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Chapter 12

Chapter 12. The Design of the Tax System. Objectives. 1.) Learn how the various governments in our economy raise and spend money. 2.) Understand the efficiency cost of taxation. 3.) Learn the criteria for evaluating the equity of a tax system.

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Chapter 12

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  1. Chapter 12 The Design of the Tax System

  2. Objectives 1.) Learn how the various governments in our economy raise and spend money. 2.) Understand the efficiency cost of taxation. 3.) Learn the criteria for evaluating the equityof a tax system. 4.) Recognize that understanding tax incidenceis important for evaluating tax issues 5.) Understand some of the tradeoffs between equity and efficiency in a tax system.

  3. “In this world nothing is certain but death and taxes.”(Benjamin Franklin) Taxes paid in 1789 accounted for 5% of personal income 100 80 60 40 20 0 1789

  4. “In this world nothing is certain but death and taxes.”(Benjamin Franklin) 100 Today, taxes account for about 35 % of personal income! 80 60 40 20 0 1789 Today

  5. Government Revenue as a Percentage of GDP

  6. The Tax System • When the government addresses the problem of externalities, provides public goods, or regulates the use of common resources, it can raise economic well-being. • For the government to perform these and its other many functions, it needs to raise revenue.

  7. The Tax System • Most people agree that taxes should impose as small a cost on society as possible, i.e... … the tax system should be efficient and equitable.

  8. A Financial Overview of the U.S. Government • Where does the government get its income from? • What does the government spend its income on? • Who contributes the most to the U.S. Government in the form of taxes? • What does the government spend most of it’s income on?

  9. The U.S. Economy may be divided into two major sectors: • The Private Sector • About two-thirds of all economic activity in the U.S. takes place within the private sector. • The Public Sector • About one-third of all economic activity in the U.S. involves the government sector.

  10. The Government Sector: Federal, State and Local • The Federal Government collects about two-thirds of the taxes in our economy. (Table 12-1) • Individual Income Taxes 48% • Social Insurance Taxes 34% • Corporate Income Taxes 10% • Excise Taxes 4% • Other 4%

  11. Receipts of the Federal Government Personal Tax Social Insurance 34% 10% 4% Tax 4% Corporate Tax 48% Excise Tax Other

  12. Individual Income Taxes... The largest source of government revenue • Tax Liabilityis how much taxes a family owes and is based upon total income. • Marginal Tax Rateis the tax rate applied to each dollar of income. (Table 12-2) • Higher-income families pay a larger percentage of their income in taxes.

  13. The Federal Income Tax Rates: 1999 On Taxable Income.... The Tax rate is .... Up to $25,750 From $25,750 - $62,450 From $62,450 - $130,250 From $130,250-283,150 Over $283,150 15.0% 28.0% 31.0% 36.0% 39.6%

  14. Federal Government Spending • Spending of government revenues (taxes) includes transfer payments and the purchase of public goods and services. (Table 12-3) • A Transfer Payment is a government payment not made in exchange for a good or a service. • Transfer payments account for the largest expenses of the government.

  15. The Federal Government and Taxes Payroll Taxes:tax on the wages that a firm pays its workers. Social Insurance Taxes:revenue from these taxes is earmarked to pay for Social Security and Medicare. Excise Taxes:taxes on specific goods like gasoline, cigarettes, and alcoholic beverages.

  16. Spending of the Federal Government Expense Category: Social Security National Defense Income Security Net Interest Medicare Health Other

  17. Social Security Defense Net Interest Income Security Medicare Health Other Spending of the Federal Government 13% 12% 8% 14% 14% 23% 16%

  18. Amount Amountper Percent of Category (billions) Person Spending Social security $ 393 $1,445 23% National defense 277 1,018 16 Net interest 243 893 14 Incomesecurity 227 837 13 Medicare 205 754 12 Health 143 526 8 Other 239 879 14 Total $1,727 $6,350 100% Federal Government Spending: 1999

  19. Financial Conditions of the Federal Budget • Budget Deficit • Situation where the expenses of the budget are greater than the revenuesfor a given period of time. • Government finances the deficit by borrowing from the public • Budget Surplus • Situation where the revenues are greater than the expenses for a given period of time.

  20. Expenses Education Public Welfare Highways Other Receipts Sales Taxes Property Taxes Individual Income Taxes Corporate Income Taxes Federal Government Other State and Local Governments: Collect about one-third of taxes paid

  21. Receipts of State and Local Governments: 1992 Tax Amount (Billions) Amount Per Person Percent of Receipts Sales taxes Property taxes Individual income tax Corporate income taxes From Federal government Other Total $249 $209 $147 $ 32 $235 $351 $1223 $940 $789 $554 $ 121 $887 $1,324 $4,615 20% 17% 12% 3% 19% 29% 100%

  22. Spending of State and Local Governments: 1992 Category Amount (Billions) Amount Per Person Percent of Spending Education Public welfare Highways Other Total $399 $197 $ 79 $518 $1,193 $1,506 $ 743 $ 298 $1,955 $4,502 33% 17% 7% 43% 100%

  23. Quick Quiz! • What are the two most important sources of tax revenue for the federal government? • What are the two most important sources for state and local governments?

  24. Taxes and Efficiency • The aim of a tax system is to raise revenue for the government. Two objectives of designing a tax system: Efficiency Equity • A tax system is more efficient if it can raise the same amount of revenue at a smaller cost to the taxpayers.

  25. Related Costs of Taxes to Taxpayers • The costs of taxes to taxpayers: • The tax payment itself • Transfer of money from taxpayer to government. • Deadweight losses • Administrative burdens

  26. Deadweight Loss of Taxation (Chapter 8) • When a tax is levied on buyers, the demand curve shifts downward by the size of the tax... • When a tax is levied on sellers, the supply curve shifts upward by that amount... The losses to buyers and sellers exceed the tax revenue, leading to a Deadweight Loss.

  27. Tax Costs: Administrative Burdens • Includes not only the time spent in early April filling out forms. • Payment for tax experts in assisting the taxpayer in filing tax returns. • The cost to the taxpayer is greater than the actual tax payment made.

  28. The Goal of an Efficient Tax System An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

  29. Alternative Tax Rates Efficiency and equity of income taxes leads to three notions of tax rates: • Average Tax Rate... ...is total taxes paid divided by total income • Marginal Tax Rate... ...is the extra taxes paid on an additional dollar of income. • Lump-Sum Tax Rate... ...everyone owes the same amount of tax.

  30. Quick Quiz! • What is meant by the efficiency of a tax system? • What can make a tax system inefficient?

  31. Taxes and Equity • How should the burden of taxes be divided among the population? • How do we evaluate whether a tax system is fair? Benefits Principle Ability-to-pay Principle

  32. Taxes and Equity: Benefit Principle “People should pay taxes based on the benefits they receive from government services.” • Example: • Gasoline Tax: These tax revenues are used to finance our highway system. • People who drive the most, use the road the most, also pay the most toward their upkeep.

  33. Taxes and Equity: Ability-to-pay Principle “Taxes should be assigned based on an individual’s ability to shoulder the tax burden.” • Two notions of equity: • Vertical Equity • Horizontal Equity

  34. Vertical Equity “Differently situated individuals should be treated differently.” • Example: People with higher incomes should pay more than people with lower incomes. • Alternative Tax Systems: • Proportional • Regressive • Progressive

  35. A proportional tax is one in which the average effective tax rate remains unchanged, whatever the size of the taxpayer’s income • A progressive tax is one in which the average effective tax rate rises as income rises • A regressive tax is one in which the average effective tax rate declines as income rises

  36. Three Tax Systems Proportional Tax Income Amount of Tax Percent of Income $ 50,000 $100,000 $200,000 $12,500 25,000 50,000 25% 25% 25%

  37. Three Tax Systems Progressive Tax Income Amount of Tax Percent of Income $ 50,000 $100,000 $200,000 $10,000 25,000 60,000 20% 25% 30%

  38. Three Tax Systems Regressive Tax Income Amount of Tax Percent of Income $ 50,000 $100,000 $200,000 $15,000 25,000 40,000 30% 25% 20%

  39. The Burden of Federal Taxes Quintile Taxes Minus Transfers as a Percent of Income Average Income Percent of all Income Percent of all Taxes Taxes as a Percent of Income Lowest Second Middle Fourth Highest $ 7,386 $18,380 $29,849 $43,363 $99,197 3.7% 9.2% 14.2% 21.7% 51.4% 1.4% .4% 12.5% 21.2% 58.2% 8.9% 15.8% 19.5% 22.1% 25.5% -29.8% -2.1% 9.5% 16.2% 23.1%

  40. Horizontal Equity “Would require people of like incomes to pay the same amount of tax.” • Example: Two different families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.

  41. The “Marriage Tax” • Marriage affects the tax liability of a couple in that tax law treats a married couple as a single taxpayer. • When a couple gets married, they stop paying taxes as individuals and start paying taxes as a family. • If each has a similar income, their total tax liability rises when they get married.

  42. Taxes and Equity • The difficult part of tax policy is to balance the sometimes conflicting nature of the efficiency and equity goals. • The study of who bears the actual burden of taxes is central to evaluating tax equity. This is called Tax Incidence.

  43. Flypaper Theory of Tax Incidence According to theflypaper theory,the burden of a tax, like a fly on flypaper, sticks wherever it first lands.

  44. The Flat Tax • First proposed by economist Robert Hall in the 1980s. • Proposed as an alternative to the current tax system. • A single, low tax rate would apply to all income in the economy.

  45. Proposed Benefits of theFlat Tax • The flat tax would eliminate many of the deductions allowed under the current income tax thereby broadening the tax base and reducing marginal tax rates for most people. • Because the flat tax is simple, the administrative burden of taxation would be greatly reduced.

  46. Proposed Benefits of theFlat Tax • Because all taxpayers would be faced with the same marginal tax rate, the tax could be collected at the source of income. • The flat tax would replace both the personal and corporate income taxes and would eliminate the current double taxation of corporate profits. • The flat tax could increase the incentive to save.

  47. Quick Quiz! • Explain the benefits principle and the ability-to-pay principle. • What are vertical equity and horizontal equity? • Why is studying tax incidence important in determining equity in a tax system?

  48. Conclusion: The tradeoff between equity and efficiency • Equity and efficiency are the two most important goals of the tax system. But often these goals conflict. • Many proposed changes in the tax laws increase efficiency while reducing equity, or increase equity while reducing efficiency.

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