Chapter Introduction
Section 1: The Economics
of Taxation
Section 2: Federal, State,
and Local
Revenue Systems
Section 3: Current Tax Issues
and Reforms
Visual Summary
You have just received your
first paycheck and are
looking forward to being paid
$8 per hour for the 20 hours
you worked. You look at your
check and . . . “What? This
check isn’t for $160! Where’s
the rest of my money?” Make
a list of the deductions that
might be subtracted from
your earnings. Read Chapter
9 to learn more about how
governments raise revenue.
All levels of government use
tax revenue to provide
essential goods and
services.
Section Preview
In this section, you will learn that taxes are the
most important way of raising revenue for the
government.
Content Vocabulary
• sin tax
• tax return
• incidence of
a tax
• benefit principle •
of taxation
•
• ability-to-pay
•
principle of
taxation
• proportional tax •
• tax loophole
• individual
income tax
• sales tax
• average tax rate
Medicare
progressive tax
marginal tax
rate
regressive tax
Academic Vocabulary
• validity
• evolved
What is the most important way for
governments to raise revenue?
A. Sell bonds
B. Sell services
C. Taxes
0%
A
A. A
B. B
0% C 0%
C.
B
C
Economic Impact of Taxes
Taxes affect the decisions we
make in a variety of ways.
Economic Impact of Taxes (cont.)
• Taxes and other governmental revenues
influence the economy by affecting
– Resource allocation
– Behavior adjustment
• Sin tax
Economic Impact of Taxes (cont.)
– Productivity and growth
– Determining incidence of a tax
Shifting the Incidence of a Tax
Which example demonstrates a tax
encouraging an activity?
A. Sin tax
0%
D
0%
A
D. None of the above
C
C. Luxury goods tax
A. A
B. B
C. 0%C
0%
D. D
B
B. Interest paid on
mortgages
Criteria for Effective Taxes
To be effective, taxes must be
equitable, easy to understand,
and efficient.
Criteria for Effective Taxes (cont.)
• Taxes must meet three criteria:
– Equity—impartial and just: Makes sense
to avoid tax loopholes
– Simplicity—tax laws written so taxpayers
and collectors can understand them
• Individual income tax—complex tax
• Sales tax—simpler
Criteria for Effective Taxes (cont.)
– Efficiency—easy to administer and
successful in generating revenue
• Individuals file a tax return before April
15th each year.
Which of the taxes below was not
worthwhile?
A. Toll booth taxes
B. Sales tax
C. Luxury tax on small
private aircraft
D. Gasoline tax
0%
A
A. A
B. B
C. 0%C
0%
D. D
B
C
0%
D
Two Principles of Taxation
Taxes can be levied on the
basis of benefits received or
the ability to pay.
Two Principles of Taxation (cont.)
• United States taxes are based on two
principles
– Benefit principle of taxation
• Limitations to the benefit principle of taxation
• Those who receive government services are
least likely to afford them.
• Benefits are hard to measure and impact
others.
Two Principles of Taxation (cont.)
– Ability-to-pay principle of taxation
• We can’t always measure benefits derived
from government spending.
• Assumes individuals taxed more suffer less
discomfort paying taxes
Which method of taxes better suits
you or your family?
A. Benefit principle
of taxation
B. Ability-to-pay
principle of taxation
A. A
B. B
0%
A
0%
B
Three Types of Taxes
All taxes can be broken down
into three categories—
proportional, progressive, and
regressive.
Three Types of Taxes (cont.)
• Three general types of taxes exist in the
United States today.
– Proportional tax
• If the percentage tax rate is constant, the
average tax rate is constant.
• Medicare tax fund
Three Types of Taxes
Three Types of Taxes (cont.)
– Progressive tax
• Marginal tax rate
– Regressive tax
Profiles in Economics:
Monica Garcia Pleiman
In which category of taxes does a
homeowner’s property tax fall?
A. Proportional tax
B. Progressive tax
C. Regressive tax
D. None of the above
0%
A
A. A
B. B
C. 0%C
0%
D. D
B
C
0%
D
Section Preview
In this section, you will learn that federal, state,
and local governments rely on different revenue
sources.
Content Vocabulary
• Internal
Revenue
Service (IRS)
• payroll
withholding
system
• corporate
income tax
• excise tax
• estate tax
• property tax
• tax assessor
• natural monopoly
• gift tax
• indexing
• customs duty
• FICA
• user fee
• payroll tax
• intergovernmental revenue
Academic Vocabulary
• implemented
• considerably
The second most important federal
revenue source is the individual
income tax.
A. True
B. False
A. A
B. B
0%
B
A
0%
Federal, State, and Local Revenue
Systems
• The Internal Revenue Service (IRS) is
the branch of the U.S. Treasury
Department in charge of collecting
taxes today.
Federal Government Revenue Sources
Individual income taxes, FICA,
and borrowing constitute the
main sources of government
revenue.
Federal Government Revenue Sources
(cont.)
• Four largest sources of government
revenue are
– Individual income taxes
• Tax is mostly collected through a payroll
withholding system.
• Tax code takes into account indexing.
Federal Government Revenue Sources
Federal Government Revenue Sources
(cont.)
– FICA or Federal Insurance Contributions
Act tax
• Social Security and Medicare are part of
payroll taxes.
– Borrowing by selling bonds to investors
– Corporate income tax
– Excise tax
The Global Economy & YOU
Total Tax Revenue as a Percentage of GDP
Federal Government Revenue Sources
(cont.)
– Estate tax and gift tax
– Customs duty
– Miscellaneous fees like a user fee
Why is indexing so important to the tax code?
A. Lowers the tax on
those who pay a
gift tax
C
0%
A
C. Keeps workers from
paying more in taxes
because of inflation
A. A
B. B
0% C 0%
C.
B
B. Helps defray costs
related to Medicare
and Social Security
State Government Revenue Sources
States rely on funds from the
federal government in
addition to income taxes and
sales taxes.
State Government Revenue Sources
(cont.)
• Largest sources of state governments
revenue
– Intergovernmental revenue
– Sales tax implemented by most states
– Individual income taxes by most states
– Other revenue sources
State and Local Government
Revenue Sources
Which of the following states does
not charge a general sales tax or
individual state income tax?
A. New Hampshire
0%
D
0%
A
D. Delaware
C
C. Washington
A. A
B. B
C. 0%C
0%
D. D
B
B. Alaska
Local Government Revenue Sources
Local governments rely
mostly on intergovernmental
revenue and property taxes.
Local Government Revenue Sources
(cont.)
• Largest sources of local governments
revenue
– Intergovernmental transfers from state
and federal governments
– Property tax
• Tax assessor determines valuations of
property
State and Local Taxes
as a Percentage of State Income
Local Government Revenue Sources
(cont.)
– Utility revenues from natural
monopolies
– Sales tax
– Other revenue sources
Which of the following property does
not fall under the property tax laws?
A. Real estate
B. Farm animals
0%
D
A
0%
C
D. Jewelry
A. A
B. B
C. 0%C
0%
D. D
B
C. Automobile
Section Preview
In this section, you will learn that one
consequence of tax reform was to make the
individual tax code more complex than ever.
Content Vocabulary
• payroll
withholding
statement
• accelerated
depreciation
• investment
tax credit
• alternative
minimum tax
• capital gains
Academic Vocabulary
• concept
• controversial
• flat tax
• value-added
tax (VAT)
Do Americans pay more in taxes than do
people in other developed countries?
A. Yes
B. No
C
A
0%
A. A
B. B
0% C 0%
C.
B
C. About the same
Examining Your Paycheck
The income taxes you pay are
summarized on the stub that
is attached to your paycheck.
Examining Your Paycheck (cont.)
• The payroll withholding statement
attached to your paycheck lists
deductions taken.
Biweekly Paycheck
and Withholding Statement
What is the FICA tax percentage
deducted from your paycheck?
A. 6.20%
B. 5.5%
0%
D
A
0%
C
D. Varies by individual
A. A
B. B
C. 0%C
0%
D. D
B
C. 7.65%
Tax Reform
Numerous changes have been
made to the federal income
tax code since 1981.
Tax Reform (cont.)
• The Economic Recovery Tax Act, signed
by Ronald Reagan in 1981, included large
tax reductions for individuals and
businesses.
• Businesses also got tax relief from
accelerated depreciation and
investment tax credit.
Tax Table for Single Individuals, 2006
Tax Reform (cont.)
• In 1983 the alternative minimum tax was
passed.
• In 1993 government added tax brackets in
order to balance the budget.
• The Taxpayer Relief Act of 1997 was both
economical and political.
– Capital gains tax was reduced.
Total Government Receipts
per Capita, Adjusted for Inflation
Tax Reform (cont.)
• Temporary tax reform in 2001—based on
the federal government collecting more
taxes than it was spending
• Temporary tax reform in 2003—due to
slow economic growth, accelerated many
of 2001 reforms
• If the present trend of government
spending more than it collects in taxes
continues, it will be difficult to preserve tax
cuts due to expire in 2011.
What do you think Congress should
do now regarding taxes?
A. Keep everything
the same
B. Reduce government
spending
C. Increase taxes
D. Change the tax
structure all together
0%
A
A. A
B. B
C. 0%C
0%
D. D
B
C
0%
D
Alternative Tax Approaches
The need for new federal
revenues will influence future
tax reform.
Alternative Tax Approaches (cont.)
• Two alternative forms of taxation
– Flat tax
– Value-added tax (VAT)
The Value-Added Tax
Alternative Tax Approaches (cont.)
• Advantages to the flat tax
– Simplicity to taxpayer
– Closes most loopholes
– Reduces need for many workers in IRS
and tax preparers
Alternative Tax Approaches (cont.)
• Disadvantages to the flat tax
– Removes many incentives built into
current tax code
– Don’t know what rate is needed to
replace revenues collected today
– Unsure if flat tax would stimulate
economic growth
Alternative Tax Approaches (cont.)
• Advantages to the VAT
– Tax is hard to avoid
– Tax incidence is widespread
– Easy to collect
– Encourages saving
Alternative Tax Approaches (cont.)
• Disadvantage to the VAT
– Virtually invisible—other factors can
change the product’s price.
• Desires to simplify the tax code,
unexpected expenditures on war and
natural disasters, and political change all
result in tax reform.
Why is it difficult for politicians to change the
tax code completely?
A. Hard to give up power of
modifying behavior and
influencing allocation of
resources
D. All of the above
0%
D
C
0%
A
C. They find it hard to grant
concessions to special
interest groups.
A. A
B. B
C. 0%C
0%
D. D
B
B. They support their own
pet projects.
Types of Taxes All taxes in the United States can
be broken down into three categories: proportional,
progressive, and regressive
Government Revenue Sources Federal, state,
and local revenue sources differ. Much of the federal
revenue is sent on to state and local governments.
Alternative Tax Approaches Because the federal
tax code has become so large and cumbersome,
people have discussed the flat tax and the valueadded tax as two alternatives.
Monica Garcia
Pleiman (1964– )
• president and CEO of OMS,
a technology consulting firm
• publisher of Hispanic
lifestyles magazine
Latino SUAVE
• cofounder of the Latina
Chamber of Commerce
xxx – insert new DFS
trans 1
sin tax
relatively high tax designed to raise
revenue and discourage consumption
of a socially undesirable product
incidence of a tax
final burden of a tax
tax loophole
exception or oversight in the tax law
allowing taxpayer to avoid paying
certain taxes
individual income tax
federal tax levied on the wages,
salaries, and other income of
individuals
sales tax
general state or city tax levied on a
product at the time of sale
tax return
annual report by a taxpayer filed
with local, state, or federal
government detailing income earned
and taxes owed
benefit principle of taxation
belief that taxes should be paid
according to benefits received
regardless of income
ability-to-pay principle of
taxation
belief that taxes should be paid
according to level of income,
regardless of benefits received
proportional tax
tax in which percentage of income
paid in tax is the same regardless of
the level of income
average tax rate
total taxes paid divided by the total
taxable income
Medicare
federal health-care program for senior
citizens
progressive tax
tax in which the percentage of income
paid in tax rises as the level of
income rises
marginal tax rate
tax rate that applies to the next dollar
of taxable income
regressive tax
tax in which the percentage of
income paid in tax goes down as
income rises
validity
justification
evolved
developed gradually
Internal Revenue Service (IRS)
branch of the U.S. Treasury
Department that collects taxes
payroll withholding system
system that automatically deducts
income taxes from paychecks on a
regular basis
indexing
adjustment of tax brackets to offset
the effects of inflation
FICA
Federal Insurance Contributions Act;
tax levied on employers and
employees to support Social Security
and Medicare
payroll tax
tax on wages and salaries deducted
from paychecks to finance Social
Security and Medicare
corporate income tax
tax on corporate profits
excise tax
general revenue tax levied on the
manufacture or sale of selected items
estate tax
tax on the transfer of property when a
person dies
gift tax
tax paid by the donor on transfer of
money or wealth
customs duty
tax on imported products
user fee
fee paid for the use of good or service
intergovernmental revenue
funds that one level of government
receives from another level of
government
property tax
tax on tangible and intangible
possessions such as real estate,
buildings, furniture, stocks, bonds,
and bank accounts
tax assessor
person who examines and assesses
property values for tax purposes
natural monopoly
market structure in which average
costs of production are lowest when a
single firm exists
implemented
put into effect
considerably
to a noticeable or significant extent
payroll withholding statement
document attached to a paycheck
summarizing pay and deductions
accelerated depreciation
schedule that spreads depreciation
over fewer years to generate larger
tax reductions
investment tax credit
tax credit given for purchase of
equipment
alternative minimum tax
personal income tax rate that applies
to cases in which taxes would
otherwise fall below a certain level
capital gains
profits from the sale of an asset held
for 12 months or longer
flat tax
proportional tax on individual income
after a specified threshold has been
reached
value-added tax (VAT)
tax on the value added at every stage
of the production process
concept
general idea
controversial
disputed
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