The Design of A Tax System

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2009 South-Western, a part of Cengage Learning, all rights reserved

C H A P T E

R

The Design of the TaxThe Design of the Tax

SystemSystem

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THE DESIGN OF THE TAX SYSTEM 2

Introduction

One of the Ten Principles from Chapter 1:

A government can sometimes

improve market outcomes.

Providing public goods

Regulating use of common resources

Remedying the effects of externalities

To perform its many functions, the government

raises revenue through taxation


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THE DESIGN OF THE TAX SYSTEM !

Introduction

"essons about taxes from earlier chapters:

# tax on a good reduces the mar$et %uantity

of that good

The burden of a tax is shared bet&een buyers

and sellers depending on the price elasticitiesof demand and supply

# tax causes a dead&eight loss


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THE DESIGN OF THE TAX SYSTEM '

TotalGovernme

ntRevenue(% of GDP)

(&eden )*+

rance ')

-nited .ingdom !/0ermany !

Canada !

Russia !2

ra3il !*

-nited (tates 24

5apan 2/

6exico 2*Chile 17

China 1)

8ndia 1'


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THE DESIGN OF THE TAX SYSTEM )

Taxes and Eciency

One tax system is more efficient than another

if it raises the same amount of revenue at asmaller cost to taxpayers

The costs to taxpayers include:

the tax payment itself

dead&eight losses

administrative burden


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THE DESIGN OF THE TAX SYSTEM

Dead!eight "osses

One of the Ten Principles:

People respond to incentives.

Recall from Chapter 4:

Taxes distort incentives, cause people to allocate

resources according to tax incentives rather thantrue costs and benefits

The result: a dead&eight loss

The fall in taxpayers9 &ellbeing exceeds therevenue the govt collects


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Income vs# $onsumtion Tax

The income tax reduces the incentive to save:

8f income tax rate ; 2)+,

4+ interest rate ; + aftertax interest rate

The lost income compounds over time

(ome economists advocate taxing consumption

instead of income


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&dministrative 'urden 8ncludes the time and money people spend to

comply &ith tax la&s

=ncourages the expenditure of resources on

legal tax avoidance

e.g, hiring accountants to exploit >loopholes?to reduce one9s tax burden

8s a type of dead&eight loss

Could be reduced if the tax code &ere simplified

but &ould re%uire removing loopholes,

politically difficult


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arginal vs# &verage TaxRates

Average tax rate

total taxes paid divided by total income

measures the sacrifice a taxpayer ma$es

Marginal tax rate

the extra taxes paid on an additional dollar of

income

measures the incentive effects of taxes

on &or$ effort, saving, etc.


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THE DESIGN OF THE TAX SYSTEM 1*

6arginal tax rate#verage tax rate8ncome

*+1*+@'*,***

*+2*+@2*,***

# lump-sum taxis the same for every person

=xample: lumpsum tax ; @'***Aperson

"umSum Taxes


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# lumpsum tax is the most efficient tax:

Causes no deadweight loss

Boes not distort incentives

Minimal administati!e "uden

o need to hire accountants, $eep trac$ ofreceipts, et#

Det, perceived as unfair:

8n dollar terms, the poor pay as much as the rich Relative to income, the poor pay much more than

the rich

"umSum Taxes


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Taxes and E*uity

#nother goal of tax policy:

e%uity E distributing the burden of taxes >fairly?

#greeing on &hat is >fair? is much harder than

agreeing on &hat is >efficient?

Det, there are several principles people apply

to evaluate the e%uity of a tax system


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THE DESIGN OF THE TAX SYSTEM 1!

The 'ene+ts Princile

Benefits principle: the idea that people should

pay taxes based on the benefits they receivefrom govt services

Tries to ma$e public goods similar to private

goods E the more you use, the more you pay

=xample: 0asoline taxes

#mount of tax paid is related to ho& much a

person uses public roads


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THE DESIGN OF THE TAX SYSTEM 1'

The &,ilityToPay Princile

Ability-to-pay principle: the idea that taxes

should be levied on a person according to ho&&ell that person can shoulder the burden

(uggests that all taxpayers should ma$e an

>e%ual sacrifice?

Recogni3es that the magnitude of the sacrifice

depends not Fust on the tax payment, but on the

person9s income and other circumstances a @1*,*** tax bill is a bigger sacrifice for a

poor person than a rich person


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THE DESIGN OF THE TAX SYSTEM 1)

-ertical E*uity Vertical equity: the idea that taxpayers &ith a

greater ability to pay taxes should pay largeramounts


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Three Tax Systems Proportional tax:

Taxpayers pay the same fraction of income,regardless of income

Regressive tax:

Gighincome taxpayers pay a smaller fraction oftheir income than lo&income taxpayers

Progressive tax:

Gighincome taxpayers pay a larger fraction oftheir income than lo&income taxpayers


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THE DESIGN OF THE TAX SYSTEM 1/

2**,***

1**,***

@)*,***

+ of

incometax

+ of

incometax

+ of

incometaxincome

!**,***

2)2),***

2*+@1*,***

Progressive

2))*,***

2)2),***

2)+@12,)**

Proportional

2*'*,***

2)2),***

!*+@1),***

Regressive

Examles of the Three TaxSystems

. S / d l I T R


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.#S# /ederal Income Tax Rates01223

On taxable

incomeH

the tax rate

isH

* E @/,42) 1*+

/,42) E !1,4)* 1)+

!1,4)* E //,1** 2)+

//,1** E 1*,4)* 24+

1*,4)* E !'7,/** !!+

Over @!'7,/** !)+

The -( has a

progressiveincome tax


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4ori5ontal E*uity

Horizontal equity: the idea that taxpayers &ith

similar abilities to pay taxes should pay the sameamount

Problem: Bifficult to agree on &hat factors,

besides income, determine ability to pay


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The income tax rate is 2)+ The first @2*,*** ofincome is excluded from taxation Tax la& treats a

married couple as a single taxpayer

(am and Biane each earn @)*,***

i. 8f (am and Biane are living together unmarried,

&hat is their combined tax billI

ii. 8f (am and Biane are married, &hat is their taxbillI

A C T I V E L E A R N I N GA C T I V E L E A R N I N G 11

Taxes and arriage6 art 7Taxes and arriage6 art 7

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8f unmarried, (am and Biane each pay*2) x J@)*,*** E 2*,***K ; @/)**

Total taxes ; @1),*** ; 1)+ of their Foint

income

8f married, they pay

*2) x J@1**,*** E 2*,***K ; @2*,***

or 2*+ of their Foint income

The @)*** increase in the tax bill is called

the >marriage tax? or >marriage penalty?


&ns!ers&ns!ers

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The income tax rate is 2)+ or singles, the first@2*,*** of income is excluded from taxation

or married couples, the exclusion is @'*,***

Garry earns @* (ally earns @1**,***

i. 8f Garry and (ally are living together unmarried,&hat is their combined tax billI

ii. 8f Garry and (ally are married, &hat is their taxbillI


Taxes and arriage6 art 1Taxes and arriage6 art 1

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8f unmarried, Garry pays @* in taxes (ally pays*2) x J@1**,*** E 2*,***K ; @2*,***

Total taxes ; @2*,*** ; 2*+ of their Foint

income

8f married, they pay

*2) x J@1**,*** E '*,***K ; @1),***

or 1)+ of their Foint income

The @)*** decrease in the tax bill is called

the >marriage subsidy?


&ns!ers&ns!ers

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THE DESIGN OF THE TAX SYSTEM 2'

arriage Taxes and Su,sidies

8n current -( tax code,

couples &ith similar incomes are li$ely to pay amarriage tax

couples &ith very different incomes are li$ely to

receive a marriage subsidy 6any have advocated reforming the tax system

to be neutral &ith respect to marital statusH


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THE DESIGN OF THE TAX SYSTEM 2)

arriage Taxes and Su,sidies

The ideal tax system &ould have these properties:

T&o married couples &ith the same total income

pay the same tax

6arital status does not affect a couple9s tax bill

# personAfamily &ith no income pays no taxes

Gighincome taxpayers pay a higher fraction of

their incomes than lo&income taxpayers

Go&ever, designing a tax system &ith all four of

these properties is mathemati#all$ im%ossi"le


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Tax Incidence and Tax E*uity

Recall: The person &ho bears the burden is not

al&ays the person &ho gets the tax bill

=xample: # tax on fur coats

6ay appear to be vertically e%uitable

ut furs are a luxury &ith very elastic demand The tax shifts demand a&ay from furs, hurting

the people &ho produce furs J&ho probably are

not richK "esson:


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THE DESIGN OF THE TAX SYSTEM 2/

8ho Pays the $ororateIncome Tax9


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/lat Taxeslat tax: a tax system under &hich the marginal taxrate is the same for all taxpayers

Typically, income above a certain threshold is taxedat a constant rate

The higher the threshold, the more progressive

the tax Radically reduces administrative burden

ot popular &ith

people &ho benefit from the complexity of the

current system Jaccountants, lobbyistsK people &ho can9t imagine life &ithout their

favorite deductionAloophole

-sed in some centralAeastern =uropean countries


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The Design of A Tax System