R. GLENN HUBBARD

1. R. GLENNHUBBARD ANTHONY PATRICKO’BRIEN Economics FOURTH EDITION

2. 18 Public Choice, Taxes, and the Distribution of Income CHAPTER Chapter Outline and Learning Objectives

3. Should the Government Use the Tax System to Reduce Inequality? • The United States has the most unequal distribution of income of any high-income country, an inequality that has been increasing in recent years. • President Obama argued that the tax cut on dividends, as well as other tax cuts enacted during the early 2000s, had increased the burden on individuals with low and moderate incomes, while reducing the burden on the wealthy and on corporations. • Republican contender Mitt Romney argued that increasing income inequality had not been caused by changes in taxes and that increasing taxes on individuals with high incomes was likely to reduce economic efficiency while having little effect on inequality. • AN INSIDE LOOK AT POLICY on page 606 describes the arguments for and against using a tax on soda to reduce budget deficits.

4. Economics in Your Life How Much Tax Should You Pay? Government is ever present in your life. Just today, you likely drove on roads that the government paid to build and maintain. You may attend a public college or university, paid for, at least in part, by government. Where does a government get its money? By taxing citizens. Think of the different taxes you pay, and see if you can answer these questions by the end of the chapter: Do you think you pay more than, less than, or just about your fair share in taxes? How do you determine what your fair share is?

5. The government itself must sometimes supply goods— known as public goods—that private firms will not supply. Public choicemodel A model that applies economic analysis to government decision making.

6. Public Choice 18.1 LEARNING OBJECTIVE Describe the public choice model and explain how it is used to analyze government decision making.

7. How Do We Know the Public Interest? Models of Voting • The Voting Paradox Suppose that there is $1 billion available in the budget, and Congress must choose whether to spend it on only one of three alternatives: • (1) Research on breast cancer • (2) Subsidies for mass transit • Increased border security • Suppose for simplicity that there are only three voters with the following preferences and results: Table 18.1 The Voting Paradox

8. Voting paradox The failure of majority voting to always result in consistent choices. Arrow impossibility theorem A mathematical theorem that holds that no system of voting can be devised that will consistently represent the underlying preferences of voters. Median voter theorem The proposition that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle.

9. The Median Voter Theorem Figure 18.1 The median voter theorem states that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle. In this case, David is in the political middle because two voters want to spend more on breast cancer research than he does and two voters want to spend less. In any vote between a proposal to spend $2 billion and a proposal to spend a different amount, a proposal to spend $2 billion will win.

10. Government Failure? Rent seeking Attempts by individuals and firms to use government action to make themselves better off at the expense of others. Policymakers may accept campaign contributions from rent-seeking firms and may be willing to introduce special interest legislation in their behalf. Logrolling and Rational Ignorance Logrolling refers to the situation where a member of Congress votes to approve a bill in exchange for favorable votes from other members on other bills. Because becoming informed on an issue may require time and effort and the economic payoff is often low, some economists argue that many voters are rationally ignorant of the effect of rent-seeking legislation.

11. Regulatory Capture One way in which the government intervenes in the economy is by establishing a regulatory agency or commission that is given authority over a particular industry or type of product. However, because the firms being regulated are significantly affected by the regulatory agency’s actions, the firms have an incentive to try to influence those actions. In extreme cases, this influence may lead the agency to make decisions that are in the best interests of the firms being regulated, even if these actions are not in the public interest. In that case, the agency has been subject to regulatory capture by the industry being regulated. Public choice analysis indicates that government failure can also occur.

12. Is Government Regulation Necessary? The public choice model raises important questions about the effect of government regulation on economic efficiency. Although government regulation can clearly provide important benefits to consumers, we need to take into account the costs of regulations. Recent estimates indicate that the costs of federal regulations may be several thousand dollars per taxpayer. Economics can help policymakers devise regulations that provide benefits to consumers that exceed their costs.

13. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy.

14. These are the most widely used taxes that the government primarily relies on to raise the revenue it needs: • Individual income taxes. The federal government, most state governments, and some local governments tax the wages, salaries, and other income of households and the profits of firms. • Social insurance taxes. The federal government taxes wages and salaries to raise revenue for the Social Security and Medicare systems. Social Security makes payments to retired workers and to disabled individuals. Medicare helps pay the medical expenses of people over age 65. • Sales taxes. Most state and local governments tax retail sales of most products. • Property taxes. Most local governments tax homes, offices, factories, and the land they are built on. • Excise taxes. The federal government and some state governments levy excise taxes on specific goods, such as gasoline, cigarettes, and beer.

15. An Overview of the U.S. Tax System Figure 18.2a Federal, State, and Local Sources of Revenue, 2010 Social insurance taxes are the most important source of revenue for the federal government, and individual income taxes are the second most important source.

16. An Overview of the U.S. Tax System Figure 18.2b Federal, State, and Local Sources of Revenue, 2010 State and local governments receive large transfers from the federal government, in part to help pay for federally mandated programs. Many local governments depend on property taxes to raise most of their tax revenue.

17. The federal government requires state and local governments to carry out programs often called federal mandates, including the Medicaid program, which provides health care to poor people, and the Temporary Assistance for Needy Families (TANF) program, which provides financial assistance to poor families. Progressive and Regressive Taxes Regressive tax A tax for which people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. Progressive tax A tax for which people with lower incomes pay a lower percentage of their income in tax than do people with higher incomes. A tax is proportional if people with lower incomes pay the same percentage of their income in tax as do people with higher incomes.

18. The federal income tax is an example of a progressive tax. To see why, we must first consider the important distinction between a tax rate and a tax bracket. A tax rate is the percentage of income paid in taxes. A tax bracket refers to the income range within which a tax rate applies. Table 18.2 Federal Income Tax Brackets and Tax Rates for Single Taxpayers, 2011

19. We can use Table 18.2 to calculate what Matt, a single taxpayer with an income of $100,000, pays in federal income tax. This example is somewhat simplified because we are ignoring the exemptions and deductions that taxpayers can use to reduce the amount of income subject to tax. Taxpayers are allowed to exclude from taxation a certain amount of income, called the personal exemption, that represents very basic living expenses. Table 18.3 Federal Income Tax Paid on Taxable Income of $100,000

20. MakingtheConnection Which Groups Pay the Most in Federal Taxes? We can conclude that the federal taxes are progressive. Whether the federal tax system should be made more or less progressive remains a source of political debate. • Your Turn:Test your understanding by doing related problem 2.9 at the end of this chapter. MyEconLab

21. Marginal and Average Income Tax Rates Marginal tax rate The fraction of each additional dollar of income that must be paid in taxes. Average tax rate Total tax paid divided by total income. In Table 18.3, Matt had a marginal tax rate of 28 percent because that is the rate he paid on the last dollar of his income. But his average tax rate was: His average tax rate was lower than his marginal tax rate because the first $83,600 of his income was taxed at rates below his marginal rate of 28 percent.

22. The Corporate Income Tax The federal government taxes the profits earned by corporations under the corporate income tax. Like the individual income tax, the corporate income tax is progressive, with the lowest tax rate being 15 percent and the highest being 35 percent. Some economists argue that if the purpose of the corporate income tax is to tax the owners of corporations, it would be better to do so directly by taxing the owners’ incomes rather than by taxing the owners indirectly through the corporate income tax.

23. International Comparison of Corporate Income Taxes In the past 10 years, several countries have cut corporate income taxes to increase investment spending and growth. Table 18.4 Corporate Income Tax Rates around the World Note: The tax rates given include taxes at all levels of government.

24. Evaluating Taxes • In selecting which taxes to use, governments take into account the following goals and principles: • The goal of economic efficiency • The ability-to-pay principle • The horizontal-equity principle • The benefits-received principle • The goal of attaining social objectives The Goal of Economic Efficiency Excess burden A measure of the efficiency loss to the economy that results from a tax having reduced the quantity of a good produced; also known as the deadweight loss. A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.

25. Figure 18.3 The Efficiency Loss from a Sales Tax A sales tax increases the cost of supplying a good, which causes the supply curve to shift up, from S1 to S2. Without the tax, the equilibrium price of the good is P1, and the equilibrium quantity is Q1. After the tax is imposed, the equilibrium price rises to P2, and the equilibrium quantity falls to Q2. After paying the tax, producers receive P3. The government receives tax revenue equal to the green-shaded rectangle. Some consumer surplus and some producer surplus become tax revenue for the government, and some become deadweight loss, shown by the yellow-shaded triangle. The deadweight loss is the excess burden of the tax.

26. MakingtheConnection Should the United States Shift from an Income Tax to a Consumption Tax? Many economists argue that a taxpayer’s well-being is better measured by his or her consumption (how much he or she spends) than by his or her income (how much he or she earns). Because the income tax taxes interest and other returns to saving, it taxes futureconsumption—which is what current saving is for—more heavily than present consumption. Some economists oppose a shift from an income tax to a consumption tax because they believe a consumption tax will be more regressive than an income tax, arguing that people with very low incomes are able to save little or nothing and so would not be able to benefit from the increased incentives for saving that exist under a consumption tax. • Your Turn:Test your understanding by doing related problem 2.10 at the end of this chapter. MyEconLab

27. The Ability-to-Pay Principle The ability-to-pay principle holds that when the government raises revenue through taxes, it is fair to expect a greater share of the tax burden to be borne by people who have a greater ability to pay. Usually this principle means raising more taxes from people with high incomes than from people with low incomes, which is sometimes referred to as vertical equity. The Horizontal-Equity Principle The horizontal-equity principle states that people in the same economic situation should be treated equally. Although this principle seems desirable, it is not easy to use in practice because it is sometimes difficult to determine whether two people are in the same economic situation. The Benefits-Received Principle According to the benefits-received principle, people who receive the benefits from a government program should pay the taxes that support the program. The Goal of Attaining Social Objectives Taxes intended to discourage certain activities are sometimes referred to as “sin taxes.”

28. Tax Incidence Revisited: The Effect of Price Elasticity 18.3 LEARNING OBJECTIVE Understand the effect of price elasticity on tax incidence.

29. Tax incidence The actual division of the burden of a tax between buyers and sellers in a market. When the demand for a product is less elastic than the supply, consumers pay the majority of the tax on the product. When demand for a product is more elastic than the supply, firms pay the majority of the tax on the product. Don’t Let This Happen to You Remember Not to Confuse Who Pays a Tax with Who Bears the Burden of the Tax The burden from imposing a sales tax is borne partly by consumers and partly by sellers. • Your Turn:Test your understanding by doing related problem 3.9 at the end of this chapter. MyEconLab

30. Figure 18.4 The Effect of Elasticity on Tax Incidence When demand is more elastic than supply, consumers bear less of the burden of a tax. When supply is more elastic than demand, firms bear less of the burden of a tax. D1 is inelastic between point Aand point B, and D2 is elastic between point A and point C. With demand curve D1, a 10-cents-per-gallon tax raises the equilibrium price from $4.00 (point A) to $4.08 (point B), so consumers pay 8 cents of the tax, and firms pay 2 cents. With D2, a 10-cents-per-gallon tax on gasoline raises the equilibrium price only from $4.00 (point A) to $4.02 (point C), so consumers pay 2 cents of the tax. Because in this case producers receive $3.92 per gallon after paying the tax, their share of the tax is 8 cents per gallon.

31. MakingtheConnection Do Corporations Really Bear the Burden of the Federal Corporate Income Tax? Most economists agree that some of the burden of the corporate income tax is passed on to consumers in the form of higher prices. There is also some agreement that, because the corporate income tax reduces the rates of return received by investors, it results in less investment in corporations. This reduced investment means workers have less capital available to them. Economists have long argued for reform of the system of double taxing income earned on investments that corporations finance by issuing stock. Will this consumer be paying part of Apple’s corporate income tax when she buys an iPad or an iPhone? • Your Turn:Test your understanding by doing related problem 3.7 at the end of this chapter. MyEconLab

32. Solved Problem 18.3 The Effect of Price Elasticity on the Excess Burden of a Tax Explain whether you agree or disagree with the following statement: “For a given supply curve, the excess burden of a tax will be greater when demand is less elastic than when it is more elastic.” Illustrate your answer with a demand and supply graph. Solving the Problem Step 1: Review the chapter material. Step 2: Draw a graph to illustrate the relationship between tax incidence and excess burden. Figure 18.4 is a good example of the type of graph to draw. Be sure to indicate the areas representing excess burden. Step 3: Use the graph to evaluate the statement. As we have seen, for a given supply curve, when demand is more elastic, as with demand curve D2, the fall in equilibrium quantity is greater than when demand is less elastic, as with demand curve D1.

33. Solved Problem 18.3 The Effect of Price Elasticity on the Excess Burden of a Tax Explain whether you agree or disagree with the following statement: “For a given supply curve, the excess burden of a tax will be greater when demand is less elastic than when it is more elastic.” Illustrate your answer with a demand and supply graph. The deadweight loss when demandis less elastic is shown by the area of the triangle made up of A, B, and C. The deadweight loss when demand is more elastic is shown by the area of the triangle made up of B, C, D, and E. The area of the deadweight loss is clearly larger when demand is more elastic than when it is less elastic. Recall that the excess burden of a tax is measured by the deadweight loss. Therefore, when demand is less elastic, the excess burden of a tax is smaller than when demand is more elastic. We can conclude that the statement is incorrect. • Your Turn:For more practice, do related problems 3.5 and 3.6 at the end of this chapter. MyEconLab

34. Income Distribution and Poverty 18.4 LEARNING OBJECTIVE Discuss the distribution of income in the United States and understand the extent of income mobility.

35. Measuring the Income Distribution and Poverty The Distribution of Household Income in the United States, 2010 Table 18.5

36. Table 18.6 How Has the Distribution of Income Changed over Time?

37. The Poverty Rate in the United States Figure 18.5 Poverty in the United States, 1960–2010 The poverty rate in the United States declined from 22 percent of the population in 1960 to 11 percent in 1973. Over the past 30 years, the poverty rate has fluctuated between 11 percent and 15 percent of the population.

38. Poverty line A level of annual income equal to three times the amount of money necessary to purchase the minimum quantity of food required for adequate nutrition. Poverty rate The percentage of the population that is poor according to the federal government’s definition. Table 18.7 Poverty Rates Vary across Groups, 2010

39. Explaining Income Inequality The marginal productivity theory of income distribution explains that in equilibrium, each factor of production receives a payment equal to its marginal revenue product. For most people, the most important factor of production they own is their labor. Therefore, the income they earn depends on how productive they are and on the prices of the goods and services their labor helps produce. Many people own other factors of production, such as capital in the form of stock in corporations or shares in mutual funds that buy the stock of corporations. Ownership of capital is not equally distributed, and income earned from capital is more unequally distributed than income earned from labor. Most economists believe that changes in tax laws have not played a major role in recent changes in income inequality. Finally, earning an income is subject to good and bad luck.

40. Figure 18.6 The Top Marginal Income Tax Rate in the United States, 1950–2011 The top marginal tax rate has varied dramatically since 1950, while the distribution of income has changed much less.

41. Showing the Income Distribution with a Lorenz Curve Lorenz curve A curve that shows the distribution of income by arraying incomes from lowest to highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis. The Gini coefficient is equal to the area between the line of perfect income equality and the Lorenz curve—area A—divided by the whole area below the line of perfect equality—area A plus area B. Or: If the income distribution were completely equal, the Lorenz curve would be the same as the line of perfect income equality and area A and the Gini coefficient would be zero. If the income distribution were completely unequal, area B would be zero, and the Gini coefficient would equal 1. Therefore, the greater the degree of income inequality, the greater the value of the Gini coefficient.

42. Figure 18.7 The Lorenz Curve and Gini Coefficient In panel (a), the Lorenz curves show the distribution of income by arraying incomes from the lowest to the highest on the horizontal axis and indicating the cumulative fraction of income by each fraction of households on the vertical axis. The straight line represents perfect income equality. Because the Lorenz curve for 1980 is closer to the line of perfect equality than the Lorenz curve for 2011, we know that income was more equally distributed in 1980 than in 2011. In panel (b), we show the Gini coefficient, which is equal to the area between the line of perfect income equality and the Lorenz curve—area A—divided by the whole area below the line of perfect equality—area A plus area B. The closer the Gini coefficient is to 1, the more unequal the income distribution.

43. Problems in Measuring Poverty and the Distribution of Income • The measures of poverty and the distribution of income that we have discussed to this point may be misleading for two reasons: • These measures are snapshots in time that do not take into account income mobility, which refers to changes in an individual’s or a family’s income over time. • They ignore the effects of government programs meant to reduce poverty.

44. Income Mobility in the United States Figure 18.8 Income Mobility in the United States, 2004–2007 Each column represents one quintile—or 20 percent—of households, arranged by their incomes in 2004. Reading up the column, we can see where the households that started in that quintile in 2004 ended up in 2007. Only 69 percent of thehouseholds that were in thebottom quintile of income in2004 were still in the bottomquintile in 2007. Only 68 percent of thehouseholds that were in thetop quintile of income in 2004 were still in the top quintile in 2007. Note: Incomes are in 2007 dollars to correct for the effects of inflation.

45. Solved Problem18.4 Are Many Individuals Stuck in Poverty? Evaluate the following statement: Government statistics indicate that 14 percent of the population is below the poverty line. The fraction of the population in poverty has never dropped below 10 percent. Therefore, more than 10 percent of the population must cope with very low incomes year after year. Solving the Problem Step 1: Review the chapter material. Step 2: Use the discussion in this chapter to evaluate the statement. Although it is true that the poverty rate in the United States is never below 10 percent, it is not the same 10 percent of the population that is in poverty each year. This chapter discusses one U.S. Census Bureau study that showed that only about 69 percent of the people who were in the lowest 20 percent of the income distribution in 2004 were still in the lowest 20 percent in 2007. Another census study of the years from 2004 to 2006 showed that only 2.8 percent of the U.S. population was poor every month during those three years. Poverty remains a problem in the United States, but fortunately, the number of people who remain in poverty for many years is much smaller than the number who are in poverty during any one year. • Your Turn:For more practice, do related problem 4.7 at the end of this chapter. MyEconLab

46. The Effect of Taxes and Transfers We have seen that at the federal level, taxes are progressive, meaning that people with high incomes pay a larger share of their incomes in taxes than do people with low incomes. Individuals with low incomes also receive noncash benefits, such as food stamps, free school lunches, and rent subsidies. The government’s Supplemental Nutrition Assistance Program, more commonly referred to as the food stamp program, has been a particularly important noncash benefit. Because individuals with low incomes are more likely to receive transfer payments and other benefits from the government than are individuals with high incomes, the distribution of income is more equal if we take these benefits into account.

47. Income Distribution and Poverty around the World Table 18.8 Income Inequality around the World

48. Poverty Has Declined Dramatically around the World Since 1970 Table 18.9 Recent economic research demonstrates a positive relationship between economic growth and the incomes of lower-income people.

49. Economics in Your Life How Much Tax Should You Pay? At the beginning of the chapter, we asked you to think about where government gets the money to provide goods and services and about whether you pay your fair share of taxes. After reading this chapter, you should see that you pay taxes in many different forms. When you work, you pay taxes on your income, both for individual income taxes and social insurance taxes. When you buy gasoline, you pay an excise tax, which, in part, pays for highways. When you buy goods at a local store, you pay state and local sales taxes, which the government uses to fund education and other services. Whether you are paying your fair share of taxes is a normative question. The U.S. tax system is progressive, so higher-income individuals pay more in taxes than do lower-income individuals. In fact, people in the lowest 40 percent of the income distribution pay no federal income taxes at all. You may find that you will not pay much in federal income taxes in your first job after college. But as your income grows during your career, so will the percentage of your income you pay in taxes.

50. AN INSIDE LOOK AT POLICY Should a Tax on Soda Be Used to Reduce Budget Deficits? A tax decreases the supply of soda. The amount of revenue raised by the tax depends on the elasticity of the demand and the elasticity of supply of the drinks.