Public Finance: The Economics of Taxation: Fernando & Yvonn Quijano

Chapter
17
Public Finance:
The Economics of Taxation
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Public Finance:
17
Chapter Outline
Taxes: Basic Concepts
Tax Equity
What Is the “Best” Tax Base?
The Gift and Estate Tax
Tax Incidence: Who Pays?

The Incidence of Payroll Taxes
oi t axa Tf o s ci mo noc Ee h T
The Incidence of Corporate Profits

Taxes
The Overall Incidence of Taxes in the
United States: Empirical Evidence
Excess Burdens and the Principle

of Neutrality
How Do Excess Burdens Arise?
The Principle of Second Best
Measuring Excess Burdens

P A HC
Excess Burdens and the Degree of

Distortion
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 35
PUBLIC FINANCE:
THE ECONOMICS OF TAXATION
No matter what functions we end up assigning to

government, to do anything at all government must
first raise revenues. The primary vehicle that the
government uses to finance itself is taxation.
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Taxes may be imposed on transactions, institutions, property, meals, and other things, but in
the final analysis they are paid by individuals or households.
TAXES: BASIC CONCEPTS
tax base The measure or value upon which

a tax is levied.
tax rate structure The percentage of a tax

base that must be paid in taxes—25 percent
of income, for example.

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Taxes on Stocks versus Taxes on Flows

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FIGURE 17.1 Taxes on Economic “Flows”
TABLE 17.1 Federal Government Receipts 1960–2005 (billions of dollars)

Individual Corporation Social Insur. Excise Other
Income Tax Income Tax Payroll Taxes Taxes Receipts Total
1960 40.7 21.5 14.7 11.7 3.9 92.5
% 44.0 23.2 15.9 12.6 4.2 100
1970 90.4 32.8 44.4 15.7 9.5 192.8
% 46.9 17.0 23.0 8.1 4.9 100
1980 244.1 64.6 157.8 24.3 26.3 517.1
% 47.2 12.5 30.1 4.7 5.1 100

1990 466.9 93.5 380.0 35.3 56.2 1,032.0
% 45.2 9.1 36.8 3.4 5.4 100
2005* 893.7 226.5 773.7 74.0 84.8 2053.0
% 43.5 11.0 37.7 3.6 4.1 100
* OMB estimate
Source: United States, Office of Management and Budget. Percentages may not add to 100 due to rounding.
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Proportional, Progressive, and Regressive Taxes
proportional tax A tax whose burden is the

same proportion of income for all
households.
progressive tax A tax whose burden,

expressed as a percentage of income,
increases as income increases.
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regressive tax A tax whose burden,

expressed as a percentage of income, falls as
income increases.
TABLE 17.2 The Burden of a Hypothetical 5% Sales Tax Imposed on Three Households with
Different Incomes
HOUSEHOLD SAVING TAX
INCOME RATE, % 5% TAX ON AS A %

SAVING CONSUMPTION CONSUMPTION OF INCOME
A $ 10,000 20 $ 2,000 $ 8,000 $ 400 4.0

B 20,000 40 8,000 12,000 600 3.0
C 50,000 50 25,000 25,000 1,250 2.5

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Marginal versus Average Tax Rates
average tax rate Total amount of tax paid

divided by total income.
marginal tax rate The tax rate paid on any

additional income earned.
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TABLE 17.3 Individual Income Tax Rates, 2005
MARRIED COUPLES FILING JOINTLY
TAXABLE INCOME TAX RATE
$0 - 14,600 10%
$14,601 – 59,400 15%
$59,401 – 119,950 25%
$119,951 – 182,800 28%
$182,801 – 326,450 33%
More than $326,450 35%
SINGLE TAXPAYERS
TAXABLE INCOME TAX RATE
$0 – 7,300 10%
$7,301 – 29,700 15%
$29,701 – 71,950 28%
$71,951 – 150,150 33%
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$150,151 – 326,450 35%

Source: The Internal Revenue Service.
TABLE 17.4 Tax Calculations for a Single Taxpayer Who Earned $100,000 in 2005
Total income $100,000
− Personal exemption $3,200
− Standard deduction $5,000
= Taxable income $91,800
Tax Calculation
0 - $7,300 taxed at 10% > $7,300 X .10 = $730
$7,300 - $29,700 taxed at 15% = ($29,700 – $7,300) X .15 = $22,400 X .15 = $3,360
$29,700 - $71,950 taxed at 25% = ($71,950 – 29,700) X .25 = $42,250 X .25 = $10,562
Income above $71,950 taxed at 28% = ($91,800 - $71,950) X .28 = $19,850 X .28 = $5,558
Total tax $20,210
Average tax rate 20.2%
Marginal tax rate 28%
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How Much Does a Deduction Save You in

Taxes?
Taxpayers may deduct income taxes paid to a state,

charitable contributions to qualifying organizations,
real estate taxes, and interest paid on a mortgage to
finance the purchase of a home, as well as other
items.
Marginal tax rates influence behavior. Decisions about how much to work depend on how
much of the added income you get to take home. Similarly, a firm’s decision about how
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much to invest depends in part on the additional, or marginal, profits that the investment
project would yield after tax.
TAX EQUITY
benefits-received principle A theory of

fairness holding that taxpayers should
contribute to government (in the form of
taxes) in proportion to the benefits that they
receive from public expenditures.
ability-to-pay principle A theory of taxation

holding that citizens should bear tax burdens
in line with their ability to pay
taxes.
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Horizontal and Vertical Equity
If we accept the idea that ability to pay should be

the basis for the distribution of tax burdens, two
principles follow.
• First, the principle of horizontal equity holds that

those with equal ability to pay should bear equal
tax burdens.
• Second, the principle of vertical equity holds that

those with greater ability to pay should pay more.
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WHAT IS THE “BEST” TAX BASE?
The three leading candidates for best tax base are

income, consumption, and wealth.
Income—to be precise, economic income—is

anything that enhances your ability to command
resources.
Economic Income = Consumption + Change in Net Worth

P A HC
In economic terms, income is income, regardless of source and use.

Consumption is the total value of things that a

household consumes in a given period.
Wealth, or net worth, is the value of all the things you

own after your liabilities are subtracted.
Net worth = Assets − Liabilities

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Consumption as the Best Tax Base

Thomas Hobbes argued that people should pay taxes
in accordance with “what they actually take out of the
common pot, not what they leave in.”
Alex’s orchard.
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Income as the Best Tax Base

According to proponents of income as a tax base, you
should be taxed not on what you actually draw out of
the common pot, but rather on the basis of your ability
to draw from that pot.
Wealth as the Best Tax Base

Still others argue that the real power to command
resources comes not from any single year’s income

but from accumulated wealth.
No Simple Answer
There is ongoing debate in the United States about
whether it would be better to shift toward a more
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comprehensive consumption tax.

THE GIFT AND ESTATE TAX
estate The property that a person owns at

the time of his or her death.
estate tax A tax on the total value of a

person’s estate.
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TAX INCIDENCE: WHO PAYS?
tax incidence The ultimate distribution of a

tax burden.
sources side/uses side The impact of a

tax may be felt on one or the other or on
both sides of the income equation. A tax
may cause net income to fall (damage on
the sources side), or it may cause prices of

goods and services to rise so that income
buys less (damage on the uses side).
The imposition of a tax or a change in a tax can change behavior. Changes in behavior can
affect supply and demand in markets and cause prices to change. When prices change in
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input or output markets, some households are made better off and some are made worse off.
These final changes determine the ultimate burden of the tax.
tax shifting Occurs when households can

alter their behavior and do something to
avoid paying a tax.
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Broad-based taxes are less likely to be shifted and more likely to “stick” where they are
levied than “partial taxes” are.
THE INCIDENCE OF PAYROLL TAXES

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FIGURE 17.2 Equilibrium in a Competitive Labor Market—No Taxes
Imposing a Payroll Tax: Who Pays?

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FIGURE 17.3 Incidence of a Per-Unit Payroll Tax in a Perfectly Competitive Labor Market
FIGURE 17.4 Payroll Tax with Elastic (a) and Inelastic (b) Labor Supply
Workers bear the bulk of the burden of a payroll tax if labor supply is relatively inelastic, and
firms bear the bulk of the burden of a payroll tax if labor supply is relatively elastic.
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Most of the payroll tax in the United States if probably borne by workers.
TABLE 17.5 Estimated Incidence of Payroll Taxes in the

United States in 2003
POPULATION RANKED BY TAX AS A % OF TOTAL
INCOME INCOME
Bottom 20% 7.6
Second 20% 9.8
Third 20% 10.7
Fourth 20% 11.2
Top 20% 8.0

Top 10% 6.7
Top 5% 5.3
Top 1% 3.0
Source: Authors’ estimate.
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THE INCIDENCE OF CORPORATE PROFITS TAXES
corporations Firms that are granted

limited liability status by the government.
Limited liability means that shareholder/owners can

lose only what they have invested.
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The Burden of the Corporate Tax
TABLE 17.6 Estimated Burden of the U.S. Corporation Income

Tax in 2004
POPULATION RANKED BY TAX AS A % OF
INCOME TOTAL INCOME
Bottom 20% 0.5
Second 20% 1.0
Third 20% 1.4
Fourth 20% 1.5

Top 20% 4.5
Top 10% 5.7
Top 5% 7.2
Top 1% 9.7
Source: Authors’ estimate.
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Owners of corporations, proprietorships, and partnerships all bear the burden of the
corporate tax in rough proportion to profits, even though it is directly levied only on
corporations.
THE OVERALL INCIDENCE OF TAXES IN THE

UNITED STATES: EMPIRICAL EVIDENCE
Many researchers have done complete analyses

under varying assumptions about tax incidence,
and in most cases their results are similar:
State and local taxes (with sales taxes playing a big role) seem as a group to be mildly
regressive. Federal taxes, dominated by the individual income tax but increasingly affected
by the regressive payroll tax, are mildly progressive. The overall system is mildly
progressive.
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EXCESS BURDENS AND THE PRINCIPLE
OF NEUTRALITY
When taxes distort economic conditions, they impose burdens on society that in aggregate
exceed the revenue collected by the government.
excess burden The amount by which the

burden of a tax exceeds the total revenue
collected. Also called deadweight loss.
principle of neutrality All else equal, taxes

that are neutral with respect to economic
decisions (that is, taxes that do not distort

economic decisions) are generally preferable to
taxes that distort economic decisions. Taxes
that are not neutral impose excess burdens.
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Ceteris paribus, or all else equal, a tax that is neutral with respect to economic decisions is
preferred to one that distorts economic decisions.
OF NEUTRALITY
HOW DO EXCESS BURDENS ARISE?

FIGURE 17.5 Firms Choose the Technology That Minimizes the Cost of Production
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OF NEUTRALITY
FIGURE 17.6 Imposition of a Tax on Capital Distorts the Choice of Technology

The larger the distortion that a tax causes in behavior, the larger the excess burden of the tax.
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Taxes levied on broad bases tend to distort choices less and impose smaller excess burdens
than taxes on more sharply defined bases.
OF NEUTRALITY
THE PRINCIPLE OF SECOND BEST
principle of second best The fact that a

tax distorts an economic decision does not
always imply that such a tax imposes an
excess burden. If there are previously
existing distortions, such a tax may actually
improve efficiency.
At least two kinds of circumstances favor nonneutral (that is, distorting) taxes: the presence
of externalities and the presence of other distorting taxes.
Optimal Taxation
The idea that taxes work together to affect behavior
has led tax theorists to search for optimal taxation
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systems.
MEASURING EXCESS BURDENS
FIGURE 17.7 The Excess Burden of a Distorting Excise Tax

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MEASURING EXCESS BURDENS
EXCESS BURDENS AND THE DEGREE OF DISTORTION
FIGURE 17.8 The Size of the Excess

Burden of a Distorting
Excise Tax Depends on
the Elasticity of
Demand
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The more elastic the demand curve, the greater is the distortion caused by any given tax rate.
REVIEW TERMS AND CONCEPTS
ability-to-pay principle principle of second best

average tax rate progressive tax
benefits-received proportional tax
principle regressive tax
excess burden sources side/uses side
corporations tax base
estate tax incidence

estate tax tax rate structure
marginal tax rate tax shifting
principle of neutrality
P A HC

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Chapter

Fernando & Yvonn Quijano

Tax Incidence: Who Pays?

The Incidence of Corporate Profits

Excess Burdens and the Principle

Measuring Excess Burdens

Excess Burdens and the Degree of

No matter what functions we end up assigning to

TAXES: BASIC CONCEPTS

tax base The measure or value upon which

tax rate structure The percentage of a tax

of income, for example.

Taxes on Stocks versus Taxes on Flows

FIGURE 17.1 Taxes on Economic “Flows”

TABLE 17.1 Federal Government Receipts 1960–2005 (billions of dollars)

% 47.2 12.5 30.1 4.7 5.1 100

Proportional, Progressive, and Regressive Taxes

proportional tax A tax whose burden is the

progressive tax A tax whose burden,

regressive tax A tax whose burden,

INCOME RATE, % 5% TAX ON AS A %

A $ 10,000 20 $ 2,000 $ 8,000 $ 400 4.0

C 50,000 50 25,000 25,000 1,250 2.5

Marginal versus Average Tax Rates

average tax rate Total amount of tax paid

marginal tax rate The tax rate paid on any

$150,151 – 326,450 35%

How Much Does a Deduction Save You in

Taxpayers may deduct income taxes paid to a state,

benefits-received principle A theory of

ability-to-pay principle A theory of taxation

Horizontal and Vertical Equity

If we accept the idea that ability to pay should be

• First, the principle of horizontal equity holds that

• Second, the principle of vertical equity holds that

WHAT IS THE “BEST” TAX BASE?

The three leading candidates for best tax base are

Income—to be precise, economic income—is

Economic Income = Consumption + Change in Net Worth

In economic terms, income is income, regardless of source and use.

Consumption is the total value of things that a

Wealth, or net worth, is the value of all the things you

Net worth = Assets − Liabilities

Consumption as the Best Tax Base

Income as the Best Tax Base

Wealth as the Best Tax Base

resources comes not from any single year’s income

comprehensive consumption tax.

THE GIFT AND ESTATE TAX

estate The property that a person owns at

estate tax A tax on the total value of a

tax incidence The ultimate distribution of a

sources side/uses side The impact of a

the sources side), or it may cause prices of

tax shifting Occurs when households can

THE INCIDENCE OF PAYROLL TAXES

FIGURE 17.2 Equilibrium in a Competitive Labor Market—No Taxes

Imposing a Payroll Tax: Who Pays?

TABLE 17.5 Estimated Incidence of Payroll Taxes in the

Top 20% 8.0

THE INCIDENCE OF CORPORATE PROFITS TAXES

corporations Firms that are granted

Limited liability means that shareholder/owners can