N.

GREGORY MANKIW
PRINCIPLES OF

ECONOMICS
Eight Edition

CHAPTER
The Design of
12 the Tax System
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Introduction
• ‘A government can sometimes improve
market outcomes’
– Providing public goods
– Regulating the use of common resources
– Remedying the effects of externalities
• The government
– Raises revenue through taxation
– To perform its many functions

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Introduction
• Lessons about taxes from earlier
chapters:
– A tax on a good reduces the market
quantity of that good.
– The burden of a tax is shared between
buyers and sellers depending on the price
elasticities of demand and supply.
– A tax causes a deadweight loss.

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 Government Revenue as a Percentage of GDP:
Changes over Time
This figure shows revenue of the
federal government and of state
and local governments as a
percentage of gross domestic
product (GDP), which measures
total income in the economy. It
shows that the government plays a
large role in the U.S. economy and
that its role has grown over time.

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An Overview of U.S. Taxation

• Government revenue - increased
– As percentage of total income
– As economy’s income has grown
• Government’s revenue from taxation has
grown even more
• As a nation gets richer
– Government - takes a larger share of
income in taxes

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Government Revenue as a Percentage of GDP:

International Comparisons

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 Receipts of the Federal Government: 2016 Q1

Amount Amount Percent

(billions) per person of receipts
Personal current taxes $1,572.8 $4,865.3 45.0%
Social insurance 1,224.1 3,786.6 35.1
Taxes on corporate income 410.6 1270.2 11.8
Others 284.2 879.1 8.1
Total $3,491.7 $10,801.2 100.0%

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Receipts of the State and Local Government: 2016 Q1

Amount Amount Percent

(billions) per person of receipts
Sales taxes $549.5 $1,699.8 34.7%
Property taxes 466.3 1,442.5 29.5
Personal income taxes 419.0 1,296.1 26.5
Corporate income taxes 58.5 181.0 3.7
Other 88.3 273.1 5.6
Total $1,581.6 $4,892.5 100.0%

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Taxes and Efficiency

• Policymakers
– Equity and efficiency
• Costs of taxes to taxpayers
– Tax payment itself
–…
• Taxes distort the decisions that people make
–…
• Taxpayers bear as they comply with the tax
laws
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 Taxes and Efficiency
• ‘People respond to incentives’
• Taxes distort incentives
– Cause people to allocate resources
according to tax incentives rather than
true costs and benefits
• Deadweight loss
– The fall in taxpayers’ well-being exceeds
the revenue the government collects

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Should income or consumption be taxed?

• Income tax reduces the incentive to
save:
– If income tax rate is 25%, then 8%
interest rate = ...
– The lost income compounds over time.
• Some economists advocate taxing
consumption instead of income.
– ...
– Better for individuals’ retirement income
security and long-run economic growth.
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Should income or consumption be taxed?

• Consumption tax-like provisions in the
U.S. tax code include ...

– People can put a limited amount of

saving into such accounts.
– The funds are not taxed until withdrawn at
retirement.
• Europe’s Value-Added Tax (VAT) is like
a consumption tax

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 Taxes and Efficiency
• Administrative burden
–…

–…

• e.g., hiring accountants to exploit “loopholes”

to reduce one’s tax burden
– Is a type of deadweight loss

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Taxes and Efficiency

• Administrative burden
– Could be reduced if the tax code were
simplified
– But would require removing loopholes,
politically difficult

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Taxes and Efficiency

• Average tax rate
–…

• Marginal tax rate

–…

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 Taxes and Efficiency
• Lump-sum taxes
–…
– Example: lump-sum tax = …

Income Average tax rate Marginal tax rate

$20,000

$40,000

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Taxes and Efficiency

• Lump-sum taxes
–…

• Doesn’t distort incentives, doesn’t cause

deadweight losses
• Imposes a minimal administrative burden
–…
• Relative to income, the poor pay much more
than the rich (even though everybody pays
the same in $ terms)
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Taxes and Equity

• Equity
–…

• Agreeing on what is “fair” is much harder

than agreeing on what is “efficient.”
– Yet, there are several principles people
apply to evaluate the equity of a tax
system

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 Taxes and Equity
• The benefits principle
–…

– Tries to make public goods …

– Example: Gasoline taxes

• Amount of tax paid is related to how much a
person uses public roads
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Taxes and Equity

• The ability-to-pay principle
–…

• All taxpayers should make an “equal

sacrifice”
• A $10,000 tax bill is a bigger sacrifice for a
poor person than a rich person.

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Taxes and Equity

• Vertical equity
–…

• Richer taxpayers should pay more than

poorer taxpayers
• How much more should the rich pay?

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 Three Tax Systems
• Proportional tax
–…

• Regressive tax
–…

• Progressive tax
–…

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Three Tax Systems

Regressive Proportional Progressive

% of % of % of
income tax tax tax
income income income

$50,000 $15,000 $12,500 $10,000

100,000 25,000 25,000 25,000

200,000 40,000 50,000 60,000

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The Federal Income Tax Rates: 2014

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 Taxes and Equity
• Horizontal equity
–…

– Problem: …

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Active Learning 1 Taxes and marriage, part 1

The income tax rate is 25%. The first $20,000

of income is excluded from taxation. Tax law
treats a married couple as a single taxpayer.
Sam and Diane each earn $50,000.
i. If Sam and Diane are living together unmarried,
what is their combined tax bill?
ii. If Sam and Diane are married, what is their tax
bill?

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Active Learning 1 Answers

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 Active Learning 1 Taxes and marriage, part 2

The income tax rate is 25%. For singles, the

first $20,000 of income is excluded from
taxation.
For married couples, the exclusion is $40,000.
Harry earns $0. Sally earns $100,000.
i. If Harry and Sally are living together unmarried,
what is their combined tax bill?
ii. If Harry and Sally are married, what is their tax
bill?

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Active Learning 1 Answers

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Taxes and Equity

• Tax incidence
– Who bears the burden of taxes
– Central to evaluating tax equity
– Person who bears the burden a tax
• Not always the person who gets the tax bill
from the government
• Taxes alter supply and demand
–…

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 Taxes and Equity
• Example: A tax on fur coats
– May appear to be …
– But furs are a luxury with very elastic
demand
– The tax shifts demand away from furs,
…

• When evaluating tax equity, must take tax

incidence into account.
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Who pays the corporate income tax?

People pay all taxes
• Tax on a corporation
– Corporation – more like a tax collector
than taxpayer
– Burden of the tax ultimately falls on …

– Workers and customers …

– Popular because it appears to be paid by

rich corporations
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Who pays the corporate income tax?

• Suppose the government levies a tax on
automakers:
– Owners receive …

– The supply of cars …

– Demand for auto workers …

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 Trade-off: Equity vs. Efficiency
• Equity and efficiency
– Most important goals of a tax system
– Often conflict
– Political leaders differ in their views on this
tradeoff
• Economics can help us:
– Better understand the tradeoff
– Avoid policies that sacrifice efficiency
without any increase in equity
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