Chapter 2 Overview
Raising Taxes: Income or Substitution Effect??
Desired: Neutrality or Fiscal Policy Tool?
Traditional Criteria: Fair, Efficient, Effective
(sufficient), Simple (convenient)
Rate Structure: Proportionate, Progressive or
Regressive
Important Terminology: Marginal vs. Average
Rates Tax Preferences
Tax Policy Issues
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Standards for a Good Tax
– In theory every tax can and should be evaluated
on a set of basic standards. In general a tax
should be:
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Sufficient to raise necessary government revenues
Convenient to administer and to pay
Efficient in economic terms
Fair to taxpayers required to pay
Tax Policy Issues
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A Sufficient Tax
– A tax is sufficient if:
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it generates enough funds to pay for the public goods and
services provided by the government levying the tax.
– In other words, if a tax is sufficient, the government can
balance its budget; tax revenues equal government
spending; and there is no need for the government to raise
additional funds.
Tax Policy Issues
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A Convenient Tax
– A tax is convenient if:
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from the Government’s Viewpoint
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the tax is easy to administer, easy to understand, and offers
few opportunities for noncompliance.
from the Taxpayer’s Viewpoint
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the tax is easy to pay, easy to determine, and requires
minimal time to comply.
Tax Policy Issues
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An Efficient Tax
– A tax is efficient if:
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judged by the classical standard of efficiency, it does not
distort the market, create suboptimal allocation of goods
and services, or modify taxpayer behavior.
judged by Keynesian standards it is an effective fiscal
policy tool for regulating the economy. Thus, taxes that
have the intended macroeconomic effect are efficient,
those that are ineffectual or result in undesirable
macroeconomic effects are inefficient.
Tax Policy Issues
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A Fair Tax
– A tax is fair if:
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It reflects each taxpayer’s ability to pay, and enhances
horizontal and vertical equity.
– Ability to Pay
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the proposition that each person’s contribution to the support
of the government reflects that person’s ability to pay the
tax.
– Horizontal Equity
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the proposition that persons with the same ability to pay the
tax should owe the same amount of tax.
– Vertical Equity
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the proposition that persons with greater ability to pay owe
more than persons with a lesser ability to pay.
Tax Policy Issues

Income versus Substitution Effects
– Taxpayers often modify their behavior in reaction
to increased tax rates. These behavioral changes
result in either a income effect or substitution
effect. They are summarized below
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Income Effect:
– Taxpayers react to rate increases by increasing their
income-producing activities to maintain the same
disposable income experienced before the tax rate
increase. In other words, taxpayers work harder to
maintain the same economic status.
Tax Policy Issues
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Income versus Substitution Effects
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Substitution Effect:
– Taxpayers react to rate increases by decreasing the
amount of income producing activities. In other words, an
hour of leisure is worth more than an additional hour of
labor.
– Theoretically, the income effect is more powerful
for lower-income taxpayers already operating at
subsistence levels and the substitution effect is
more compelling to higher-income taxpayers for
whom the significance of an additional dollar is
declining.
Tax Policy Issues
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Equity Issues
– Horizontal and Vertical Equity Revisited.
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Horizontal Equity
– the proposition that persons with the same ability to pay
the tax should owe the same amount of tax.
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Achieving horizontal equity depends heavily on the tax base
definition. In the United States horizontal equity is difficult to
achieve because numerous tax preferences that help shape
the tax base are not impartially distributed across taxpayers.
A simple but unpopular solution is to eliminate all tax
preferences; this would require adopting a “just say no”
approach to tax policy. This solution would likely increase
the current systems’ horizontal equity but at the expense of
the economic or social benefits derived from income
producing activities that tax preferences are designed to
promote.
Tax Policy Issues
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Equity Issues
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Vertical Equity
– the proposition that persons with greater ability to pay
owe more than persons with a lesser ability to pay.
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This form of equity is concerned primarily with the rate
structure necessary to calculate the tax on different tax base
amounts. The ongoing policy issue is usually not whether
paying more taxes is appropriate but how much more is
appropriate. The definition of how much “more” is, may
result in a tax rate structure that is regressive, proportional,
or progressive. The effect on vertical equity is quite different
among these rate structures. See next Slide
Tax Policy Issues
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Tax Rate Structure
– Regressive Rate Structure
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A regressive tax structure is one for which the rate of tax
paid decreases with an increase in tax base.
– Assume a tax rate structure for which John Smith who
earns $20,000 pays a tax of $2,000 and John Jones earns
$40,000 pays a tax of $3,000.
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John Smith’s average tax rate is 10% ($2,000/$20,000)
while John Jones’s is 7.5% ($3,000/$40,000). Thus,
although the rate structure meets the strict standards of
vertical equity $3,000>$2,000 one might question whether
John Jones is paying an amount consistent with his “ability to
pay.”
Tax Policy Issues
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Tax Rate Structure
– Proportional Rate Structure
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A proportional rate structure levies a tax that is the same
percentage of income regardless of tax base amount.
– Assume a rate structure for which John Smith with income
of $20,000 pays $2,000 in tax and John Jones with
$40,000 of income pays $4,000.
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John Smith’s and John Jones’s average tax rates are both
10%. However, based on the theory of the declining
marginal utility of income John Smith’s tax burden is a
greater hardship than John Jones’s because the financial
importance of each dollar declines as total income increases.
A proportional rate structure is often referred to as a
“flat tax.”
Tax Policy Issues
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Tax Rate Structure
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Presidential Candidate Steve Forbes, Congressman Dick
Armey, and Senator Richard Shelby are proponents of a
flat tax system. Check out some of their arguments at
– http://www.house.gov/flattax/index.htm
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Did you ever wonder why Steve Forbes wouldn’t disclose
his personal tax return?
– Some would suggest that his proposed flat tax plan would
unfairly benefit taxpayers in Mr. Forbes income level and
would violate the vertical equity arguments of a good tax.
What do you think?
Tax Policy Issues
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Tax Rate Structure
– Progressive Rate Structure
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A progressive rate structure levies a tax, which as a
proportion of income, increases as income increases.
– Assume a rate structure for which John Smith with income
of $20,000 pays a tax of $2,000 and John Jones with
income of $40,000 pays a tax of $4,400.
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John Smith’s average tax rate is 10% and John Jones’s is
11%. In this situation, not only does John Jones owe a
greater amount it also represents a greater proportion of his
income.
Whether the tax burden is now equitable is a question that is
still unanswered. Until a measure of each taxpayer’s
marginal utility for income is determined, equity will remain
at the center of tax policy discussions.
Tax Policy Issues
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Tax Rate Structure
– Before leaving tax rate structure here are two
definitions you should be familiar with:
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Average Tax Rate
– The tax rate on income determined by dividing tax paid by
an income measure. Income measures selected are
usually gross income or taxable income.
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Marginal Tax Rate
– The rate of tax applied to the next dollar of taxable
income. In a progressive rate structure this rate increases
as income levels increase. In a proportionate rate
structure average and marginal rates are the same.
Exhibit 2-1
The Potentially Regressive Effect
of Itemized Deductions
The Progressive Effect of a
Personal Exemption