Chapter 2

Tax Policy Issues: Standards for a Good Tax

Standards for a Good Tax:

In theory, every tax can be evaluated on four standards. A good tax should be:
• Sufficient‫ كافية‬to raise necessary government revenues
• Convenient ‫مريحة‬for government to administer and for people to pay
• Efficient in economic terms
• A good tax should be fair

Sufficiency: a tax is sufficient if it generates enough fund to pay for the public goods
and services provided by the government .If tax is sufficient, government can balance its
budget. Tax revenue equal government spending, and the government has no needed to
raise additional funds.
What is the consequences of an insufficient tax system?
- The government must make up its revenue shortfall (the excess of current spending is
over tax receipts) from some other sources.
The government may depend on alternative source of revenue :
1. Legalized gambling ‫المقامرة‬
2. Lease or sell its own assets or property rights
3. Borrow money from internal and external lender to finance their operating deficits.
4. Sell debt obligations (short-term instruments‫ الصكوك‬and long term instruments) in the
capital market.
Debt financing is not a permanent ‫دائم‬solution to an insufficient tax system .because:
1. The public debt and interest burden increase
2. Damage the government creditability position
Is our Palestinian tax system sufficient?
No. The Palestinian government has operated at a deficit for every fiscal year since
1995, the current budget (2016) with deficit equal 1382 million dollar

1
 American tax system is insufficient
The federal government has operated at a deficit for every fiscal year since 1970, except
for 2000 and 2001 when small surpluses were generated
How to Increase Tax Revenue?
Taxing jurisdictions can attempt to increase revenues in at least three ways:
1. Exploit‫ استغالل‬a new tax base. The most radical and politically sensitive
2. Increase the rate of an existing tax. This is the more obvious strategy and therefore
is likely to anger the greatest number of voters
3. Enlarge‫ تكبير‬an existing tax base: A jurisdiction with a retail sales tax applying to
tangible goods could expand the tax to selected personal services. Most subtle‫ دهاء‬and
less likely to attract public attention
Static versus Dynamic Forecasting
• Static forecasting: refers to the forecast of tax revenue is static because it assume the
B, the base variable in the equation (T = r × B ) , is unrelated to r, the rate variable ,
according to change in the rate has no effect on the tax base
• Dynamic forecasting : refers to increases in the tax rate caused a decrease in the tax
base( Negative correlation) , these projection which assume a correlation between rate
and base are called Dynamic forecasts …P.26
The accuracy of dynamic forecasts depend on the accuracy of the assumption about
the correlation.
The rate may be only one of many factors effect on the tax base.
Forecasting revenue:
• Static forecast - assumes base stays the same
If the tax rate is 5% and the base is $100,000, a rate increase of 1% should generate $1,000 more
revenue
• Dynamic forecast - estimate change in base due to change in rate
If the tax rate is 5% and the base $100,000, a rate increase of 1% may decrease the base so that
less than $1,000 more revenue is generated.

2
Behavioral Responses to Rate Change
Income versus substitution effect
Income Effect
Taxpayers change their behavior in reaction to increased tax rates. These
changes result in either an income effect or substitution effect.
An income effect: an increase in income tax rates might induce people to engage in more
income producing activities.
Reaction of taxpayers to stay in the same place.
With the income effect, the taxpayer work more hours or take a second job to increase his
before tax income
Income effect:
Tax increase → base increase
Tax decrease → base decrease
Taxpayers work to maintain after-tax income (This is akin to running faster just to stay in
the same place!)
The government will enjoy a revenue windfall.
Example of Income Effect
A self-employed taxpayer works 30 hours a week, earns $100 an hour, and pays 20%
income tax. Disposable (after-tax) weekly income is $2,400(3000× %80), tax =
$600.Assume that the tax rate increases to 25% .If the taxpayer increases his hours to 32
per week, he will maintain his disposable income at $2,400 per week
$3,200 - $800 tax = $2,400
With the income effect , income before tax = 2400 / %75=3200
The government will collect an additional $200 revenue
($3,200 × 25%) – ($3,000 × 20%) = $200
Note: with a static forecast indicates that the government should collect an additional income

3
The Substitution Effect: Taxpayers respond to the higher tax rate by working fewer hours and
generating less income.
The government will suffer a revenue shortfall
Theoretically, the income effect is more powerful for lower-income taxpayers and the
substitution effect is more powerful for higher-income taxpayers.
Substitution effect differ from taxpayer to another
• Example of Substitution Effect
• A self-employed taxpayer works 30 hours a week, earns, $100 an hour before taxes, and
pays a 20% income tax. Disposable (after-tax) weekly income is $2,400
• Assume that the tax rate increases to 25%
• If the taxpayer decreases his hours to 28 per week, the government will collect only $100
additional revenue
($2,800 × 25%) – ($3,000 × 20%) = $100
Supply-Side Economic theory: refers that a decreases in the income tax rates should ultimately
result in an increase in government revenues.
People who benefit directly from the rate reduction will invest their tax windfall in new
commercial ventures. (Tax reform‫)االصالح الضريبي‬

Standards - Convenience
A tax is convenient if:
A). from the government’s view a good tax should be:
1- The tax is easy to administer,
2- easy to understand,
3- And offers few opportunities for noncompliance. (Retail sale taxes, the sellers are
responsible for collecting the tax from buyers, this method effortless for taxpayer and
government).
4. Economical for Gov. (the administrative cost of collecting and enforcing the tax should
be reasonable in comparison with the total revenue.
B) From the taxpayer’s view
1-The tax is easy to pay
2-Easy to compute.
3- And requires minimal time to comply

4
Standards - Efficiency
Tax policymakers use the term efficiency in two different ways.
A tax is efficient if:
• Judged by the classical standard of efficiency , tax does not interfere with or influence
taxpayer economic behavior , it is neutral in its effect on the market so that it does not
distort the market, create suboptimal allocation of goods and services, or modify taxpayer
behavior.
• The classical Adam Smith believed that taxes have as little impact as possible on the
economy .
• Judged by Keynesian (modern) standards, it is an effective fiscal policy tool for
regulating the economy. Governments should use taxes to move the economy in the
desired direction.
• Keynes believed that free markets are effective in organizing production and allocating
scarce resources ,but lack adequate self regulating mechanisms for maintaining economic
stability .
• Keynes believed tax system are a primary tool of fiscal policy . Rather than trying to
design a neutral tax system , government should deliberately use taxes to move the
economy in the desired direction.
• If the economy suffering from high unemployment , the government could reduce
taxes to transfer fund from the public to private sector .
Taxes and Behavior modification
• Modern government use their tax system to solve social problem( social considerations),
and deter unfavorable behavior and negative externalities
• Example: the tax law include some provision (abetments) that encourage to solve :
• environment pollution, rehabilitation a historic building
• Government use tax breaks to subsidize targeted activities , and making those activities
less costly or more profitability
Tax Preferences : refers to the provision in the income tax system designed as incentives
for certain behaviors or as subsidies for targeted activities .
• Tax preferences allow certain persons or organizations to pay less tax
• Tax preferences decrees the tax base
• Tax preferences classified as indirect government expenditure

5
Standards - Fairness
A tax is fair if:
• The taxpayer has the ability to pay the tax.
Ability to pay refers to the economic resources under a person’s control.( the same taxable
income)
Income taxes are based on a person inflow of economic resources under persons control , but
sales and excise taxes are based on a different dimension of ability to pay : a person’s
consumption of resources represented by the purchase of goods and services .
The tax enhances horizontal equity
• Persons with the same ability to pay should owe the same tax
• In a jurisdiction with a 6 percent sales tax , every consumer who buys a taxable
goods with a $50 retail price pays the same $3 sales tax .
• The horizontal equity of taxes with more complex structures may not be so
easy to analyze .
• The horizontal equity of income tax is enhanced by refining the calculation of
taxable income include the significant variables affecting a person economic
circumstances .
The tax enhances vertical equity
• Persons with greater ability to pay owe more tax than persons with lesser
ability to pay
In the income tax system , the tax base is annual taxable income .
Horizontal equity
• Is achieved when persons with the same
ability to pay owe the same tax
• Ability to pay varies with marital status,
number of dependents, health, etc.
Taxable income and ability to pay
The taxpayer with the same ability to pay ,If taxpayer earning the same annual salaries , and
with the same marital status .
The horizontal equity of the income tax is enhanced by refining the calculation of taxable
income to include the significant variables affecting a persons economic circumstances
• Annual versus lifetime horizontal equity

6
Taxable income is computed on a 12-month .
This annual measurement of ability to pay may bear little or no relationship to a person lifetime
ability to pay.
Tax Preference and Horizontal Equity
Preferences is not distributed impartially across taxpayers .
Preferences can distort the horizontal equity of the income tax
Vertical equity
• Is achieved if persons with greater ability to pay owe more tax than persons with lesser
ability to pay
• While horizontal equity is concerned with a rational and impartial measurement of the
tax base, vertical equity is concerned with a fair rate structure. P.36
The relative tax burdens of taxpayers with different abilities to pay depends on the tax rate
structure
• Regressive Taxes: graduated rates that decreases as the base increases.
• Regressive rate structure violate the standard of equity because the
proportionally grate tax burden on persons with smaller tax base.
• Retail sales tax consist of only a single rate and therefore are explicitly
regressive.
• Modern study concluded that sales and excise taxes are classified regressive
taxes
Proportionate rate structure : a single rate applied to taxable income .
Theorists believe that a single rate fails to fairly apportion the tax burden across people
with different incomes .
Declining marginal utility of income : this theory presumes that the financial important
of each dollar of income diminishes as total income increase . P.37
Progressive rate structure : the rate increase as income increases resulting in an equality of
sacrifice across taxpayers.
• Is the proportionate or progressive rate structure the more equitable for taxpayers?
• Progressive rate structure are more equitable at limited range of progressive rate . P.37
Regressive: rate decreases as base increases
• Smith pays $2,000 tax (10%) on $20,000 income and Jones pays $3,000 tax (5%) on
$60,000 income

7
Proportionate: single rate applied to taxable income
• Smith pays $2,000 tax (10%) on $20,000 income and Jones pays $6,000 tax (10%) on
$60,000 income
Progressive: rate increases as base increases
• Smith pays $2,000 tax (10%) on $20,000 income and Jones pays 12,000 (20%) on
$60,000 income

Marginal and Average Tax Rate

Marginal Rate: is the rate that applies to the next dollar of income.
Average Tax rate: equal tax payable divided by taxable income.
Under a proportionate rate structure, the marginal and average rate are the same for all levels
of taxable income.
Under progressive rate structure, the marginal rate is higher than the average rate for incomes in
excess of the first bracket (for the first bracket, the average equal marginal rate structure)
Government Z Levies an income tax with the following rate structure:
Percentage Rate Bracket
%5 Income from 0 - to $15,000
%10 Income from 15,001 - to $25,000
%15 Income from $25,001 - to $40,000
%20 Income from $ 40,001 -to $70,000
%25 Income is excess of $ 70000
Taxpayer (B) annual taxable income is $ 40000. Compute tax expense, average tax,
and marginal tax for taxpayer (B)
Tax expense = 15000×%5= 750
10000 × %10 = 1000
15000 × %15 = 2250
Total tax expense = 4000$
Average Tax = tax expense ÷ taxable income
= 4000 ÷ 40000 = %10
Marginal tax = %20

8
 Tax rate structure
10% of the first $100,000; 12% of the second $500,000;
15% of income in excess of $500,000
Taxpayer has $1 million income and pays a $130,000 tax
10% × $100,000 $10,000
12% × $500,000 60,000
15% × $400,000 60,000
$130,000
What is the taxpayer’s marginal rate?
15%
What is the taxpayer’s average rate?
13% (130/1,000)
Distributive justice and the perception of inequity
Taxes become mechanism for the redistribution of wealth across society.
Good tax system must decrease the level of poverty in society
The perception of inequity:
The public perception that the federal income tax is unfair has increased in recent
decades, this perception of inequity has many negative consequences.
The individuals who believe that income tax system is unfair are more likely to
deliberately underreport their income than individuals believe the system is fair, and
the level of compliance will decline.