The Tax System


Most people agree that taxes
should impose as small a
cost on society as possible.
The tax system should be
efficient and equitable.
Taxes and Equity Criteria


Benefits principle
Ability-to-pay principle
Benefits Principle


The benefits principle is the idea that people
should pay taxes based on the benefits they
receive from government services.
An example is a gasoline tax:
 Tax revenues from a gasoline tax are used to
finance our highway system.
 People who drive the most also pay the most
toward maintaining roads.
Ability-to-Pay Principle


The ability-to-pay principle is the idea that
taxes should be levied according to an
individual’s ability to shoulder the tax burden.
The ability-to-pay principle leads to two
corollary notions of equity.
 Vertical equity
 Horizontal equity
Paying for the Public Sector

Marginal Tax Rate


The tax rate on the last dollars earned
Average Tax Rate

The proportion of total income paid in taxes
Paying for the Public Sector
Marginal Tax Rate =

change in taxes due
change in taxable income
Tax Bracket

A specified level of taxable income to which a
specific and unique marginal tax rate is
applied
Paying for the Public Sector

Taxation systems

Progressive Taxation

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Marginal tax rate > Average tax rate
As a person’s taxable income increases, the
percentage of income paid in taxes increases
Progressive Taxation: Income Tax
Taxable Income
0–$10,000
$10,001–20,000
$20,001–30,000
Tax Rate
5%
10%
30%
Tax Liability
$500
$1,000
$3,000
$4,500
Income = $30,000
Marginal Tax Rate = 30%
Average Tax Rate = 15% or $4,500/$30,000
Federal Corporate Income Tax
Schedule
Progressive Taxation: Income Tax
Corporate Taxable Income
Corporate Tax Rate
$0–$50,000
$50,001–75,000
$75,001–10,000,000
$10,000,001 and up
15%
25%
34%
35%
Source: U.S. Department of Treasury
The Most Important Federal Taxes

The corporate income tax


Accounts for 12% of all federal revenue
The federal personal income tax

Accounts for 46% of all federal revenue
Federal Income Tax Rates:
Schedule X — Single
If taxable income
is over--
But not
over--
The tax is:
$0
$7,825
10% of the amount over $0
$7,825
$31,850
$782.50 plus 15% of the amount over
7,825
$31,850
$77,100
$4,386.25 plus 25% of the amount over
31,850
$77,100
$160,850
$15,698.75 plus 28% of the amount
over 77,100
$160,850
$349,700
$39,148.75 plus 33% of the amount
over 160,850
$349,700
no limit
$101,469.25 plus 35% of the amount
over 349,700
Paying for the Public Sector

Taxation systems

Proportional Taxation (flat-rate tax)
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Marginal tax rate = Average tax rate
Everyone pays the same percentage of their income in
taxes
Proportional Taxation
Proportional Tax Rate = 20%
Taxable Income x Tax Rate = Tax Liability
$10,000
20%
$2,000
$100,000
20%
$20,000
Marginal Tax Rate = 20%
Average Tax Rate = 20%
Paying for the Public Sector

Taxation systems

Regressive Taxation


Marginal tax rate < Average tax rate
As a person’s taxable income increases, the
percentage of income paid in taxes decreases
Regressive Taxation
Taxable Income Tax Rate* Tax Liability
$5,000
10%
$500
$100,000
———
$5,000
*Tax Rate = 10% on first $50,000 of income; no tax on add. income
Income = $5,000
Marginal Tax Rate and Average Tax Rate = 10%
Income = $100,000
Marginal Tax Rate = 0%
Average Tax Rate = 5% or $5,000/$100,000
Taxes and Equity
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How should the burden of taxes be divided
among the population?
How do we evaluate whether a tax system is
fair?
Tax Incidence and Equity
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The difficulty in formulating tax policy is
balancing the often conflicting goals of
efficiency and equity.
The study of who bears the burden of taxes is
central to evaluating tax equity.
This study is called tax incidence.
Lorenz Curve
• Shows the degree of inequality that exists in the
distributions of two variables, and is often used to
illustrate the extent that income or wealth are
distributed unequally in a particular society.
Laffer Curve
http://www.heritage.org/Research/Taxes/bg1765.cfm
Conclusion
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A proportional tax is one for which highincome and low-income taxpayers pay the
same fraction of income.
Conclusion

A regressive tax is one for which high-income
taxpayers pay a smaller fraction of their
income than do low-income taxpayers.
Conclusion

A progressive tax is one for which highincome taxpayers pay a larger fraction of their
income than do low-income taxpayers.
Conclusion

The U.S. government raises revenue using
various taxes.

Income taxes and payroll taxes raise the most
revenue for the federal government.
Sales taxes and property taxes raise the most revenue
for the state governments.

Conclusion
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Equity and efficiency are the two most
important goals of the tax system.
A tax system is said to be more efficient if it
raises the same amount of revenue at a
smaller cost to taxpayers.
Conclusion


Many proposed changes in the tax laws
increase efficiency while reducing equity, or
increase equity while reducing efficiency.
Debates over tax policy arise because people
value these two goals differently.
The next four questions refer to the below supply and demand
graph for a product on which the government imposes an
excise tax.
(a) What is the amount of the tax per unit?
(b) What is the total amount of the excise tax paid by the
consumer? By the producer?
(c) What is the total tax revenue for government?
(d) What is the efficiency loss of the tax?
Answer the next two questions on the basis of the following
demand and supply data for a competitive market:
Quantity
Quantity
demanded
Price supplied
3,000
$7
7,000
4,000
6
6,000
5,000
5
5,000
6,000
4
4,000
7,000
3
3,000
(a) If government levies a per unit excise tax of $2 on suppliers
of this product, what would the equilibrium price and quantity
be? How much tax will be paid?
(b) If government has instead provided a per unit subsidy of $2
to suppliers of this product, what would the equilibrium price
and quantity be?