Ch.12+Design+of+the+Tax+System

Do you like paying taxes? I'm sure no one does, but you know governments need money to provide you with some important public goods. Previously, we have studied how taxes can affect the market. In this chapter, we are going to discuss the nature of the taxation and our attempts at making the taxation efficient and equitable.

How much of the nation's income does the government take as taxes? Let's look at how the total breaks down into some broad categories.

Federal Government
U.S federal government collects about 2/3 of the taxes in our economy.

Receipts
As the economy grows, government will take in more of the income of the nation as taxes. The largest source of revenue for the federal government is the **individual income tax**. Watch this graph...



The income tax is an interesting topic. How much should people with high income get taxed? Should they get taxed the same amount as the poor people? We will discuss this efficiency vs. equity issue later.

After the individual income taxes that plays a big role in the government revenue is the **payroll taxes**. It is a tax on the wages that a firm pays its workers.

Next in magnitude, but much smaller than the income taxes or payroll taxes, is the **corporate income tax**. It is a business that is set up as a separate legal entity. The government taxes each corporation based on its profit.

Look at this graph to see how much the government raises money with tax.

Spending
This table shows the U.S. government spending in 2004. As you can see, the U.S. government spent the most on Social Security, followed by National defense, Income security, and Medicare.

You can see that the total $ the federal government spends exceeds the total amount raised by $412 billion. When the spending exceeds receipts, it is called a **budget deficit**. When the receipts exceed spending, it is called a **budget surplus**.

State and Local Government
State and local gov't collects about 40% of all the taxes!

Receipts


As you can see above, sales taxes and property taxes are the two most important for the state and local governments.

Sales taxes are all those taxes you pay every time you buy stuff. Property taxes are taxes paid for properties like lands by the property owners.

Spending
The U.S. state and local gov't spent the most on education in 2002, according to the chart above. Local gov'ts pay for the public schools.

Taxes and Efficiency
So, how should the gov't tax people? Gov't wants to raise tax revenue, but taxes create deadweight losses as well as administrative burdens. We will discuss these two factors.

Deadweight Losses
In Chapter 8, we have discussed how taxes create deadweight losses. To review, visit Ch.8 Application - The Costs of Taxation YD. An efficient tax system will try to minimize the deadweight losses caused by the taxes.

Administrative Burden
If the gov't raises the tax from 3% to 10%, what would you do? You would rise up and do your best to put the tax back to 3%. Administrative burden is all the resources to comply with the tax law. It is a type of deadweight loss, because some time and effort are wasted with this burden.

Marginal Tax Rates vs. Average Tax Rates
There are two important notions when discussing efficiency vs. equity.


 * Average tax rate** is (total tax paid) / (total income).


 * Marginal tax rate** is extra taxes paid on an additional dollar of income.

Average tax rate shows how much the taxpayers are sacrificing.

Marginal tax rate shows how much the tax distorts the incentives of the people. Higher the marginal tax rate, the less people want to earn more.

Lump-Sum Taxes
If the government taxes a fixed amount on everyone, then such a tax is called a **lump-sum tax**. If the government taxes $5,000 on everyone, the average tax rate of a person with income of $30,000 will be ($5000) / ($30,000) = 1/6. However, the marginal tax rate is zero because people pay the same amount of tax no matter how much more they earn.

This is the most efficient form of tax, because this does not distort people's incentives to earn more.

Tax and Equity
And yet, we still want to consider equity...

The Benefits Principle
This principle states that people who benefit the most from government services should pay more taxes. It seems logical, because gov't uses taxes to provide gov't services. But how can this principle be applied?

One way is by taxing the gasoline. The more gasoline you use indicates that you use the road more.

This principle also argues that the rich should pay more taxes than the poor, because the rich people benefit more from the gov't services. For example, rich people benefit more from police services because rich people are more likely to be robbed.

The Ability-to-Pay Principle
This principle states that all people should have equal tax burden. However, equal tax burden does not mean the same amount of money. For example, $1,000 tax paid by a guy that earns $40,000 a year may be a larger sacrifice than $3,000 tax paid by a guy that earns $100,000 a year.

There are two notions of equity. Vertical equity and horizontal equity.

Vertical Equity

 * Vertical equality** believes that taxpayers with a greater ability to pay taxes should pay the larger amount. But how much more?

There are three tax systems. Check this out.



In all three tax systems, the rich pays more than the poor, yet they differ.

First system is called **proportional** because everyone pays the same fraction of their income. But the rich would still pay more because of their larger income.

Second system is called **regressive** because richer people pay the smaller fraction of their income. The rich still pays larger amount of taxes because of their larger income.

Third system is called **progressive**, because richer people pay the larger fraction of their income.

These three systems all strive for equality, but which ones the most equal? Who know?

We don't know, because equality is always a difficult topic to talk about.

Horizontal Equity
This equity believes that similar taxpayers should pay similar amounts of taxes.

All families are different. Some families can have 4 children that all go to college. Some people have diseases. Even though some have the same amount of income, sometimes it is not equal to tax them the same amount depending on their environment.

Tax Incidence and Tax Equity
It is also important to take into account who bears the burden of the taxes. If you check Ch.6 Supply, Demand, and Government Policies, you can see that the burden of taxes is not solely on the product being taxed. For example, if you tax furs, it would seem like the rich people will get taxed because rich people buy more furs. However, tax on furs can affect the poor workers who make fur products and other inferior products that are substitutes for furs.

Conclusion
So, efficiency or equity....which one would you choose? Clearly, you can't favor one over another. They are both important. This is why taxation is always a conflict in our society. The best tax system is one that weighs both efficiency and equity equally. However, we just do not know what's equal. All economics does is to help lead the society into making better decisions about taxation.

budget deficit**: too much government spencing compared to government receipts
 * __Key Concepts__
 * budget surplus**: too much government receipts compared to government spending
 * average tax rate**: total taxes paid divided by total income
 * marginal tax rate**: extra taxses paid on additional income
 * lump-sum tax**: tax that is the same for every person
 * benefits principle**: idea that taxes should be based on the amount a person receives frmo the government
 * ability-to-pay principle**: idea that taxes should be based on the ability of the person to pay the taxes
 * vertical equity**: idea that people with greater abilities to pay taxes should pay more taxes
 * horizontal equity**: idea that people with similar abilities to pay taxes should pay the same taxes
 * proportional tax**: tax which people with high income and low income should be pay taxes with same percentage of income
 * regressive tax**: tax which people with high income should pay smaller percentage of income than the peopole with low income
 * progressive tax**: tax which people with high income should pay larger percentage of income than the peopole with low income

Questions 1. What is the tax called that is the same for everyone? 2. Which tax says that people with high income and low income should be pay taxes with same percentage of income?

Answers 1. Lump-sum tax 2. proportional tax