reagan's views on taxation

When Ronald Reagan was elected president in 1980, the marginal tax rate for the richest Americans was 50% - this number was 70% for interest income. Reagan signed in large cuts in tax rates, arguing that such high tax rates greatly distorted incentives to work and save (cost too much in terms of efficiency). By the time Reagan left office in 1989, the taxes for the richest Americans was only 28%

In what cases can taxes increase efficiency?

When taxes are used to internalize externalities and thereby correct market failures, they can increase efficiency.

Why do administrative burdens persist?

While the administrative burden of tax could be reduced by simplifying tax laws, this is politically difficult. The taxpayers that benefit from tax loopholes lobby for their special interests. As such, while most taxpayers may be willing to simplify the tax code by eliminating such loopholes, the political process to do so is challenging.