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Chapter 12
The Design of the Tax System
Objectives
1.) Learn how the various governments in our
economy raise and spend money.
2.) Understand the efficiency cost of taxation.
3.) Learn the criteria for evaluating the equity
of a tax system.
4.) Recognize that understanding tax incidence
is important for evaluating tax issues
5.) Understand some of the tradeoffs between
equity and efficiency in a tax system.
“In this world nothing is certain but
death and taxes.” (Benjamin Franklin)
100
Taxes paid in 1789
accounted for 5%
of personal income
80
60
40
20
0
1789
“In this world nothing is certain but
death and taxes.” (Benjamin Franklin)
100
80
Today, taxes account
for about 35 % of
personal income!
60
40
20
0
1789 Today
Government Revenue as a Percentage of
GDP
The Tax System
When
the government addresses the
problem of externalities, provides
public goods, or regulates the use of
common resources, it can raise
economic well-being.
For
the government to perform these
and its other many functions, it needs
to raise revenue.
The Tax System
Most
people agree
that taxes should
impose as small a
cost on society as
possible, i.e...
… the tax system
should be efficient
and equitable.
A Financial Overview of the U.S.
Government
Where
does the government get its
income from?
What
does the government spend its
income on?
Who
contributes the most to the U.S.
Government in the form of taxes?
What
does the government spend
most of it’s income on?
The U.S. Economy may be divided
into two major sectors:
The
Private Sector
– About two-thirds of all economic activity
in the U.S. takes place within the private
sector.
The
Public Sector
– About one-third of all economic activity in
the U.S. involves the government sector.
The Government Sector:
Federal, State and Local
The
Federal Government collects
about two-thirds of the taxes in our
economy. (Table 12-1)
– Individual Income Taxes
48%
– Social Insurance Taxes
34%
– Corporate Income Taxes
10%
– Excise Taxes
4%
– Other
4%
Receipts of the Federal Government
Personal Tax
34%
10%
4%
4%
48%
Social Insurance
Tax
Corporate Tax
Excise Tax
Other
Individual Income Taxes...
The largest source of government revenue
Tax
Liability is how much
taxes a family owes and is
based upon total income.
Marginal
Tax Rate is the tax
rate applied to each dollar of
income. (Table 12-2)
 Higher-income
families pay a
larger percentage of their
income in taxes.
The Federal Income Tax Rates: 1999
On Taxable Income....
The Tax rate is ....
Up to $25,750
15.0%
From $25,750 - $62,450
28.0%
From $62,450 - $130,250
31.0%
From $130,250-283,150
36.0%
Over $283,150
39.6%
Federal Government Spending
Spending
of government revenues
(taxes) includes transfer payments and
the purchase of public goods and
services. (Table 12-3)
A
Transfer Payment is a government
payment not made in exchange for a
good or a service.
– Transfer payments account for the largest
expenses of the government.
The Federal Government and
Taxes
Payroll
Taxes: tax on the wages
that a firm pays its workers.
Social
Insurance Taxes: revenue
from these taxes is earmarked to pay
for Social Security and Medicare.
Excise
Taxes: taxes on specific
goods like gasoline, cigarettes, and
alcoholic beverages.
Spending of the Federal Government
Expense Category:
Social Security
National Defense
Income Security
Net Interest
Medicare
Health
Other
Spending of the Federal Government
13%
14%
12%
Social Security
8%
Defense
14%
16%
23%
Net Interest
Income Security
Medicare
Health
Other
Federal Government Spending: 1999
Category
Social security
Amount
Amount per Percent of
(billions)
Person
Spending
$ 393
National defense
277
Net interest
243
Income security
227
Medicare
205
Health
143
Other
239
Total
$1,727
$1,445
1,018
893
837
754
526
879
$6,350
23%
16
14
13
12
8
14
100%
Financial Conditions of the
Federal Budget
Budget
Deficit
– Situation where the expenses of the
budget are greater than the revenues
for a given period of time.
– Government finances the deficit by
borrowing from the public
Budget
Surplus
– Situation where the revenues are greater
than the expenses for a given period of
time.
State and Local Governments:
Collect about one-third of taxes paid
Expenses
– Education
– Public Welfare
– Highways
– Other
Receipts
– Sales Taxes
– Property Taxes
– Individual Income
Taxes
– Corporate Income
Taxes
– Federal Government
– Other
Receipts of State and Local
Governments: 1992
Tax
Amount
(Billions)
Amount
Percent
Per Person of Receipts
Sales taxes
$249
$940
20%
Property taxes
$209
$789
17%
Individual income tax
$147
$554
12%
Corporate income taxes
$ 32
$ 121
3%
From Federal government
$235
$887
19%
Other
$351
$1,324
29%
Total
$1223
$4,615
100%
Spending of State and Local
Governments: 1992
Category
Amount
(Billions)
Amount
Per Person
Percent
of Spending
Education
$399
$1,506
33%
Public welfare
$197
$ 743
17%
Highways
$ 79
$ 298
7%
Other
$518
$1,955
43%
Total
$1,193
$4,502
100%
Quick Quiz!
What
are the two most
important sources of
tax revenue for the
federal government?
What
are the two most
important sources for
state and local
governments?
Taxes and Efficiency
The
aim of a tax system is to raise
revenue for the government. Two
objectives of designing a tax system:
Efficiency
Equity
A
tax system is more efficient if it can
raise the same amount of revenue at a
smaller cost to the taxpayers.
Related Costs of Taxes to Taxpayers
The
costs of taxes to taxpayers:
– The tax payment itself
Transfer
of money from taxpayer to
government.
– Deadweight losses
– Administrative burdens
Deadweight Loss of Taxation (Chapter 8)
When
a tax is levied on buyers, the
demand curve shifts downward by the
size of the tax...
When
a tax is levied on sellers, the
supply curve shifts upward by that
amount...
The losses to buyers and sellers
exceed the tax revenue, leading to a
Deadweight Loss.
Tax Costs: Administrative Burdens
Includes
not only the time spent in
early April filling out forms.
Payment
for tax experts in assisting
the taxpayer in filing tax returns.
The
cost to the taxpayer is greater than
the actual tax payment made.
The Goal of an Efficient Tax System
An efficient tax system is one that
imposes small deadweight losses and
small administrative burdens.
Alternative Tax Rates
Efficiency and equity of income taxes
leads to three notions of tax rates:
Average Tax Rate...
...is total taxes paid divided by total income
Marginal Tax Rate...
...is the extra taxes paid on an additional
dollar of income.
Lump-Sum Tax Rate...
...everyone owes the same amount of tax.
Quick Quiz!
What
is meant by
the efficiency of a
tax system?
What
can make a
tax system
inefficient?
Taxes and Equity
How
should the burden of taxes be
divided among the population?
How
do we evaluate whether a tax
system is fair?
Benefits Principle
Ability-to-pay Principle
Taxes and Equity: Benefit Principle
“People should pay taxes based on the
benefits they receive from government
services.”
Example:
– Gasoline Tax: These tax revenues are
used to finance our highway system.
– People who drive the most, use the road
the most, also pay the most toward their
upkeep.
Taxes and Equity: Ability-to-pay
Principle
“Taxes should be assigned based on an
individual’s ability to shoulder the tax
burden.”
Two
notions of equity:
– Vertical Equity
– Horizontal Equity
Vertical Equity
“Differently situated individuals should
be treated differently.”
Example:
People with higher incomes
should pay more than people with
lower incomes.
– Alternative Tax Systems:
Proportional
Regressive
Progressive

A proportional tax is one in which the
average effective tax rate remains
unchanged, whatever the size of the
taxpayer’s income

A progressive tax is one in which the
average effective tax rate rises as
income rises

A regressive tax is one in which the
average effective tax rate declines as
income rises
Three Tax Systems
Proportional Tax
Income
Amount
of Tax
Percent
of Income
$ 50,000
$12,500
25%
$100,000
25,000
25%
$200,000
50,000
25%
Three Tax Systems
Progressive Tax
Income
Amount
of Tax
Percent
of Income
$ 50,000
$10,000
20%
$100,000
25,000
25%
$200,000
60,000
30%
Three Tax Systems
Regressive Tax
Income
Amount
of Tax
Percent
of Income
$ 50,000
$15,000
30%
$100,000
25,000
25%
$200,000
40,000
20%
The Burden of Federal Taxes
Quintile
Average
Income
Percent of all
Income
Percent of all
Taxes
Taxes as a
Percent of
Income
Taxes Minus
Transfers as a
Percent of
Income
Lowest
$ 7,386
3.7%
1.4%
8.9%
-29.8%
Second
$18,380
9.2%
.4%
15.8%
-2.1%
Middle
$29,849
14.2%
12.5%
19.5%
9.5%
Fourth
$43,363
21.7%
21.2%
22.1%
16.2%
Highest
$99,197
51.4%
58.2%
25.5%
23.1%
Horizontal Equity
“Would require people of like incomes to
pay the same amount of tax.”
Example:
Two different families with
the same number of dependents and
the same income living in different
parts of the country should pay the
same federal taxes.
The “Marriage Tax”
Marriage
affects the tax liability
of a couple in that tax law treats a
married couple as a single
taxpayer.
When
a couple gets married, they
stop paying taxes as individuals
and start paying taxes as a
family.
If
each has a similar income, their
total tax liability rises when they
get married.
Taxes and Equity
The
difficult part of tax policy is to
balance the sometimes conflicting
nature of the efficiency and equity
goals.
The
study of who bears the actual
burden of taxes is central to evaluating
tax equity. This is called Tax
Incidence.
Flypaper Theory of Tax Incidence
According to the flypaper
theory, the burden of a tax, like
a fly on flypaper, sticks
wherever it first lands.
The Flat Tax
First proposed by economist
Robert Hall in the 1980s.
Proposed as an alternative to the
current tax system.
A single, low tax rate would apply
to all income in the economy.
Proposed Benefits of the
Flat Tax
 The
flat tax would eliminate many of
the deductions allowed under the
current income tax thereby
broadening the tax base and reducing
marginal tax rates for most people.
 Because
the flat tax is simple, the
administrative burden of taxation
would be greatly reduced.
Proposed Benefits of the
Flat Tax
 Because
all taxpayers would be faced
with the same marginal tax rate, the
tax could be collected at the source
of income.
 The
flat tax would replace both the
personal and corporate income taxes
and would eliminate the current
double taxation of corporate profits.
 The
flat tax could increase the
incentive to save.
Quick Quiz!
Explain
the benefits
principle and the
ability-to-pay principle.
What
are vertical equity
and horizontal equity?
 Why
is studying tax
incidence important in
determining equity in a tax
system?
Conclusion: The tradeoff between
equity and efficiency
Equity
and efficiency are the two most
important goals of the tax system. But
often these goals conflict.
Many
proposed changes in the tax
laws increase efficiency while reducing
equity, or increase equity while
reducing efficiency.