Chapter 2 - Policy Standards for a Good Tax

Standards for a good tax

1.) A good tax should be sufficient to raise government revenues 2.) A good tax should be convenient for the government to administer and for people to pay 3.) A good tax should be efficient in economic terms 4.) A good tax should be fair

Substitution effect

A behavioral response to an income tax rate increase: Taxpayers engage in fewer income producing activities and more non-income producing activities. -Tax increase → base decrease -Tax decrease → base increase Assume Ms. Hoover works 60 hours a week as a self-employed management consultant, earning $350,000 annual income. At a 20% tax rate her after-tax income is $280,000 - more than enough to support her comfortable lifestyle. If the Government increases her tax rate to 30%, Ms. Hoover may devote less time and effort to her income producing activities. Such a reaction makes sense if the after-tax value of an hour of additional labor is now worth less to her than an additional hour of leisure. If Ms. Hoover responds to the higher tax rate by working fewer hours and generating less income, the government will suffer a shortfall. On the basis of a static forecast, the government is anticipating an additional $35,000 revenue from Ms. Hoover. Theoretically, income effect is more powerful for lower-income taxpayers and substitution effect is more powerful for higher-income taxpayers.

Income Effect

A behavioral response to an income tax rate increase: Taxpayers engage in more income producing activities to maintain their level of disposable income. -Tax increase → base increase -Tax decrease → base decrease Consider the case of Mr. Spivey, who earns $25,000 a year as a factory worker and pay's 20% of that income ($5,000) in tax. Mr. Spivey spends every penny of his $20,000 after tax income to make ends meet. How might Mr. Spivey react if the government increases the tax rate to 30%, thereby reducing his disposable income to $17,500? He might decide to work more hours or even take on a second job to increase his before tax income to at least $28,600. Under the new rate structure, Mr. Spivey will pay $8,580 tax on his income leaving him with $20,020 and the same disposable income he enjoyed before the rate increase.

Supply Side Economic Theory

A decrease in the highest income tax rates should stimulate economic growth and ultimately result in an increase in government revenues. The logic underlying this theory is that a rate cut increases the value of income generating activities (work and investment) relative of the value of non-income generating activities (leisure and consumption). Accordingly, people who benefit directly from the rate reduction will invest their tax windfall into into new commercial ventures rather than simply spend it. This influx of economic capital will stimulate economic growth and job creation. An expanding economy will result in prosperity across the board so that everyone, regardless of income level, indirectly benefits from the tax rate reduction. People will earn more income for the government to tax, and revenues attributable to this enlarged tax base will swell.

Tax Policy

A government's attitude, objectives, and actions with respect to its tax system. Tax policy reflects the normative standards that the government deems most important.

Regressive Tax Structure

A graduated rate structure with rates that decrease as the base decreases. Tax policy makers agree that regressive rates are inequitable because they place a proportionally greater tax burden on persons with smaller tax bases. However, the regressive nature is not always obvious from its rate structure. Retail sales taxes consist of only a single rate and therefore are not explicitly regressive. Even so, many economists criticize these taxes as implicitly regressive in operation, bearing most heavily on people with the least economic resources. Mr. James and Mr. Kim live in Maryland, which has a 5 percent sales tax on all retail purchases. Mr. James earns $20,000 annual disposable income and spends the entire amount on taxable purchases. Mr. James pays $1,000 sales tax and his average tax rate (with respect to disposable income) is 5 percent. $1,000 tax / $20,000 base = 5% average tax rate In contrast, Mr. Kim earns $100,000 annual disposable income, spends only $75,000, and invests the remaining $25,000. Mr. Kim pays $3,750 sales tax, and his average tax rate is 3.75 percent. $3,750 tax / $100,000 base = 3.75 tax rate This doesn't actually exist

Progressive Rate Structure

A graduated rate structure with rates that increase as the base increases resulting in equality of sacrifice across tax payers

Dynamic Forecast

A projection of revenue gain or loss resulting from a tax rate change that assumes that the change will affect the tax base If rate is 5% and base is $100,000, a rate increase of 1% may decrease the base so that less than $1,000 more revenue is generated If a jurisdiction can predict the extent to which a change in tax rates will affect the tax base, it can incorporate the effect into its revenue projections. In a complex economic environment, a change in tax rates may be only one of many factors contributing to an expansion or contraction of a tax base. Economists may be unable to isolate the effect of the rate change or to test their assumption empirically. Consequently, governments have generally relied on static forecasting to estimate the revenues gained or lost because of tax rate changes.

Static Forecast

A projection of revenue gain or loss resulting from a tax rate change that assumes that the change will have no effect on the tax base. If rate is 5% and base is $100,000, a rate increase of 1% should generate $1,000 more revenue This forecast is static because it assumes that B, the base variable in the equation, is independent of r, the rate variable. Accordingly, a change in the rate has no effect on the base. Economic Theoru suggests that in many cases the two variables in the equation T = r * B correlated. In other words a change in the rate actually causes a change in the base.

Proportionate Rate Structure

A rate structure with a single, or flat, rate

Adam Smith

Adam Smith believed that taxes should have as little effect as possible on the economy. The laissee-faire system favored by Adam Smith theoretically creates a level playing field on which individuals and organizations, operating in their own self-interest, freely compete. When governments interfere with the system by taking certain economic activities, the playing field tilts against the competitors engaging in those activities. The capitalistic game is disrupted, and the outcome may no longer be the best for society. When governments change their tax structures, firms are forced to reevaluate their tax situations in light of the change.

Negative Externalities

An undesirable by product of the free enterprise system. One of the most widely recognized is environmental pollution. The tax system contains provisions that either pressure or entice companies to clean up their act. One example of a provision that discourages environmentally unfriendly behavior is the excise tax ozone depleting chemicals manufactured in or exported to the United States. An example of a provision that encourages the private sector to be more environmentally responsible is the lucrative tax break for the construction of pollution control facilities such as wastewater purification plants.

Ability to pay

Economic resources under a person's control from which he or she can pay tax. Each of the major taxes used in this country is based on some dimension of ability to pay. For instance, income taxes are based on a persons inflow of economic resources during the year. Sales and excise taxes are based on a persons consumption of resources represented by the purchase of goods and services. Real and personal property taxes compliment income and sales taxes by focusing on a persons accumulation of resources in the form of property. Transfer taxes capture the accumulated wealth that a person gives to other during life or death.

Tax Preferences

In a general context, provisions included in the federal tax law as incentives to encourage certain behaviors or as subsidies for certain activities. These provisions do not contribute to the accurate measurement of the tax base or the correct calculation of the base. Tax preferences do not support the primary function of the law, which is to raise revenues. In fact, tax preferences do just the opposite. Because they allow certain persons or organizations to pay less tax, preferences lose money for the treasury. In this respect, preferences are indirect government expenditures.

John Maynard Kaynes

Keynes disagreed with the notion that tax should be neutral. Keynes believed that free markets are effective in organizing production and allocating scarce resources but lack adequate self-regulating mechanisms for maintaining economic stability. According to Keynes, governments should protect their citizens and institutions against inherent instability of capitalisms. Historically, the instability has caused cycles of high unemployment, severe fluctuations in prices (inflation or deflation), and uneven economic growth. In the Keynesian schema, tax systems are a primary tool of fiscal policy. Rather than trying to design a neutral tax system, governments should deliberately use taxes to move the economy in the desired direction. If an economy is suffering from sluggish growth and high unemployment, the government could reduce taxes to transfer funds from the public to the private sector. The tax cut should both stimulate demand for consumer goods and services and increase private investment. As a result the economy should expand and new jobs should be created. Conversely, if an economy is overheated so that wages and prices are in an inflammatory spiral, the government could raise taxes. People will have less money to spend, the demand for consumer and investment goods should weaken, and the upward pressure on wages and prices should be relived.

Tax and Behavior Modification

Modern governments use their tax systems to address not only macroeconomic concerns but also social problems. Many such problems could be reduced if people or organizations could be persuaded to alter their behavior. Governments could also promote behavioral change by writing tax laws to penalize undesirable behavior or reward desirable behavior. The penalty takes the form of a higher tax burden, while the reward is some type of tax relief.

Taxes should be fair

More below

Vertical Equity

One aspect of the fourth standard of a good tax: A tax is fair if persons with a greater ability to pay (as measured by the tax base) owe more tax than persons with a lesser ability to pay. The property tax with Mr. Foley and Ms. Lennon is a strict definition of a vertical tax because Mr. Foley pays less than Ms. Lennon.

Horizontal Equity

One aspect of the fourth standard of a good tax: A tax is fair if persons with the same ability to pay (as measured by the tax base) owe the same tax. Ms. Buell and Mr. Deetz are both unmarried and earn $65,000 annual salary. Neither has additional inflows. Suppose Ms. Buell suffers from a chronic illness and have $7,000 of uninsured medical expenses annually. Mr. Deetz is in perfect health but has to provide for 2 children. Ms. Buell has no children. The horizontal equity of an income tax is enhanced by refining the calculation of taxable income to include significant variables affecting a persons economic circumstances. Every refinement adds another page to the Internal Revenue Code. Increased precision in the measurement of ability to pay may improve the horizontal equity of the income tax, but increases the complexity of the law. Two unrelated individuals, Mr. Malone and Ms. Olaf invested in two different businesses this year. Both businesses earned a $20,000 profit for their respective investors. Mr. Malone's business qualifies for several tax preferences. As a result, Mr. Malone must only $14,000 of profits on his income tax return. In contrast, Ms. Olaf must report her entire profit.

Tax Expenditures Budget

Part of the federal budget that quantifies the annual revenue loss attributable to each major tax preference Opponent's of tax preferences maintain that they are too well hidden within the Internal Revenue Code and, as a result, their cost to the government is easily overlooked. In response to this criticism, the Congressional Joint Committee on Taxation publishes an annual Tax Expenditures Budget that quantifies the revenue loss from each major tax presence.

Fairview example

Reread in book The increase in tax rate caused a decrease in tax base.

Financial Carrot

Tax systems may also promote activities that are undervalued by the free market but that the government believes are socially desirable. By bestowing a tax benefit on the activity, the government is providing a financial "carrot." The carrot should induce more taxpayers to engage in the activity and thus result in a greater level of activity across society. An example of an activity that the federal government promotes is the rehabilitation of historic buildings. This law allows firms to reduce their annual tax bill by a percentage of the cost of renovating a certified historic structure. Without this tax break, firms might find it cheaper to build or purchase modern buildings than to invest in historic structures requiring extensive renovation.

How to increase tax revenues

Taxing Jurisdictions can increase tax revenues in at least three ways: 1.) Exploit a new tax base (difficult) 2.) Increase the rate of an existing tax (5 percent corporate income tax increase to 7)(easy) 3.) Enlarge an existing tax base (Ex. a jurisdiction with a retail sales tax applying to tangible goods could expand the tax to personal services such as haircuts or dry cleaning. A jurisdiction that exempts land owned by private charities could remove the exemption.)

A convenient tax should be economical to the government

The administrative cost of collecting and enforcing the tax should be reasonable in comparison with the total revenue generated. The IRS is responsible for administering the income, payroll, excise, and transfer taxes. From a taxpayers point of view a good tax should be convenient to pay. The convenience standard suggests that people can compute their tax with reasonable certainty. Moreover, people do not have to devote undue time or incur undue costs in complying with the tax law. In contrast, the federal income tax is denounced as both uncertain and costly. Because the income tax laws are so complex and change with such frequency, even tax professionals are unsure how the law should apply to a particular transaction. Millions of Americans are bewildered by the income tax and have no confidence in their ability to compute the amount they owe. As a result the majority pay somebody else to prepare their income tax returns.

The National Debt

The federal government has operated at a deficit for every fiscal year since 1970, except in 2000 and 2001 when small surpluses were granted. In 2019, The debt exceeded $23 trillion with the related interest payments on the debt estimated at $572 billion. This data shows that our federal tax data is insufficient to support the level of government spending. Yet politicians continue to tell their constituents that taxes are too high, and few people seem inclined to disagree. But the arithmetic is inescapable. If we want to pay less tax and at the same time curb the growth of the national debt, the federal government must cut spending. If we want our government to maintain its level of spending without incurring additional debt, we should be prepared to pay the necessary federal tax.

Sufficiency

The first standard for a good tax. A tax should generate enough revenue to pay for the public goods and services provided by the government levying the tax. The reason that governments tax their citizens in the first place is to raise revenues needed for specific purposes. If a tax is sufficient, a government can balance its budget. Tax revenues equal government spending, and the government has no need to raise additional funds. It allows a government to balance its budget (earning = spending)

Consequence of Insufficient tax system

The government must make up its revenue shortfall (the excess of current spending over its tax receipts) from some other source. Some governments look to legalized gambling as an alternative source of funds. Governments may also own assets or property rights that they can lease or sell to raise money. Another option for governments to borrow money is to finance their operating deficits. In the United States, the Federal, State, and Local governments sell debt obligations in the capital markets. By selling both short-term instruments (such as U.S. Treasure bills) and long-term bonds, governments with insufficient tax systems can make ends meet. Debt financing isn't a permeant solution to an insufficient tax system. Like anybody else, governments must pay interest on borrowed funds. As public debt increases, so does the annual interest burden. In a worst-case scenario, a government may be forced to default on its debt obligations, damaging its credibility and creating havoc in its capital markets

Convenience

The second standard for a good tax. A tax should be convenient for the government to administer and for people to pay. Specifically, the government should have a method for collecting the tax that most taxpayers understand and with which they routinely cooperate. The collection method should not overly intrude on individual privacy but should offer minimal opportunity for noncompliance. States that levy retail sales taxes use a collection method under which sellers are responsible for collecting the tax from buyers at the point of the sale and remitting the tax to the state. This method is effortless for buyers and offers them no opportunity to evade the tax. States can concentrate their enforcement efforts on retail businesses, which are much easier to audit than individual customers. In contrast, states have yet to develop a workable collection mechanism for use taxes. consequently, these taxes generate almost no revenue. Collection of $100 is the U.S. is about 37 cents Closely related with a certainty and clearness of taxation. The tax with which every individual is bound to pay ought to be certain and not arbitrary and plain to the contributor and every other person. "I know what I collect and you know what I collect." All taxes should be levied by law

Average Rate

The tax rate determined by dividing the total tax liability by the total tax base

Marginal Rate

The tax rate that applies to the next dollar of taxable income. In the progressive rate structure example, individual C with $100,000 taxable income owed $12,000 tax. If C earns one dollar more, the dollar is subject to a 16 percent tax rate. Nevertheless, the fact that C is in the 16 percent marginal tax bracket doesn't mean that she is paying 16 percent of her income to the government. Her $12,000 tax divided by the $100,000 taxable income is the average rate of only 12 percent.

Declining Marginal Utility of Income

The theory that the financial importance associated with each dollar of income diminishes as total income increases. In other words, people value the subsistence income spent on necessities, such as good and shelter, more than they value incremental income spent on luxury items.

Efficiency

The third standard for a good tax. Classical economic theory holds that an efficient tax is neutral and has no effect on economic behavior of the taxpayer. In contrast, Keynesian theory holds that an efficient tax is a fiscal policy tool by which the government can deliberately change economic behavior.