Chapter 18: Introduction to Taxation

This lecture discusses a few institutional and theoretical issues for understanding tax policy. Overview of the types of taxation that

exist in the U.S. at different governmental levels.

Federal income tax. Structure of the income tax.

Figure 1 The federal government relies heavily on the individual income tax

and the payroll tax.State and local governments rely more heavily on sales taxes and

property taxes.

Figure 2

Other countries are more dependent on consumption taxes

than the United States.

Figure 3

Marginal tax rates rise with taxable income, with a current

maximum rate of 35%.

Be clear: even a taxpayers with TI of $400,000 pays10% on her first $14,300, 15% on the next $43,800, etc.

A Set of Important Taxation Concepts:

Measuring the fairness of tax systems

A marginal tax rate is the percentage that is paid in taxes on the next dollar earned.

An average tax rate is the percentage of total income is that is paid in taxes.

Most think a progressive tax system is fairest, in that it respects the ability to pay. A progressive tax system is one in which effective average

tax rates rise with income. A proportional tax system is one in which effective average

rates do not change with income, so that everyone pays the same proportion of their income in taxes.

A regressive tax system is one in which effective average tax rates fall with income.

Measuring the fairness of tax systems

Effective versus statutory rates

Another important distinction is between statutory and effective tax rates.

Statutory tax rates are tax rates laid out in the legal tax schedule.

Effective tax rates are tax rates an individual actually pays. The two diverge because

There are many exemptions and deductions from taxable income, which reduces the tax base.

As we will discuss next chapter, the burden of some taxes can be shifted.

Measuring the fairness of tax systems

Vertical and horizontal equity

Two distributional goals are frequently cited in measuring tax fairness.

Vertical equity is the principle that groups with more resources should pay higher taxes than groups with fewer resources. Could be motivated by utilitarian SWF, that calls for

redistribution. Horizontal equity is the principle that similar

individuals who make different economic choices should be treated similarly by the tax system. In reality, horizontal inequities are hard to define,

because the person endogenously made a choice to earn more or less.

Defining the income tax base: The Haig-Simons comprehensive income

definition The Haig-Simons comprehensive income definition

defines taxable resources as the change in an individual’s power to consume during the year.

It is best viewed as a measure of ability to pay – regardless of the actual choices in terms of consumption and savings.

In reality, the U.S. tax system deviates from this definition in many ways, for example, the exclusion of employer-provided health insurance. In practice it is very difficult to implement the Haig-Simons

income concept. Problems include Adjusting for an individual’s ability to pay (property and casualty losses,

medical expenses, state and local taxes); the costs of earning income; and difficult to value items (imputed rent on owner-occupied housing).

Externality/Public goods rationales for deviating from

Haig-Simons: Tax expenditures Tax expenditures are government revenue

losses attributable to tax law provisions that allow special exclusions, exemptions, or deductions from gross income, or that provide a special credit, preferential tax rate or deferral of liability.

The government measures how much tax revenue is lost by excluding health insurance from taxable compensation, or allowing deductibility of charitable contributions. Overall, in 2005, the government is projected to lose

$740 billion through all tax expenditures, the largest of which is the exclusion of employer-provided health insurance.

Tax deductions vs. tax credits Tax credits are more equitable than

deductions. The value of deductions (such as for home

mortgage interest or charitable contributions) rises with a person’s marginal tax rate, making them regressive.

Credits are equally available for all incomes, so they are progressive.

In reality, a tax credit may not be very progressive if those with low tax liabilities cannot have the excess of the credit refunded. A tax credit is refundable if it is available to

individuals even if they pay few or no taxes.

THE APPROPRIATE UNIT OF TAXATION

The problem of the “marriage tax” Choosing the appropriate unit of

taxation is a difficult task as well. Should the government impose taxes on family income or individual income?

It is not possible to design a tax system that achieves the following three goals: Progressivity. Across-Family Horizontal Equity (i.e., uses

the family as the unit of taxation). Across-Marriage Horizontal Equity (e.g.,

marriage neutrality).

The appropriate unit of taxation

Marriage taxes in practice Why the concern about marriage taxes?

Horizontal equity. The tax might discourage marriage. The high marginal tax rate on the secondary earner.

This last problem could be solved with a secondary earner deduction.

There is no empirical evidence that the “marriage penalty” does discourage marriage. But people might still be concerned about the

“optics” of the tax system providing a financial incentive for some not to marry.

The appropriate unit of taxation

Marriage taxes in practice The U.S. is unusual in that it has a tax

system based on family income. 19 OECD countries tax husbands and wives

individually. 5 OECD countries offer marriage subsidies

through family taxation with income splitting – which lowers the tax burden with a progressive tax schedule.

Only 2 other OECD nations have pure family taxation system similar to the U.S. Ireland and Norway…