Chapter 18: Introduction to Taxation
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This lecture discusses a few institutional and
theoretical issues for understanding tax
policy.
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Overview of the types of taxation that exist in
the U.S. at different governmental levels.
Federal income tax.
Structure of the income tax.
Figure 1
The federal government relies
heavily on the individual income
tax and the payroll tax.
State and local governments rely
more heavily on sales taxes and
property taxes.
Figure 2
Other countries are more
dependent on consumption taxes
than the United States.
Figure 3
Marginal tax rates rise with
taxable income, with a current
maximum rate of 35%.
Be clear: even a taxpayers with TI of $400,000 pays
10% on her first $14,300, 15% on the next $43,800, etc.
A Set of Important Taxation Concepts:
Measuring the fairness of tax systems
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A marginal tax rate is the percentage that is paid in taxes
on the next dollar earned.
An average tax rate is the percentage of total income is
that is paid in taxes.
Most think a progressive tax system is fairest, in that it
respects the ability to pay.
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A progressive tax system is one in which effective average tax
rates rise with income.
A proportional tax system is one in which effective average rates
do not change with income, so that everyone pays the same
proportion of their income in taxes.
A regressive tax system is one in which effective average tax rates
fall with income.
Measuring the fairness of tax systems
Effective versus statutory rates
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Another important distinction is between statutory
and effective tax rates.
Statutory tax rates are tax rates laid out in the legal
tax schedule.
Effective tax rates are tax rates an individual
actually pays.
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The two diverge because
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There are many exemptions and deductions from taxable
income, which reduces the tax base.
As we will discuss next chapter, the burden of some taxes can be
shifted.
Measuring the fairness of tax systems
Vertical and horizontal equity
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Two distributional goals are frequently cited in
measuring tax fairness.
Vertical equity is the principle that groups with
more resources should pay higher taxes than groups
with fewer resources.
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Could be motivated by utilitarian SWF, that calls for
redistribution.
Horizontal equity is the principle that similar
individuals who make different economic choices
should be treated similarly by the tax system.
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In reality, horizontal inequities are hard to define, because
the person endogenously made a choice to earn more or
less.
Defining the income tax base: The Haig-Simons
comprehensive income definition
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The Haig-Simons comprehensive income definition
defines taxable resources as the change in an individual’s
power to consume during the year.
It is best viewed as a measure of ability to pay – regardless
of the actual choices in terms of consumption and savings.
In reality, the U.S. tax system deviates from this definition in
many ways, for example, the exclusion of employer-provided
health insurance.
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In practice it is very difficult to implement the Haig-Simons income
concept. Problems include
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Adjusting for an individual’s ability to pay (property and casualty losses,
medical expenses, state and local taxes); the costs of earning income; and
difficult to value items (imputed rent on owner-occupied housing).
Externality/Public goods rationales for
deviating from Haig-Simons: Tax
expenditures
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Tax expenditures are government revenue losses
attributable to tax law provisions that allow special
exclusions, exemptions, or deductions from gross
income, or that provide a special credit, preferential
tax rate or deferral of liability.
The government measures how much tax revenue is
lost by excluding health insurance from taxable
compensation, or allowing deductibility of
charitable contributions.
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Overall, in 2005, the government is projected to lose $740
billion through all tax expenditures, the largest of which
is the exclusion of employer-provided health insurance.
Tax deductions vs. tax credits
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Tax credits are more equitable than deductions.
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The value of deductions (such as for home mortgage
interest or charitable contributions) rises with a person’s
marginal tax rate, making them regressive.
Credits are equally available for all incomes, so they are
progressive.
In reality, a tax credit may not be very progressive if
those with low tax liabilities cannot have the excess
of the credit refunded.
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A tax credit is refundable if it is available to individuals
even if they pay few or no taxes.
THE APPROPRIATE UNIT OF
TAXATION
The problem of the “marriage tax”
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Choosing the appropriate unit of taxation is a
difficult task as well. Should the government
impose taxes on family income or individual
income?
It is not possible to design a tax system that achieves
the following three goals:
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Progressivity.
Across-Family Horizontal Equity (i.e., uses the family as
the unit of taxation).
Across-Marriage Horizontal Equity (e.g., marriage
neutrality).
The appropriate unit of taxation
Marriage taxes in practice
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Why the concern about marriage taxes?
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Horizontal equity.
The tax might discourage marriage.
The high marginal tax rate on the secondary earner.
This last problem could be solved with a secondary
earner deduction.
There is no empirical evidence that the “marriage
penalty” does discourage marriage.
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But people might still be concerned about the “optics” of
the tax system providing a financial incentive for some
not to marry.
The appropriate unit of taxation
Marriage taxes in practice
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The U.S. is unusual in that it has a tax system based
on family income.
19 OECD countries tax husbands and wives
individually.
5 OECD countries offer marriage subsidies through
family taxation with income splitting – which lowers
the tax burden with a progressive tax schedule.
Only 2 other OECD nations have pure family
taxation system similar to the U.S.
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Ireland and Norway…