Methods to Promote Equity:
Policies of Redistribution
Ch. 11, p. 309-318
What is the difference between a direct and indirect tax? What
are examples of each?
Define and explain the difference between proportional,
progressive, and regressive taxes.
How can income tax be used to lower income inequalities?
Adam Smith’s “canons of taxation”
• Smith outlined four main characteristics of
taxation in TWoN:
– Certainty: those paying should know how
much they are paying
– Convenience: easy to collect
– Economy: taxes should be cheap to collect
realtive to their yield (“cost-efficient” to collect)
– Equity: fairness of taxes levied, efficiency (not
counterproductive to goals of economic
policies)
Equity
Equity in tax terms means “fairness” of taxes
levied (i.e., burden should be felt equally among
those paying):
• Horizontal equity: “treating equals equal”—two
people having the same income should pay the
same tax
• Vertical equity: “treating different people
differently” in order to enhance fairness; less tax
paid by lower income earners than higher
(again, normative)
Transfer payments: why taxes
matter
• Transfer payments:
payments made by the
government to individuals
specifically for
redistributing income
away from certain groups
and towards others
– Transferred from those who
work and pay taxes
towards those who
cannot/need assistance
– Groups are called
vulnerable and include:
elderly, sick, very poor (and
their children), unemployed
Types of payments:
• Old age pension (Social
Security in the US)
• Disability pensions
• Unemployment benefits
• War veterans’ benefits
• Housing benefits for the
poor
• Student grants
• Etc….
Other methods of distribution
The government uses other
methods to help with income
inequalities:
1. Subsidized provision or direct
provision of merit goods:
– Health and education (major
goods under-consumed by
those with low incomes/in
poverty); both in provision
and accessibility
– Provision of infrastructure,
including physical capital
such as clean water,
sanitation
This works by making certain
goods available to people on
low incomes that would not
otherwise be able to afford
them.
2. Government intervention in
markets; i.e., minimum wage
legislation, food price ceilings;
rent control; price floors for
farmers
3. Taxation: the most important
source of government revenue
and source of transfer payments
and subsidized provision of
goods (allows achievement of
greater equity through direct and
indirect methods)
Two broad categories of taxes:
– Direct
– indirect
Direct taxation
• Direct taxation: tax
paid directly to the
government tax
authority by the
taxpayer
– in the US, the IRS
– Taxpayer=economic
agents=firms and
households
– Paid on income,
wealth, or property
Firms pay:
– Profit tax (corporate
income tax)
– Labor tax
Households/individuals
pay:
– Income tax
– Capital gains tax
(profits from
stockholding)
– Property
tax/inheritance tax
One extra type…
• Social insurance
contribution (payroll
tax)—paid by workers
and their employees
• Instead of going into the
gov’t budget (fiscal year
spending), it goes into
specific funds for
pensions, SS, and health
care (i.e., Canada)
• This is also known as
“earmarked” taxation, as
the money is earmarked,
or set aside, for a certain
purpose
• So why would it matter
that many of today’s
workers will be retiring in
the next 20 years?
Indirect taxation
• Indirect tax--tax paid
indirectly to the
government tax authority
by firms selling
goods/services
– Taxes on spending on g/s
• Indirect taxes affect
supply, implying that
market equilibrium is
negatively affected
– Supply curve shifts left
– Can have negative and
positive outcomes
(externalities)
Types of indirect taxes:
• Value-added tax (VAT;
Europe, Asia) or sales
tax in the US
• Excise duties (on
specifics/ “bad” g/s such
as tobacco, gasoline,
alcohol, gambling in US)
• Tariffs (taxes on imports)
– aka customs duties
Calculating tax
• Using a tax table,
multiply income times
the corresponding tax
rate.
– Data available through
IRS or other government
taxation organization
– Example (simple) table for
Europe on p. 313
Progressive tax
• Progressive tax—as
income increases, the
fraction of income paid in
taxes increases; creating
an increasing tax rate
• Is it the most “fair”? Why?
According to what
principle?
Examples:
• Income tax
– Based on marginal tax
rate, calculated using
“layers” of income, or
income brackets
• Taxes on luxury items, for
example, yachts and
private jets
– not normally paid by lower
income people; only paid
by people wealthy enough
to purchase such items
Proportional tax
• Proportional tax—as
income increases, the
fraction of income
paid as taxes remains
constant; constant tax
rate
Examples:
• Some countries’
income taxes (flat tax)
– Can also be
progressive with
addition of exclusions
(amounts not taxed,
etc.)
• Sales tax
Regressive tax
• Regressive tax—as
income increases, the
fraction of income paid as
taxes decreases;
decreasing tax rate
– “flat-rate” tax, or unit
tax
• Indirect taxes are always
regressive.
– A slight exception may
be tax-exempt items
such as necessities
like medicines
Examples:
• The FICA (Federal Insurance
Contributions Act) tax is a
federal payroll tax used to fund
Social Security
• Sales tax can also be
considered a regressive tax.
– Every person buys
relatively the same amount
of food regardless of their
income.
• Therefore a low income
person would pay a larger
proportion of their income
for food sales tax than a
high income person
A note about these taxes
• All three: progressive, regressive, and proportional relate
not just to income tax, but to all types of tax (direct or
indirect)
• This is because taxes are paid out of income; therefore,
they can be compared with income
• The more progressive the tax system, the more
equal is the after-tax distribution of income,
compared to the pre-tax distribution.
• Regressive tax systems tend to make the
distribution of income less equal.