Case Econ08 Ppt 17

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2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & YvonnQuijano

17

Chapter

Public Finance:The Economics of Taxation

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2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 35

Chapter Outline17Public Finance:

The Economics of TaxationThe Economics of TaxationTaxes: Basic ConceptsTax EquityWhat Is the Best Tax Base?The Gift and Estate Tax

Tax Incidence: Who Pays?The Incidence of Payroll TaxesThe Incidence of Corporate Profits

TaxesThe Overall Incidence of Taxes in the

United States: Empirical Evidence

Excess Burdens and the Principleof Neutrality

How Do Excess Burdens Arise?The Principle of Second Best

Measuring Excess BurdensExcess Burdens and the Degree of

Distortion

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PUBLIC FINANCE:THE ECONOMICS OF 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.

No matter what functions we end up assigning togovernment, to do anything at all government mustfirst raise revenues. The primary vehicle that the

government uses to finance itself is taxation.

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THE ECONOMICS OF TAXATION

tax base The measure or value upon whicha tax is levied.

TAXES: BASIC CONCEPTS

tax rate structure The percentage of a taxbase that must be paid in taxes25 percentof income, for example.

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Taxes on Stocks versus Taxes on Flows

FIGURE 17.1Taxes on Economic Flows

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TABLE 17.1 Federal Government Receipts 19602005 (billions of dollars)

IndividualIncome Tax

CorporationIncome Tax

Social Insur.Payroll Taxes

ExciseTaxes

OtherReceipts 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 estimateSource: United States, Office of Management and Budget. Percentages may not add to 100 due to rounding.

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Proportional, Progressive, and RegressiveTaxes

proportional tax A tax whose burden is thesame 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, fallsas income increases.

TABLE 17.2 The Burden of a Hypothetical 5% Sales Tax Imposed on Three Households withDifferent Incomes

HOUSEHOLDSAVINGINCOME RATE, % SAVING CONSUMPTION

5% TAX ONCONSUMPTION

TAXAS A %

OFINCOME

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 paiddivided by total income.

marginal tax rate The tax rate paid on anyadditional 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%

$14,60159,400 15%

$59,401119,950 25%

$119,951182,800 28%$182,801326,450 33%

More than $326,450 35%

SINGLE TAXPAYERS

TAXABLE INCOME TAX RATE

$07,300 10%

$7,30129,700 15%

$29,701 71,950 28%

$71,951150,150 33%

$150,151326,450 35%

Source: The Internal Revenue Service.

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TABLE 17.4 Tax Calculations for a Single Taxpayer Who Earned $100,000 in 2005

Total incom e $100,000

Personal exemption $3,200

Standard deduction $5,000

= Taxable income $91,800

Tax Calculat ion

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% = ($71,95029,700) 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 = $5,558Total tax $20,210

Average tax rate 20.2%

Marginal tax rate 28%

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How Much Does a Deduction Save You inTaxes?

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.

Taxpayers may deduct income taxes paid to a state,charitable contributions to qualifying organizations,

real estate taxes, and interest paid on a mortgage tofinance the purchase of a home, as well as otheritems.

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TAX EQUITY

benefits-received principle A theory offairness holding that taxpayers should

contribute to government (in the form oftaxes) in proportion to the benefits that theyreceive from public expenditures.

ability-to-pay principle A theory oftaxation holding that citizens should beartax burdens in line with their ability to paytaxes.

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Horizontal and Vertical Equity

If we accept the idea that ability to pay should bethe basis for the distribution of tax burdens, twoprinciples follow.

First, the principle of horizontal equity holds thatthose with equal ability to pay should bear equaltax burdens.

Second, the principle of vertical equity holds thatthose 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 areincome, consumption, and wealth.

Incometo be precise, economicincomeisanything that enhances your ability to commandresources.

Economic Income = Consumption + Change in Net Worth

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

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Consumptionis the total value of things that ahousehold 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 paytaxes 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

Wealth as the Best Tax Base

According to proponents of income as a tax base,you should be taxed not on what you actually drawout of the common pot, but rather on the basis ofyour abilityto draw from that pot.

Still others argue that the real power to commandresources comes not from any single years income

but from accumulated wealth.

No Simple Answer

There is ongoing debate in the United States aboutwhether it would be better to shift toward a morecomprehensive consumption tax.

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THE GIFT AND ESTATE TAX

estate The property that a person owns atthe time of his or her death.

estate tax A tax on the total value of apersons estate.

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TAX INCIDENCE: WHO PAYS?

tax incidence The ultimate distribution of atax burden.

sources side/uses side The impact of a

tax may be felt on one or the other or onboth sides of the income equation. A taxmay cause net income to fall (damage onthe sources side), or it may cause prices ofgoods and services to rise so that incomebuys 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 shifting Occurs when households canalter their behavior and do something toavoid 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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THE INCIDENCE OF PAYROLL TAXES

FIGURE 17.2 Equilibrium in a Competitive Labor MarketNo Taxes

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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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TABLE 17.5 Estimated Incidence of Payroll Taxes in theUnited States in 2003

POPULATION RANKEDBY INCOME

TAX AS A % OFTOTAL 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 grantedlimited liability status by the government.

Limited liability means that shareholder/owners canlose only what they have invested.

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The Burden of the Corporate Tax

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.

TABLE 17.6 Estimated Burden of the U.S. CorporationIncome Tax in 2004

POPULATION RANKEDBY INCOME

TAX AS A % OFTOTAL INCOME

Bottom 20% 0.5Second 20% 1.0

Third 20% 1.4

Fourth 20% 1.5

Top 20% 4.5

Top 10% 5.7Top 5% 7.2

Top 1% 9.7Source: Authors estimate.

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THE OVERALL INCIDENCE OF TAXES IN THEUNITED STATES: EMPIRICAL EVIDENCE

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.

Many researchers have done complete analysesunder varying assumptions about tax incidence,and in most cases their results are similar:

EXCESS BURDENS AND THE PRINCIPLE

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EXCESS BURDENS AND THE PRINCIPLEOF 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 theburden of a tax exceeds the total revenuecollected. Also called deadweight loss.

principle of neutrality All else equal, taxesthat are neutral with respect to economicdecisions (that is, taxes that do not distort

economic decisions) are generally preferable totaxes that distort economic decisions. Taxesthat are not neutral impose excess burdens.

Ceter is p ar ibus, 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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FIGURE 17.5 Firms Choose the Technology That Minimizes the Cost of Production

HOW DO EXCESS BURDENS ARISE?


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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.

FIGURE 17.6 Imposition of a Tax on Capital Distorts the Choice of Technology


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At least two kinds of circumstances favor nonneutral (that is, distorting) taxes: the presence

of externalities and the presence of other distorting taxes.

THE PRINCIPLE OF SECOND BEST

principle of second best The fact that atax distorts an economic decision does notalways imply that such a tax imposes anexcess burden. If there are previously

existing distortions, such a tax may actuallyimprove efficiency.

Optimal Taxation

The idea that taxes work together to affect behaviorhas led tax theorists to search for optimal taxationsystems.

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MEASURING EXCESS BURDENS

FIGURE 17.7 The Excess Burden of a Distorting Excise Tax

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MEASURING EXCESS BURDENS

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

EXCESS BURDENS AND THE DEGREE OF

DISTORTION

FIGURE 17.8 The Size of the ExcessBurden of a DistortingExcise Tax Depends

on the Elasticity ofDemand

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ability-to-pay principle

average tax rate

benefits-received

principle

excess burden

corporations

estate

estate taxmarginal tax rate

principle of neutrality

REVIEW TERMS AND CONCEPTS

principle of second best

progressive tax

proportional tax

regressive tax

sources side/uses side

tax base

tax incidence

tax rate structuretax shifting

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Case Econ08 Ppt 17