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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

CHAPTER 17: Public Finance: The Economics of Taxation

Public Finance: The Economics of Taxation

17
Chapter Outline
The Economics of Taxation 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 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 Excess Burdens and the Degree of Distortion
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PUBLIC FINANCE: THE ECONOMICS OF TAXATION


CHAPTER 17: 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.

Taxes may be imposed on transactions, institutions, property, meals, and other things, but in the final analysis they are paid by individuals or households.
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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 taxes25 percent of income, for example.

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Taxes on Stocks versus Taxes on Flows

FIGURE 17.1 Taxes on Economic Flows


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TABLE 17.1 Federal Government Receipts 19602005 (billions of dollars) Individual Income Tax 1960 % 1970 % 40.7 44.0 90.4 46.9 Corporation Income Tax 21.5 23.2 32.8 17.0 Social Insur. Payroll Taxes 14.7 15.9 44.4 23.0 Excise Taxes 11.7 12.6 15.7 8.1 Other Receipts 3.9 4.2 9.5 4.9 Total 92.5 100 192.8 100

1980
% 1990 % 2005* %

244.1
47.2 466.9 45.2 893.7 43.5

64.6
12.5 93.5 9.1 226.5 11.0

157.8
30.1 380.0 36.8 773.7 37.7

24.3
4.7 35.3 3.4 74.0 3.6

26.3
5.1 56.2 5.4 84.8 4.1

517.1
100 1,032.0 100 2053.0 100

* OMB estimate Source: United States, Office of Management and Budget. Percentages may not add to 100 due to rounding.

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CHAPTER 17: Public Finance: The Economics of Taxation

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
TAX AS A % OF INCOME

HOUSEHOLD

SAVING INCOME

RATE, %

SAVING

CONSUMPTION

5% TAX ON CONSUMPTION

A B C

$ 10,000 20,000 50,000

20 40 50

$ 2,000 8,000 25,000

$ 8,000 12,000 25,000

$ 400 600 1,250

4.0 3.0 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 $0 - 14,600 $14,601 59,400 $59,401 119,950 TAX RATE 10% 15% 25%

$119,951 182,800
$182,801 326,450 More than $326,450 SINGLE TAXPAYERS

28%
33% 35%

TAXABLE INCOME
$0 7,300 $7,301 29,700 $29,701 71,950 $71,951 150,150 $150,151 326,450
Source: The Internal Revenue Service.

TAX RATE
10% 15% 28% 33% 35%
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TABLE 17.4 Tax Calculations for a Single Taxpayer Who Earned $100,000 in 2005

Total income Personal exemption

$100,000 $3,200

Standard deduction
= Taxable income Tax Calculation
0 - $7,300 taxed at 10% > $7,300 X .10 =

$5,000
$91,800

$730

$7,300 - $29,700 taxed at 15% = ($29,700 $7,300) X .15 = $22,400 X .15 =


$29,700 - $71,950 taxed at 25% = ($71,950 29,700) X .25 = $42,250 X .25 = Income above $71,950 taxed at 28% = ($91,800 - $71,950) X .28 = $19,850 X .28 = Total tax Average tax rate Marginal tax rate

$3,360
$10,562 $5,558 $20,210 20.2% 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 firms decision about how much to invest depends in part on the additional, or marginal, profits that the investment project would yield after tax.
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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.
Incometo be precise, economic incomeis anything that enhances your ability to command resources. Economic Income = Consumption + Change in Net Worth

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


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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.

Alexs 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 years 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 comprehensive consumption tax.
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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 persons estate.

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TAX INCIDENCE: WHO PAYS?


CHAPTER 17: Public Finance: The Economics of Taxation

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 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.
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TAX INCIDENCE: WHO PAYS?


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tax shifting Occurs when households can alter their behavior and do something to avoid paying a tax.

Broad-based taxes are less likely to be shifted and more likely to stick where they are levied than partial taxes are.
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TAX INCIDENCE: WHO PAYS?


CHAPTER 17: Public Finance: The Economics of Taxation

THE INCIDENCE OF PAYROLL TAXES

FIGURE 17.2 Equilibrium in a Competitive Labor MarketNo Taxes


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TAX INCIDENCE: WHO PAYS?


CHAPTER 17: Public Finance: The Economics of Taxation

Imposing a Payroll Tax: Who Pays?

FIGURE 17.3 Incidence of a Per-Unit Payroll Tax in a Perfectly Competitive Labor Market
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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. Most of the payroll tax in the United States if probably borne by workers.
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TAX INCIDENCE: WHO PAYS?


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TABLE 17.5 Estimated Incidence of Payroll Taxes in the United States in 2003

POPULATION RANKED BY INCOME


Bottom 20% Second 20% Third 20% Fourth 20% Top 20%

TAX AS A % OF TOTAL INCOME


7.6 9.8 10.7 11.2 8.0

Top 10%
Top 5% Top 1%
Source: Authors estimate.

6.7
5.3 3.0

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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 INCOME Bottom 20% Second 20% Third 20% Fourth 20% Top 20% Top 10% Top 5% Top 1%
Source: Authors estimate.

TAX AS A % OF TOTAL INCOME 0.5 1.0 1.4 1.5 4.5 5.7 7.2 9.7

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.
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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


CHAPTER 17: Public Finance: The Economics of Taxation
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.
Ceteris paribus, or all else equal, a tax that is neutral with respect to economic decisions is preferred to one that distorts economic decisions.
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EXCESS BURDENS AND THE PRINCIPLE OF NEUTRALITY


CHAPTER 17: Public Finance: The Economics of Taxation

HOW DO EXCESS BURDENS ARISE?

FIGURE 17.5 Firms Choose the Technology That Minimizes the Cost of Production

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CHAPTER 17: Public Finance: The Economics of Taxation

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. Taxes levied on broad bases tend to distort choices less and impose smaller excess burdens than taxes on more sharply defined bases.
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EXCESS BURDENS AND THE PRINCIPLE OF NEUTRALITY


CHAPTER 17: Public Finance: The Economics of Taxation

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 systems.
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MEASURING EXCESS BURDENS


CHAPTER 17: Public Finance: The Economics of Taxation

FIGURE 17.7 The Excess Burden of a Distorting Excise Tax

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MEASURING EXCESS BURDENS


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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

The more elastic the demand curve, the greater is the distortion caused by any given tax rate.
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REVIEW TERMS AND CONCEPTS


CHAPTER 17: Public Finance: The Economics of Taxation

ability-to-pay principle average tax rate benefits-received principle excess burden corporations estate estate tax marginal tax rate principle of neutrality

principle of second best progressive tax proportional tax regressive tax sources side/uses side tax base tax incidence tax rate structure tax shifting

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