Chapter 12

The Design of the Tax System

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We expect the government to provide us with various goods and services, thus taxes are inevitable. According to the Ten Principles of Economics, governments can control the market through tax. The government raises economic well-being by the remedying externalities, proving a public good, and regulating the use of a common resource. Tax revenue is required to do so.

As the economy’s income has grown, the government’s revenue from taxation has grown as well. For example, in 1902, the government collected about 7 percent of total income, but in recent years, the government has collected about 30 percent of it. We can assume that as a country gets richer, the government typically levies more income in taxes.

The Federal Government



- Two-third of the taxes in our economy are collected by the federal government.
- Individual income tax is the largest source of the tax revenue.
- The amount of tax levied depends on the family's income.
- Taxable income = total income minus an amount based on the number of dependents minus certain expenses that policymakers have deemed “deductible”
- Marginal tax rate: the tax rate applied to each additional amount of income.
- Payroll tax: tax on the wages that a firm pays its workers.
- Social insurance tax: tax for social security and medical care. Used to maintain the living standards of the elderly.
- Corporate income tax: tax each corporation pays based on their profit.
- Excise taxes: taxes on specific goods, (Ex: gasoline, cigarettes, and alcoholic beverages)


- Federal government’s spending is divided among major categories.
- Largest category: Social security (22% of spending): A transfer payment is a government payment not made in exchange for a good or service.
- Second largest category: National defense (17~20% of spending): Includes both the salaries of military personnel and the purchases of military equipment to supply war and defense.
- Third largest category: Income security: Includes transfer payments to poor families.
- Medicare, health spending: health plan for the country.
- Net interest: bank related taxes.
- There are other less expensive functions of government.
- Budget deficit: government spending > government receipts.
- Budget surplus: government receipts > government spending.

State and Local Government


State and Local governments collect about 40 percent of all taxes paid.


- Two of the most important taxes are sales taxes and property taxes.
- Sales taxes are levied as a percentage of the total amount spent at retail stores.
- Property taxes are levied as a percentage of the value of land and structures and are paid by the owners.
- Individual and corporate taxes are levied as well.
- State and Local governments also receive substantial funds from the federal government.


- Education: Biggest single expenditure (third of the spending): Pays for public schools.
- Highways: Second biggest: Building of new roads and the maintenance of existing ones.
- Others: additional services such as libraries, police, garbage removal fire protection, park maintenance, and snow removal.

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Taxes and Efficiency

The aim of a tax system is to raise revenue for the government.

Two major objects: Efficiency and Equity

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- Efficiency: raise the same amount of revenue at a smaller cost to taxpayers.
- Yet, taxes still have two other costs: Dead Weight Loss and administrative burdens.
- The deadweight loss is the inefficiency that a tax creates.
- Tax also discourages people from working as hard as they can.
- However, consumption tax is likely to encourage saving and capital formation.
- The administrative burden of any tax system is part of the inefficiency it creates. The resources devoted to complying with the tax laws are a type of DWL as well. (Time and Money)

- Average tax rate: total taxes paid / total income.
- Marginal tax rate: the extra taxes paid on additional income. (how much the tax system discourages people from working)
- Lump-sum tax: Tax that is the same for everyone. Does not cause DWL. Efficient, but not equal.
- Benefits principle: Tax based on what one receives from the government
- Ability-to-pay principle: Tax based on how a person can shoulder the burden.
- Vertical Equity: More rich, more tax
- Horizontal Equity: Similar abilities pay similar tax
- Proportional Tax: Same fraction of tax
- Regressive Tax: Rich people pay lower proportion, while poor pay higher proportion.
- Progressive Tax: Opposite of regressive tax.

Taxes are levied in different ways by different governments. Its ultimate goal is to make the public better off. There are various kinds of taxes levied depending on the situation. Governments use tax to raise their own revenue and do stuff through it.



1. Tax makes DWL (T/F)
2. State and Local Governments barely spend money on education (T/F)
3. Horizontal Equity is about making taxpayers with similar abilities pay the same amount of tax. (T/F)


1. T
2. F- They spend the most on education (EX. Public schools)
3. T

Vid on inefficiency of tax