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Chapter 20
Taxation and the Public Budget
© 2014 by McGraw-Hill Education
1
What will you learn in this chapter?
• What the major public policy goals of taxation are.
• How deadweight loss and administrative costs
contribute to the inefficiency of a tax.
• How taxes effect business revenue.
• What differences exist between proportional,
progressive, and regressive taxes.
• What sources of tax revenue exist in the United
States.
• What the public budget is and what relationship
exists between revenues and expenditures.
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Why tax?
• Recall that taxes have two effects:
– Raise revenue.
– Change the behavior of buyers and sellers.
Price
S
Price paid by
consumers
Tax
Price received
by sellers
1. Raises revenue…
D
1
D
2
Quantity
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2. …and changes
behavior.
• As a tax is levied on
consumers, the
demand curve shifts
down by the amount
of the tax.
• Raises revenue for
the government.
• Changes behavior of
buyers and sellers.
3
1
Principles of taxation
Each tax considered must compare trade-offs
between revenue and inefficiency.
Price ($)
100
1. Tax creates a new
demand curve $20 below…
90
2. …which moves equilibrium
to a lower quantity.
80
S
70
60
• Taxes cause changes in
behavior and a deadweight
loss to occur.
– A $20 tax on jeans shifts the
demand curve downward.
– Deadweight loss is the loss
of total surplus that occurs
because the quantity of a
good that is bought and
sold is below the market
equilibrium quantity.
– Inefficiency is loss in total
surplus.
Deadweight loss is
surplus lost due to
the reduced quantity.
50
40
30
D1
20
10
D2
1
0
2
3
4
5
6
7
Quantity of jeans (millions of pairs)
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Principles of taxation
The size of deadweight loss is determined by the
price elasticity of supply and demand.
Original demand
DWL = $60
Less elastic demand
DWL = $40
58
50
$20
Price
S
S
62
50
42
More elastic demand
DWL = $80
Price
Price
54
50
$20
38
D1
$20
D1
34
D2
0
26 30
Quantity
D1
D2
D2
0
24 30
Quantity
Deadweight loss (DWL)
0
22 30
Quantity
• The more elastic demand leads to a larger reduction in
quantity under a tax, which leads to larger deadweight loss.
• Deadweight loss is minimized under inelastic goods.
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Principles of taxation
• If deadweight loss is minimized by taxing
activities that people will continue to engage
in, a tax on people just existing should
minimize deadweight loss.
• A lump-sum (head) tax charges the same
amount to each taxpayer regardless of their
economic behavior or circumstances.
– Highly efficient.
– People do not find it fair.
– Size of the tax is limited by the poorest citizens’
ability to pay.
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2
Principles of taxation
• The second inefficiency is the administrative
burden, which includes the logistical costs of
implementing a tax.
– Resource costs for government agencies (such as
the IRS) and for taxpayers (in the form of lawyers
and filling out forms).
• The more complex the tax is, the higher the
administrative burden will be.
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Tax effects
• There are two opposing effects when a tax increases:
– The price effect increases tax revenue.
– The quantity effect decreases tax revenue.
• The tax revenue raised is equal to:
Tax revenue = Tax per unit × Number of units sold
• The tax revenue calculation is an after-the-fact
analysis.
• Taking the number of units sold without a tax and
multiplying by the tax rate is incorrect.
– It doesn’t account for individuals’ changes.
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Tax effects
As the tax rate increases, revenue will:
Price effect
Tax rate (%)
Quantity effect
100
+
= Revenue before tax increase
90
+
= Revenue after tax increase
• Increase, as the
government gets more
revenue per units sold.
• Decrease, as fewer units
are sold.
• The net effect on revenue
depends on whether the
quantity effect outweighs
the price effect.
80
70
T2
60
1. Tax rate increases …
50
T1
40
30
20
2. … and
quantity
decreases
10
0
2
4
6
8
10
12
14
16
18
20
Quantity (millions)
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3
Diminishing returns to revenue
Given these two opposing effects, there is a maximum
tax revenue generated for a given tax.
Revenue
• As the tax rate increases from 0,
the price effect dominates the
quantity effect and revenue rises.
• After the maximum, the tax rate
is so high that the quantity effect
dominates the price effect and
revenue falls.
• The revenue-maximizing tax rate
depends on the elasticity of
supply and demand:
Up to a point,
Increasing the tax
rate increases
total revenue.
Past that point,
increasing the tax
rate decreases
total revenue.
– The more inelastic supply and demand
are, the larger the tax rate required to
reach the revenue-maximizing point is.
X%
0%
100%
Tax rate
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• This curve is sometimes referred
to as the Laffer curve.
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Incidence: Who ultimately pays the tax?
• Policy-makers and taxpayers are concerned not only with
what a tax does, but also with who pays it.
• The incidence of a tax tells who bears the burden of a tax.
– The statutory incidence tells who is legally obligated to pay the
tax to the government.
– The economic incidence tells who loses surplus as a result of the
tax.
– The statutory incidence has no effect on the economic incidence.
• The side of the market that is more price-inelastic bears
more of the tax burden.
• Policy-makers can levy a tax, but have little power in
shifting the tax burden between buyers and sellers.
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Active Learning: Who pays the tax?
For each of the following goods, identify whether
the tax burden would mostly fall on buyers or
sellers.
1. Mountain bikes with an elasticity of
supply of 1.32 and an elasticity of
demand of -3.5.
2. Cigarettes with an elasticity of supply of
2.5 and an elasticity of demand of -.24.
3. Soft drinks with an elasticity of supply of
1 and an elasticity of demand of -2.5.
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4
Incidence: Who ultimately pays the tax?
Policy-makers can affect the relative economic incidence of a tax
burden by varying the tax rates between rich and the poor.
• Suppose two people earn $20,000 and $200,000, respectively.
65%
$20k
$60K
$200k
$50K
30%
25%
20%
$13K
$5K
6.5%
$4K
Rate
Amount
Proportional
Rate
Amount
Regressive
Rate
Amount
Progressive
Proportional/flat tax
•
Same tax rate.
•
Differing amounts of taxes paid.
Progressive tax
•
Low-income pay lower rate than
high-income.
•
High-income pay more taxes.
•
Low-income pay less taxes.
Regressive tax
•
Low-income pay higher rate than
high-income.
•
High-income pay less taxes.
•
Low-income pay more taxes.
Must weigh positive judgments about the efficiency of the proposed tax and
normative judgments about the “fairness” of its incidence.
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A taxonomy of taxes
• The U.S. government has several sources of tax
revenue.
• Over 90% of tax revenue comes from three
sources:
– Personal income tax: 40% of all tax revenue.
– Payroll tax: 40% of all tax revenue.
– Corporate income tax: 10% of all tax revenue.
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A taxonomy of taxes
The rate of taxation between taxes differs over time.
% of GDP
21
Excise taxes
Other
2012*
0.5%
1%
18
2.3%
15
12
Corporation income
taxes
6.2%
Payroll taxes
9
6
0
1940
1950
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8.5%
Personal income
taxes
3
1960
1970
1980
1990
2000
2010
15
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A taxonomy of taxes
• The income tax is charged on the earnings of
individuals and corporations.
• The U.S. income tax is based on expected annual
income.
– If actual earnings are less than expected earnings,
individuals receive a tax refund.
– If actual earnings are greater than expected earnings,
individuals must pay the difference to the government.
• The U.S. income tax is progressive.
– Higher income earners pay taxes at higher rates.
– Defined by income tax “bracket.”
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A taxonomy of taxes
• Each tax bracket has its own tax rate, called the
marginal tax rate.
– Individuals pay different amounts of taxes on each
bracket of income earned.
• The U.S. personal income tax bracket provides
the means to calculate one’s tax bill.
Single Tax Bracket ($)
0 – 8,700
Marginal Tax Rate (%)
10
8,701 – 35,350
15
35,351 – 86,650
25
85,651 – 178,650
28
178,651 – 388,350
33
388,350+
35
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Active Learning: Calculating tax bills
Suppose an individual earned $40,000 in 2010.
• Calculate the tax bill using the following table.
• What would be the average tax rate?
Single Tax Bracket ($)
10
15
35,351 – 86,650
25
85,651 – 178,650
28
178,651 – 388,350
33
388,350+
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Marginal Tax Rate (%)
0 – 8,700
8,701 – 35,350
35
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A taxonomy of taxes
• The personal income tax does not distinguish
incomes by their sources, except for capital.
• The capital gains tax is applicable on all income
earned/lost by buying and selling of investments.
• Taxed at a lower rate than most other income.
• Assets owned for longer than one year are taxed
at a lower rate than those held for a short time.
• Sale of a house that was used as a primary
residence is taxed at a lower rate than other real
estate.
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A taxonomy of taxes
• In the U.S., part of one’s income is taxed based
on wages (and not other sources of income).
• Payroll taxes (FICA) are applied to paychecks.
– Charged in equal parts to employees and
employers.
– Pays for current Social Security and Medicare
benefits.
– Regressive, as earners over $110,000 pay a smaller
rate and only on wages.
• Evidence suggests that most of the tax burden
falls on employees in the form of lower wages.
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Corporate income tax and other taxes
• Corporations also pay taxes, the most prominent
being the corporate income tax.
• A sales tax is charged on the value of a good or
service being purchased.
– Major source of revenue for state governments.
– No U.S. federal sales tax.
– Excise tax is a sales tax on a specific good or service.
• A property tax is charged on the estimated value
of a home or other property.
– Local tax authorities assess property values every few
years and levy a fraction of the value as the tax.
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Active Learning: Distinguishing types of taxes
For each of the following scenarios, identify the type
of tax that must be paid.
1. John buys two houses when house values are low
and sells them when values rise.
2. While on vacation, Sarah buys gum and pays an
additional 8% in taxes.
3. Camille pays her local tax authority 2% of the value of
her home.
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The public budget
• The tax revenue received by the government is included
with other sources of revenue to finance government
spending.
• Comparing tax revenue as a percent of GDP provides
one way to compare taxes across countries.
Country (world ranking)
65%
Cuba (6)
57%
Norway (13)
45%
Germany (30)
41%
United Kingdom (44)
34%
Japan (78)
25%
Argentina (126)
United States (184)
Uganda (195)
Pakistan (201)
16%
14%
13%
• Low-income countries tend to collect
less in taxes as a percentage of GDP
• High-income countries tend to
collect more.
• The U.S. is an extreme exception.
% of GDP
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The public budget
• The relationship between public revenues and public
spending is messy.
– Spending eventually has to be covered by revenues.
– Most public spending is not tied directly to government
revenue, nor particular taxes.
• Spending can be categorized by whether Congressional
approval is required.
– Discretionary spending requires approval each year.
• Includes spending on the military, public construction and road
building, and scientific and medical research.
– Entitlement spending is a permanent law that benefits
individuals with a certain characteristic or factor.
• Age, income, and disability are examples of characteristics.
• Social Security, Medicare, and welfare programs are the vast
majority of federal expenditures.
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8
The public budget
U.S. budget shifts in response to national events.
% of budget
100
90
80
Function
% of Budget
(2012)
Other
2.7
70
Veterans
affairs
3.3
60
Education and
social services
3.1
50
Physical
resources
4.7
40
Net interest
9.1
30
Income
security
15.0
20
National
defense
18.2
Social
Security
20.5
Health
expenditures
23.4
10
0
1940
1950
1960
1970
1980
1990
2000
2010
• During World War II, defense was priority.
• In recent years, health and social security spending has increased.
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The public budget
• In many years, governments spend more than they bring in.
– Causes a budget deficit, and the difference between spending
and revenue must be financed by issuing debt.
– A budget surplus occurs when spending is less than revenue.
• Commonly calculated as a percentage of national GDP.
• The U.S. has sustained more deficits than surpluses in recent years.
Surpluses and deficits in recent U.S. history
Billions of $
400
200
Recession period
236.2
0
-149.7
-200
-400
-600
-412.7
-800
-1,000
-1,200
-1,400
-1,600
1980
1984
1988
1992
1996
2000
Fiscal year
2004
-1,412.7
2008
2012
• The debt is equal to the
sum of all annual budget
deficits and surpluses.
• It can be difficult to balance
a public budget every year.
• Many economists suggest
balancing the budget over
the business cycle.
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The future of social security
Presently, the revenue stream for Social Security
is greater than the outlays paid in benefits.
% of GDP
7
Actual
6
The future of Social Security
Projected
Outlays
Revenue
5
4
Surplus
3
Deficit
2
1
0
1990
2000
2010
2020
2030
Year
2040
2050
2060
• Funds can be withdrawn from the Social Security Trust to
make up the difference between revenue and outlays for
several more decades.
• Trust fund is projected to run out in 2037.
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9
Summary
• The most important goal of taxation is to raise
public revenue; it is also used to changes the
behavior of market participants.
• Each tax source has its own trade-off between
efficiency and tax incidence.
• Two sources of inefficiency associated with
taxation:
– Deadweight loss is the reduction in total surplus that
results when the number of trades that occur
decreases due to the tax.
– Administrative burden includes the time and money
spent by the government, as well as by individuals.
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Summary
• Changing a tax rate has a price effect and a
quantity effect.
• At some point, taxes become so high that raising
taxes reduces total revenue.
• Incidence describes who bears the burden of
paying a tax.
– A proportional tax charges all taxpayers the same
percentage of income.
– A progressive tax charges low-income earners a
smaller percentage of their income than high-income
earners.
– A regressive tax charges low-income earners a larger
percentage of their income than high-income earners.
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Summary
• The vast majority of tax revenue in the U.S.
comes from personal income and payroll taxes;
a significant minority comes from corporate
income taxes.
• Government spending is not tied directly to
government revenue.
• The majority of federal spending is entitlement
spending.
• When government revenues are less than
spending, a budget deficit occurs.
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