12
THE DESIGN OF THE TAX
SYSTEM
WHAT’S NEW:
There are no changes in this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:

how the U.S. government raises and spends money.

the efficiency costs of taxes.

alternative ways to judge the equity of a tax system.

why studying tax incidence is crucial for evaluating tax equity.

the tradeoff between efficiency and equity in the design of a tax system.
KEY POINTS:
1. The U.S. government raises revenue using various taxes. The most important taxes for the
federal government are individual income taxes and payroll taxes for social insurance. The
most important taxes for state and local governments are sales taxes and property taxes.
2. The efficiency of a tax system refers to the costs it imposes on taxpayers. There are two
costs of taxes beyond the transfer of resources from the taxpayer to the government. The
first is the distortion in the allocation of resources that arises as taxes alter incentives and
behavior. The second is the administrative burden of complying with the tax laws.
3. The equity of a tax system concerns whether the tax burden is distributed fairly among the
population. According to the benefits principle, it is fair for people to pay taxes based on the
benefits they receive from the government. According to the ability-to-pay-principle, it is fair
for people to pay taxes based on their capability to handle the financial burden. When
evaluating the equity of a tax system, it is important to remember a lesson from the study of
tax incidence: The distribution of tax burdens is not the same as the distribution of tax bills.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
2
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
4. When considering changes in the tax laws, policymakers often face a tradeoff between
efficiency and equity. Much of the debate over tax policy arises because people give
different weights to these two goals.
CHAPTER OUTLINE:
I.
A Financial Overview of the U.S. Government
In order for this material to be relevant, you will want to update it from time to time.
Data on government receipts and expenditures can now easily be found on the
internet or through the most recent edition of the Economic Report of the President.
A.
Figure 12-1 shows the level of government revenue in the United States,
including federal, state and local governments, as a percentage of total income
for the U.S. economy.
Figure 12-1
B.
Table 12-1 compares the tax burden for several major countries.
Table 12-1
C.
1.
The U. S. falls in the middle of the list.
2.
Tax burden in the U.S. is low when compared with that of European
countries, but is high when compared with that of other areas of the
world.
The Federal Government
1.
Receipts
a.
Table 12-2 reports the receipts of the federal government in
1999.
b.
Total receipts were $1,806 billion or $6,639 per person.
c.
Largest source of revenue is individual income tax.
d.
A family’s income tax liability is how much it owes based on
income. This tax is not proportional to income. It is based on
income minus deductions, and the marginal tax rate rises as
income rises. Table 12-3 presents marginal tax rates for 1999.
e.
Other important revenue sources include social insurance taxes,
corporate income tax, and excise taxes.
Table 12-2
Table 12-3
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
2.
3
Spending
a.
Table 12-4 reports where the federal government spent its
budget in 1999.
b.
Total spending was $1,727 billion or $6,350 per person.
c.
The largest category of expenditure is Social Security. The
second largest expense is national defense.
d.
Other important categories of expenditure include income
security programs, net interest on the federal debt, and
Medicare.
Table 12-4
D.
3.
Definition of Budget Surplus: an excess of government receipts
over government spending.
4.
Definition of Budget Deficit: an excess of government spending
over government receipts.
State and Local Government
1.
Receipts
a.
Table 12-5 reports the receipts from state and local
governments for 1996.
b.
Total receipts were $1,223 billion or $4,615 per person.
c.
The two most important taxes for state and local governments
are sales taxes and property taxes.
Table 12-5
2.
Spending
a.
Table 12-6 shows how state and local governments spent their
budgets in 1996.
b.
The largest category of spending was education.
Table 12-6
II.
Taxes and Efficiency
A.
Well-designed tax policies minimize the deadweight losses that occur when taxes
distort incentives. They also minimize the administrative burdens that taxpayers
face when complying with tax laws.
B.
Deadweight Losses
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
4
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
1.
Taxes lead to deadweight losses because they lower total surplus.
Provide students with several examples of how taxes lead to an inefficient outcome.
Some examples to discuss include an inefficient shifting of productive activity from
the market sector to the household sector, diminished saving, and increased leisure.
2.
C.
Case Study: Should Income or Consumption Be Taxed?
a.
Because interest income is taxed, the current income tax laws
discourage saving.
b.
If consumption (instead of income) is taxed, this disincentive
disappears.
Administrative Burden
1.
The current tax system is quite burdensome because of the large
amount of paperwork required both when filling out tax forms and
keeping records throughout the year.
For most undergraduate students, this burden may seem somewhat trivial. Use
some real-world examples of actual compliance costs to underscore this important
aspect of taxation. Use some personal examples if appropriate.
D.
2.
Many taxpayers spend resources seeking ways to minimize their tax
burden.
3.
In the News: Small Business and the Tax Laws
a.
Small firms have to face as much paperwork in doing taxes as
large firms.
b.
The cost of complying with the tax laws is likely a larger burden
for these firms because these costs are a larger portion of the
firm’s revenues.
Marginal Tax Rates Versus Average Tax Rates
ALTERNATIVE CLASSROOM EXAMPLE:
Income = $30,000
Tax Brackets
$0 - $10,000
$10,001 +
Tax Rate:
0%
15%
Tax liability = (0.15)($20,000) = $3,000
Average tax rate = $3,000/$30,000 = 10%
Marginal tax rate = 15%
1.
Definition of Average Tax Rate: total taxes paid divided by total
income.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
E.
III.
2.
Definition of Marginal Tax Rate: the extra taxes paid on an
additional dollar of income.
3.
The average tax rate measures the sacrifice made by a taxpayer; the
marginal tax rate measures how much the tax system discourages
people from working hard.
5
Lump-Sum Taxes
1.
Definition of Lump-Sum Tax: a tax that is the same amount for
every person.
2.
For this type of tax, the marginal tax rate is equal to zero.
3.
This is the most efficient type of tax because it does not distort
incentives and thus has no effect on total surplus. There is also little
administrative burden with this type of tax.
Taxes and Equity
A.
B.
The Benefits Principle
1.
Definition of Benefits Principle: the idea that people should pay
taxes based on the benefits they receive from government
services.
2.
This principle tries to make private goods out of public goods.
The Ability-to-Pay Principle
1.
Definition of Ability-to-Pay Principle: the idea that taxes should
be levied on a person according to how well that person can
shoulder the burden.
2.
Definition of Vertical Equity: the idea that taxpayers with a
greater ability to pay should pay larger amounts.
Table 12-7
a.
Three tax systems: proportional, regressive, and progressive.
b.
Definition of Proportional Tax: a tax for which highincome and low-income taxpayers pay the same fraction
of income.
c.
Definition of Regressive Tax: a tax for which high-income
taxpayers pay a smaller fraction of their income than do
low-income taxpayers.
d.
Definition of Progressive Tax: a tax for which high-income
taxpayers pay a larger fraction of their income than do
low-income taxpayers.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
6
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
e.
Case Study: How the Burden of Taxes Is Distributed – Table 128 shows that when we take into account both taxes and
transfers, we can see that the tax burden in this country is
highly progressive.
Table 12-8
3.
Definition of Horizontal Equity: the idea that taxpayers with
similar abilities to pay taxes should pay the same amount.
Case Study: Horizontal Equity and the Marriage Tax – if a man and
a woman have similar incomes, their total tax liability increases if they
get married.
C.
Tax Incidence and Tax Equity
1.
The burden of a tax is not always borne by who pays the tax bill.
2.
Example: tax on fur coats. This will ultimately affect those who sell and
produce the fur coats because the quantity of fur coats demanded will
fall due to the increase in price.
3.
Case Study: Who Pays the Corporate Income Tax?
4.
a.
The burden of the corporate tax falls on stockholders,
customers, and workers.
b.
An increase in corporate taxes means an increase in the cost of
producing the product. Firms will cut back production (which
lowers supply and raises the price to the consumer) and/or lay
off workers (which causes unemployment, lower wages, or
both).
Case Study: The Flat Tax
a.
A flat tax would mean that every tax payer would be subject to
the same marginal tax rate.
b.
The system could be progressive in that those with low level of
income could receive money back from the government.
c.
Most deductions would be eliminated including those for home
mortgages and charitable contributions.
d.
The administrative burden of the federal tax system would be
lowered because of the simplicity of the plan.
e.
Opponents argue that there is not enough vertical equity in this
type of tax system and that much of the burden of the tax
system would be shifted from the wealthy to the middle class.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
IV.
7
Conclusion: The Tradeoff Between Equity and Efficiency
ADJUNCT TEACHING TIPS AND WARM-UP ACTIVITIES:
1. To give students some perspective concerning the federal expenditure on the interest on the
federal debt, ask them to calculate 15 percent of their monthly income and imagine that they
were paying that amount as interest on their credit cards – not reducing the balances, just
paying interest. Ask students to define the opportunity cost of the federal government using
so much of its budget to pay interest.
2. Ask students to interview four people about taxes: one old (a grandparent or elderly
neighbor), one new (a younger friend or classmate), one borrowed (a stranger), and one
blue (someone who is unemployed or underemployed). Each person should be asked three
questions:



What percentage of your income do you pay in taxes? (Some may not know. Guessing
is okay.)
Do you think that the tax system in the United States is fair?
How would you change the way taxes are collected if you could make them fairer or
more efficient? (Note: Some may say “Stop collecting taxes!” Remind them that the
government needs at least some tax revenue to provide public goods.)
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1.
The two most important sources of tax revenue for the federal government are the
individual income tax and payroll taxes. The two most important sources of tax revenue
for state and local governments are sales taxes and property taxes.
2.
The efficiency of a tax system refers to how low the costs are of collecting a given
amount of tax revenue. One tax system is more efficient than another if the same
amount of tax revenue can be raised at lower cost. A tax system can be inefficient
because of the deadweight losses that result when taxes distort the decisions that people
make and because of the administrative burdens that taxpayers bear as they comply with
the tax laws. An efficient tax system has low deadweight losses and small administrative
burdens.
3.
The benefits principle is the idea that people should pay taxes based on the benefits they
receive from government services. It tries to make public goods similar to private goods
by making those who benefit more from the public good pay more for it. The ability-topay principle is the idea that taxes should be levied on a person according to how well
that person can shoulder the burden. It tries to equalize the sacrifice each person makes
toward paying taxes.
Vertical equity is the idea that taxpayers with greater ability to pay taxes should pay
larger amounts. Horizontal equity is the idea that taxpayers with similar abilities to pay
taxes should pay the same amount.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
8
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
Studying tax incidence is important for determining the equity of a tax system because
understanding how equitable the tax system is requires understanding the indirect
effects of taxes. In many cases, the burden of the tax is borne by people other than
those who actually pay the tax.
Questions for Review
1.
Over the past several decades, government has grown more rapidly than the rest of the
economy. The ratio of government revenue to GDP has increased over time.
2.
The two most important sources of revenue for the U.S. federal government are
individual income taxes (about 44 percent of total revenue) and social insurance taxes
(about 36 percent).
3.
Corporate profits are taxed first when the corporate income tax is taken out of a
corporation's income and again when the profits are used to pay dividends to the
corporation's shareholders, which are taxed by the individual income tax.
4.
The burden of a tax to taxpayers is greater than the revenue received by the government
because: (1) taxes impose deadweight losses by reducing the quantity of goods
produced and purchased below their efficient level; and (2) taxes entail a costly
administrative burden on taxpayers.
5.
Some economists advocate taxing consumption rather than income because taxing
income discourages saving. A consumption tax would not distort people's saving
decisions.
6.
Wealthy taxpayers should pay more taxes than poor taxpayers because: (1) they benefit
more from public services; and (2) they have a greater ability to pay.
7.
Horizontal equity refers to the idea that families in the same economic situation should
be taxed equally. The concept of horizontal equity is hard to apply because families
differ in many ways, so it isn't obvious how to tax them equitably. For examples, two
families with the same income may have different numbers of children and different
levels of medical expenses.
8.
The arguments in favor of replacing the current tax system with a flat tax include: (1)
the flat tax would broaden the tax base and reduce marginal tax rates, improving
economic efficiency; (2) the tax is simple, so the administrative burden of the tax system
would be greatly reduced; (3) the tax could be collected at the income source rather
than from the person receiving the income, reducing administrative costs; (4) the flat tax
would eliminate the double taxation of corporate income; and (5) businesses would be
able to deduct expenses for investment, which would encourage additional saving and
investment.
The arguments against replacing the current tax system with a flat tax include: (1) the
flat tax gives too little weight to the goal of vertical equity; and (2) the flat tax would be
less progressive than the current tax system, with the wealthy paying less.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
9
Problems and Applications
1.
Government spending has grown over time as our society has come to rely on the
government to provide a social safety net, including medical care, for everyone. The
trend is likely to continue as the average age of the population increases.
2.
The federal government had a budget surplus in 1999. As of early 2000, policymakers
expected even larger surpluses in 2000, 2001, and 2002.
3.
a.
Over the past 37 years, the increase in revenue of the total government is
attributable more to increases in state and local government revenue than to
federal government revenue. In 1960, state and local government revenue was
35 percent of total government revenue; by 1997 it had risen to 42 percent.
b.
Personal taxes account for a bit more of the total revenue of federal and state
and local governments now as they did 37 years ago (35 percent in 1960, 38
percent in 1997); corporate taxes account for a lower proportion (16 percent in
1960, 10 percent in 1997), social insurance taxes account for a substantially
greater proportion (16 percent in 1960, 28 percent in 1997), and excise taxes
account for a lower proportion (33 percent in 1960, 24 percent in 1997).
c.
Transfer payments account for a much greater proportion of the total
expenditures of federal and state and local governments now than they did 37
years ago (24 percent in 1960, 44 percent in 1997), while purchases account for
a much smaller proportion (70 percent in 1960, 49 percent in 1997).
a.
If the number of retirees is rising and total expenditures are frozen, then benefits
per retiree will decline over time. Since the number of workers is rising, albeit
slowly, tax payments per worker would decline slowly over time.
b.
If benefits per retiree were frozen, total expenditures would rise quickly, along
with the number of retirees. To pay for the increased expenditures, tax
payments per worker would rise, since the number of workers isn't growing as
rapidly as the number of retirees.
c.
If tax payments per worker were frozen, total expenditures would rise slowly, at
the same rate as the growth rate of the number of workers. Since the number
of retirees is rising more rapidly, benefits per retiree would decline over time.
d.
The answers to parts a, b, and c suggest there's no easy solution. Either
workers will pay more per person or retirees will get fewer benefits per person.
Policymakers may eventually be forced to compromise, both reducing benefits
per retiree and increasing tax payments per worker.
4.
5.
If you earn $20,000 a year, then you pay $20,000 x 0.15 = $3,000 in federal income
taxes, $20,000 x 0.153 = $3,060 in federal payroll taxes, and $20,000 x 0.04 = $800 in
state income taxes, for a total tax bill of $6,860. Your average tax rate is
$6,860/$20,000 = 0.343 = 34.3 percent. Your marginal tax rate is 0.15 + 0.153 + 0.04
= 0.343 = 34.3 percent.
If you earn $40,000 a year, then you pay federal income taxes in two parts: 15 percent
on the first $25,750 of income and 28 percent on the amount above $25,750, so your
federal income taxes are $25,750 x 0.15 = $3,862.50 plus $14,250 x 0.28 = $3,990.00,
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
10
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
for a total of $7,852.50 in federal income taxes. You also pay $40,000 x 0.153 = $6,120
in federal payroll taxes, and $40,000 x 0.04 = $1,600 in state income taxes. Your total
tax bill is $15,572.50. Your average tax rate is $15,572.50/$40,000 = 0.389 = 38.9
percent. Your marginal tax rate is 0.28 + 0.153 + 0.04 = 0.473 = 47.3 percent.
6.
Excluding food and clothing from the sales tax is justified on equity grounds because
poor people spend a greater proportion of their income on those items. By exempting
them from taxation, the system makes the rich bear a greater burden than the poor.
From the point of view of efficiency, however, excluding food and clothing from the sales
tax is inefficient, since the demand for food and clothing is probably relatively inelastic.
There's less deadweight loss from taxing a good with inelastic demand than a good with
elastic demand.
7.
a.
Because contributions to charity are tax deductible, people donate more to
charity than they otherwise would.
b.
Because sales of beer are taxed, people buy less beer than they otherwise
would.
c.
Because interest that a homeowner pays on a mortgage is tax deductible,
homeownership is encouraged.
d.
Because realized capital gains are taxed, but accrued gains are not, people sell
assets that have fallen in value, but they don't sell assets that have appreciated,
so they can avoid paying taxes on their gains.
8.
If the state raises its sales tax from 5 percent to 6 percent, it isn't plausible that sales tax
revenue will increase 20 percent. The increase in the tax rate is 20 percent, so the only
way tax revenue could increase 20 percent would be if total spending didn't fall in
response to the tax increase, which is unlikely. Instead, the higher tax would raise the
price of goods, so people would spend less. Thus tax revenues might go up, because the
tax rate is higher, but by less than 20 percent.
9.
a.
Because a woman who earns income loses TANF benefits, the tax discourages
labor supply; it's like a higher tax on her wages.
b.
The subsidy from the EITC encourages labor supply, since it provides a subsidy.
c.
The advantage of eliminating TANF and putting the money into EITC is that it
would make people more self-sufficient by giving them the incentive to work.
The disadvantage is that their children would receive less care, since their
parents would be working.
10.
The effect of the Tax Reform Act of 1986 on interest payments was to reduce consumer
debt and increase home equity debt. People started financing general expenditures
through home equity loans and paid down their mortgages less quickly.
11.
a.
The fact that visitors to many national parks pay an entrance fee is an example
of the benefits principle, since people are paying for the benefits they receive.
b.
The fact that local property taxes support elementary and secondary schools is
an example of the ability-to-pay principle, since if you own more expensive
property you must pay more tax.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.
CHAPTER 12 – THE DESIGN OF THE TAX SYSTEM
12.
11
c.
The setup of airport trust funds is an example of the benefits principle, since use
of the airport generates a tax that pays for upkeep of the airport.
a.
For the proportional tax system, the average tax rate is 25 percent whether a
person earns income of $50,000, $100,000, and $200,000.
For the regressive tax system, the average tax rate is 30 percent for someone
earning $50,000, 25 percent for someone earning $100,000, and 20 percent for
someone earning $200,000.
For the progressive tax system, the average tax rate is 20 percent for someone
earning $50,000, 25 percent for someone earning $100,000, and 30 percent for
someone earning $200,000.
b.
For the proportional tax system, the marginal tax rate as income rises from
$50,000 to $100,000 is the increase in taxes ($12,500) divided by the increase in
income ($50,000) = 25 percent. The marginal tax rate as income rises from
$100,000 to $200,000 is the increase in taxes ($25,000) divided by the increase
in income ($100,000) = 25 percent.
For the regressive tax system, the marginal tax rate as income rises from
$50,000 to $100,000 is the increase in taxes ($10,000) divided by the increase in
income ($50,000) = 20 percent. The marginal tax rate as income rises from
$100,000 to $200,000 is the increase in taxes ($15,000) divided by the increase
in income ($100,000) = 15 percent.
For the progressive tax system, the marginal tax rate as income rises from
$50,000 to $100,000 is the increase in taxes ($15,000) divided by the increase in
income ($50,000) = 30 percent. The marginal tax rate as income rises from
$100,000 to $200,000 is the increase in taxes ($35,000) divided by the increase
in income ($100,000) = 35 percent.
c.
In the proportional tax system, the average tax rate equals the marginal tax rate.
In the regressive tax system, the marginal tax rate is less than the average tax
rate and both tax rates decline as income rises. In the progressive tax system,
the marginal tax rate is greater than the average tax rate and both tax rates rise
as income rises. The marginal tax rate is relevant to someone deciding whether
to accept a job that pays slightly more than her current job, since it tells her how
much of the extra income she'll keep after taxes. For judging the vertical equity
of the tax system, the average tax rate is relevant, since vertical equity suggests
that people with a greater ability to pay should pay a larger amount.
13.
The efficiency justification for taxing consumption rather than income is that taxing
income discourages saving. If the United States were to adopt a consumption tax, the
U.S. tax system would become less progressive because the poor spend a greater
proportion of their income than the rich. However, tax rates could be modified or
deductions increased to make the tax more progressive.
14.
Eliminating the tax deduction for meals would reduce the amount of lunches to which
corporate executives take clients. But the incidence wouldn't be borne entirely by
corporations, but instead by eating and drinking establishments that would lose a
substantial portion of their business.
Harcourt, Inc. items and derived items copyright  2001 by Harcourt, Inc.