Case Econ08 PPT 17

2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Prepared by:
Fernando & Yvonn Quijano
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 Outline
17
Public Finance:
Taxes: Basic Concepts
Tax Equity
What Is the Best Tax Base?
The Gift and Estate Tax

Tax Incidence: Who Pays?
The Incidence of Payroll Taxes
The Incidence of Corporate Profits
Taxes
The Overall Incidence of Taxes in the
United States: Empirical Evidence

Excess Burdens and the Principle
of Neutrality
How Do Excess Burdens Arise?
The Principle of Second Best

Measuring Excess Burdens
Excess 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 to
government, to do anything at all government must
first raise revenues. The primary vehicle that the
government uses to finance itself is taxation.

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tax base The measure or value upon which
a tax is levied.
TAXES: BASIC CONCEPTS
tax rate structure The percentage of a tax
base that must be paid in taxes25 percent
of income, for example.

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Taxes on Stocks versus Taxes on Flows
FIGURE 17.1 Taxes on Economic Flows

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TABLE 17.1 Federal Government Receipts 19602005 (billions of dollars)
Individual
Income Tax
Corporation
Income Tax
Social Insur.
Payroll Taxes
Excise
Taxes
Other
Receipts

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

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Proportional, Progressive, and Regressive
Taxes
proportional tax A tax whose burden is the
same 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, falls
as income increases.
TABLE 17.2 The Burden of a Hypothetical 5% Sales Tax Imposed on Three Households with
Different Incomes
HOUSEHOLD
SAVING
INCOME

RATE, %

SAVING

CONSUMPTION

5% TAX ON
CONSUMPTION
TAX
AS A %
OF
INCOME
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 paid
divided by total income.
marginal tax rate The tax rate paid on any
additional 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%
$14,601 59,400 15%
$59,401 119,950 25%
$119,951 182,800 28%
$182,801 326,450 33%
More than $326,450 35%
SINGLE TAXPAYERS
TAXABLE INCOME TAX RATE
$0 7,300 10%
$7,301 29,700 15%
$29,701 71,950 28%
$71,951 150,150 33%
$150,151 326,450 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 income $100,000
Personal exemption $3,200
Standard deduction $5,000
= Taxable income $91,800
Tax Calculation
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% = ($71,950 29,700) 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 =
$5,558
Total tax
$20,210
Average tax rate
20.2%
Marginal tax rate
28%

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How Much Does a Deduction Save You in
Taxes?
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 to
finance the purchase of a home, as well as other
items.

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TAX EQUITY
benefits-received principle A theory of
fairness holding that taxpayers should
contribute to government (in the form of
taxes) in proportion to the benefits that they
receive from public expenditures.
ability-to-pay principle A theory of
taxation holding that citizens should bear
tax burdens in line with their ability to pay
taxes.

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Horizontal and Vertical Equity
If we accept the idea that ability to pay should be
the basis for the distribution of tax burdens, two
principles follow.

First, the principle of horizontal equity holds that
those with equal ability to pay should bear equal
tax burdens.

Second, the principle of vertical equity holds that
those 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 are
income, consumption, and wealth.
Incometo be precise, economic incomeis
anything that enhances your ability to command
resources.
Economic Income = Consumption + Change in Net Worth
In economic terms, income is income, regardless of source and use.

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Consumption is the total value of things that a
household 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 pay
taxes 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 draw
out of the common pot, but rather on the basis of
your ability to draw from that pot.
Still others argue that the real power to command
resources comes not from any single years income
but from accumulated wealth.
No Simple Answer
There is ongoing debate in the United States about
whether it would be better to shift toward a more
comprehensive consumption tax.

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THE GIFT AND ESTATE TAX
estate The property that a person owns at
the time of his or her death.
estate tax A tax on the total value of a
persons estate.

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TAX INCIDENCE: WHO PAYS?
tax incidence The ultimate distribution of a
tax burden.
sources side/uses side The impact of a
tax may be felt on one or the other or on
both sides of the income equation. A tax
may cause net income to fall (damage on
the sources side), or it may cause prices of
goods and services to rise so that income
buys 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 can
alter their behavior and do something to
avoid 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 the
United States in 2003
POPULATION RANKED
BY INCOME
TAX AS A % OF
TOTAL 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 granted
limited liability status by the government.
Limited liability means that shareholder/owners can
lose 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. Corporation
Income Tax in 2004
POPULATION RANKED
BY INCOME
TAX AS A % OF
TOTAL INCOME
Bottom 20% 0.5
Second 20% 1.0
Third 20% 1.4
Fourth 20% 1.5
Top 20% 4.5
Top 10% 5.7
Top 5% 7.2
Top 1% 9.7
Source: Authors estimate.

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THE OVERALL INCIDENCE OF TAXES IN THE
UNITED 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 analyses
under varying assumptions about tax incidence,
and in most cases their results are similar:

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EXCESS BURDENS AND THE PRINCIPLE
OF 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 the
burden of a tax exceeds the total revenue
collected. Also called deadweight loss.
principle of neutrality All else equal, taxes
that are neutral with respect to economic
decisions (that is, taxes that do not distort
economic decisions) are generally preferable to
taxes that distort economic decisions. Taxes
that are not neutral impose excess burdens.
Ceteris paribus, 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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OF NEUTRALITY
FIGURE 17.5 Firms Choose the Technology That Minimizes the Cost of Production
HOW DO EXCESS BURDENS ARISE?

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OF NEUTRALITY
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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OF NEUTRALITY
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 a
tax distorts an economic decision does not
always imply that such a tax imposes an
excess burden. If there are previously
existing distortions, such a tax may actually
improve efficiency.
Optimal Taxation
The idea that taxes work together to affect behavior
has led tax theorists to search for optimal taxation
systems.

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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 Excess
Burden of a Distorting
Excise Tax Depends
on the Elasticity of
Demand

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ability-to-pay principle
average tax rate
benefits-received
principle
excess burden
corporations
estate
estate tax
marginal 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 structure
tax shifting

Case Econ08 PPT 17

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

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