978-1260152616 Chapter 20 Solution Manual Part 1

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Chapter 20 – Taxation and the Public Budget

CHAPTER 20

TAXATION AND THE PUBLIC BUDGET

Chapter Overview

The fine points of tax law are complex, but the basics are fairly

straightforward. The ideas and evidence in this chapter show what’s at stake

in political debates. Understanding the implications of taxes can also help

you make better personal financial choices.

When it comes to taxes, economists focus on trade-o#s between revenue,

efficiency, and incidence. In other words, we’re concerned with how much

money is raised, how costly it is to raise it, and who ultimately shoulders the

burden. We’ve seen why governments need to balance revenues and

expenditures in the long run, but also why they might not want to do so in

the short run.

Public support for taxation depends on whether citizens like how

governments spend their tax dollars. If voters think that governments misuse

money or spend too much, they’ll want to reduce taxes. When voters think

that governments are helping to create stronger communities and better

opportunities for citizens, they won’t mind the tax bite as much. We’ll dig

deeper into some of these questions in the next chapter, as we address

issues around poverty, inequality, and the uses of public funds.

Learning Objectives

LO 20.1 Describe the major public policy goals of taxation.

LO 20.2 Explain how deadweight loss and administrative costs contribute to

the inefficiency of a tax.

LO 20.3 Calculate the effect of a tax increase on revenue, taking into

account price and quantity effects.

LO 20.4 Identify proportional, progressive, and regressive taxes.

LO 20.5 Describe the sources of tax revenue in the United States, and

discuss the role played by di#erent types of taxes.

LO 20.6 Discuss the important features of the public budget and the

relationship between revenues and expenditures.

Chapter Outline

HAPPY TO PAY TAXES?

Why Tax? (LO 20.1)

BOX FEATURE: FROM ANOTHER ANGLE – LOVE THE SINNER, LOVE THE SIN

TAX

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Chapter 20 – Taxation and the Public Budget

Principles of Taxation

efficiency: How Much (Extra) Will the Tax Cost? (LO 20.2)

Revenue: How Much Money Will the Tax Raise? (LO 20.3)

Incidence: Who Ultimately Pays the Tax? (LO 20.4)

BOX FEATURE: REAL LIFE – WHO REALLY PAYS THE SALES TAX?

A Taxonomy of Taxes (LO 20.5)

Personal Income Tax

Payroll Tax

Corporate Income Tax

Other Taxes

BOX FEATURE: WHAT DO YOU THINK? – DEATH, TAXES, AND “DEATH TAXES”

The Public Budget (LO 20.6)

Expenditures

Balancing the Budget

BOX FEATURE: REAL LIFE – THE INSECURE FUTURE OF SOCIAL SECURITY

Beyond the Lecture

Class Media: Why Tax? (LO 20.1)

Consider playing the song Taxman by The Beatles for students before class.

While George Harrison wrote the song about what he perceived to be

excessive tax rates, it is a nice way to start a discussion regarding the impact

of taxes on the supply of labor (or any other tax related issue). Lyrics for the

song can be viewed here.

Class Activity: Why Tax and Tax Incidence (LO20.1, LO 20.4)

Depending on where you teach, students may or may not have a lot of

experience with income taxes. One way to drive the idea home is to have

students calculate the income tax for a family of four. Place students in

groups (aka, families) and provide them with household incomes, giving

di#erent incomes to different groups. You can provide as many details as you

like about each family, but you may want to keep it simple and have

students take the standard deduction according to the 2017 tax rates located

here. You could also ask students to figure out state and local taxes for their

family.

Writing Assignment/Class Discussion: Tax E4ciency and Revenue

(LO 20.2, LO 20.3)

Ask students to consider whether income taxes impact the decision to work

and the decision regarding where to live. Included here are two articles that

are great conversation starts. This New York Times article discusses the

income tax in California. And this paper by Eissa and Liebman examines the

impact of the earned income tax credit on employment.

1. How do changes in income tax rates impact labor decisions?

2. Do individuals consider taxes when choosing a place to work and

reside?

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Chapter 20 – Taxation and the Public Budget

3. Are there any di#erences between local, state, and federal income

taxes in terms of their impact on individual’s decisions?

Class Assignment: A Taxonomy of Taxes and The Public Budget (LO

20.5, LO 20.6)

Have students explore the o$cial U.S. revenue and expenditure numbers

here. They should especially consider the following:

Table 1.1: Examine government receipts, outlays, and surplus/deficit

(first three columns).

Table 2.1: Examine the sources of government revenue.

Table 5.1: Examine federal government spending by category.

Table 7.1: Examine government debt over time.

Clicker Questions

There are three main purposes to clicker questions. First, they are a great

way to do a quick and instant “on demand” test of student understanding of

the material. You can cover material, and instantly get feedback on student

comprehension. You can see whether you need to explain certain topics

again, or move on to the next subject. Second, they are a great method to

break up the class and take a moment away from lecture. It gets the

students actively involved. Finally, certain clicker questions can be framed in

a “discussion” manner, in which you can invite students to talk about the

possible right answer with their peers. You can instruct students to convince

their classmate of a right or wrong answer.

1. What is the main reason why economists like the idea of a lump-sum

(head) tax? [LO 20.1]

A. It might be easy to implement

Feedback: Pay it no matter what. Doesn’t cause incentive to change

buying or selling, or any other activity you might do.

2. Why might many people dislike the idea of a lump-sum (head) tax? [LO

20.2]

D. It doesn’t generate enough revenue for government spending needs

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Chapter 20 – Taxation and the Public Budget

Feedback: If everyone must pay $2,000 no matter what, the tax will hurt a

low income person more than a high-income person. In this sense, it may be

very regressive.

3. Consider income taxes. What is an intuitive reason why the La#er curve

may start to slope downward at higher tax rates? [LO 20.3]

A. People will work more hours if tax rates go up

Feedback: If the tax rate is 90%, I’m going to run my business in a cash-

only manner and not report much of my earnings to the government!

4. What’s a quick and easy way to predict the relative tax burden faced by

buyers and sellers if an excise tax is placed on a good? [LO 20.4]

Feedback: The market participant that is relatively more inelastic will pay

more of the tax compared to the relatively elastic participant. If they’re not

price-sensitive, the price change will go to their side of the market.

5. John was interested in owning stock in Amazon (AMZN). He bought the

shares at $600 each, but decided to sell the shares when the stock price was

$720. What type of tax would John have to pay on his profits? [LO 20.5]

A. Income tax

Solutions to End-of-Chapter Questions and Problems

Review Questions

1. Both a payroll tax and an excise tax on alcohol raise revenue and,

respectively, shrink the markets for labor and alcohol. Although both have

some functions in common, governments may have di#erent goals when

levying them. What goals do you think motivate a payroll tax? What goals

motivate an alcohol tax? [LO 20.1]

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Chapter 20 – Taxation and the Public Budget

Answer: Since a payroll tax is levied on income from many different

types of income-generating activities, it doesn’t target one specific

2. The demand for cigarettes, which create negative externalities through

secondhand smoke, is often relatively inelastic. That is, when the price of

cigarettes changes, the quantity demanded changes by a smaller portion.

Using this fact, explain to what extent you think a tax on cigarettes would

fulfill each of the goals of taxation. [LO 20.1]

Answer: The demand curve for inelastic goods is more vertical relative to

elastic goods. When a tax is raised on cigarettes, therefore, the new

3. Which would you expect to be less efficient, a Rat tax on all income or a

property tax (charged based on the assessed value of real estate)? Explain

why, in terms of both deadweight loss and administrative costs. [LO 20.2]

Answer: Implementing a Rat tax on income entails less administrative

cost than a property tax, which requires assessors to calculate the value

4. A local government is considering ways to raise taxes to pay for making

sidewalks. One prominent citizen suggests taxing people based on how much

they walk on the sidewalk, measured in yards each day. Explain why, despite

its apparent fairness, this tax is likely very ine$cient. [LO 20.2]

Answer: Levying this tax would entail a large amount of administrative

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Chapter 20 – Taxation and the Public Budget

5. In an election debate, two candidates for governor are debating about

whether to raise the general sales tax from 5 to 7 percent. One argues that

this would increase tax revenues, enabling the state to maintain essential

services. The other argues that the tax would hurt retailers and consumers,

and would actually slow down the economy so much that it would decrease

tax revenues too. Restate these candidates’ positions in economic

terminology and explain what assumptions they must be making in order to

justify their di#erent positions, in terms of price and quantity effects. [LO

20.3]

Answer: The two candidates disagree about the relative sizes of the price

and quantity effects of the sales tax. The first candidate believes

revenues would increase, i.e., that the price effect would be larger than

6. Explain, with reference to the price and quantity effects, why all else

equal, taxing several goods at a modest rate is better than taxing one good

at a very high rate. [LO 20.3]

Answer: All else equal, taxing one good instead of many to receive the

same level of government revenue would require a very high tax rate on

7. People with low income spend more, as a share of their overall income, on

food and clothing than wealthier people. As a result, they tend to spend a

higher proportion of their income relative to people with high income. Given

this trend, explain how a general sales tax of 8 percent could be regressive.

Now, suppose that food and children’s clothing are exempted from the sales

tax. Is this likely to make the tax more or less regressive? [LO 20.4]

Answer: The general sales tax would add 8 percent to all of the money

spent by each person. Since people with lower income spend a greater

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Chapter 20 – Taxation and the Public Budget

8. Suppose you turn on the television to find an ad by a local politician

accusing car dealers of making too much money o# consumers. As a remedy

for this abuse, the o$cial proposes to tax the dealers at a higher rate and

reward car buyers with the proceeds of the tax. Drawing on the idea of

economic incidence and administrative cost, explain why this tax may not

benefit consumers after all. [LO 20.4]

Answer: There are two reasons this tax might not help consumers. As we

learned, statutory incidence is not the same as economic incidence: Even

9. Your friend Edgar has just finished his first year working full-time and

comes home beaming with an envelope from the IRS, which has sent him a

check for $650 after he sent in his tax forms. Explain to Edgar why this does

not mean that he didn’t pay taxes. [LO 20.5]

Answer: Throughout the year, the government automatically takes a

fraction of every paycheck for income taxes. When it comes time to report

income taxes, each person calculates how much he needs to pay and

10. Explain why most people’s marginal tax rate is higher than their

average tax rate. Is a system in which average tax rates are higher than

marginal tax rates regressive, proportional, or progressive? [LO 20.5]

Answer: In a progressive tax system, the higher the tax bracket, the

higher the marginal tax rate. For example, the government might tax

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Chapter 20 – Taxation and the Public Budget

11. A challenger presidential candidate vows to cut entitlement spending

by 20 percent in the first few weeks that he is in o$ce. Why is it unlikely the

candidate could achieve this reduction? [LO 20.6]

Answer: The majority of entitlement spending is non-discretionary,

meaning that it’s mandated by law to occur automatically. Although the

12. When the federal government borrows money, it can fund higher

expenditures in the short term, but incurs a debt that accrues interest and

has to be paid o# in the long term. What does this imply about the tradeo#

between current and future taxes? How might this tradeo# change if the

overall size of the economy grows over time? [LO 20.6]

Answer: Borrowing money in the short term requires the government to

pay it back at some point in the long term. All else equal, this borrowing

would require higher taxes in the future—or lower spending. The size of

Problems and Applications

1. Consider each of the following tax policies. Decide for each whether the

primary public policy goal is most likely raising revenue or changing behavior

(with or without a market failure). [LO 20.1]

a. Income tax.

b. Cigarette tax.

c. Gas tax.

d. Payroll tax.

e. Toll road.

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Chapter 20 – Taxation and the Public Budget

f. Income tax exemption for charity donations.

Answer:

a. Income taxes target a wide array of income-generating activities, so it

b. Cigarette taxes target negative externalities—second-hand smoke and

c. Gas taxes also target a market failure, the negative externality of

d. Like income taxes, payroll taxes target a variety of activities, making it

e. Toll road taxes are often collected to raise revenue to fund the

f. Tax exemptions result in lowered revenue for the government for the

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Chapter 20 – Taxation and the Public Budget

2. Governments throughout history have levied some very interesting taxes.

Each of the following taxes changed citizens’ behavior. Determine whether

it’s likely that the tax also addressed a market failure. [LO 20.1]

a. The Hat Tax: Adopted by the British government, requiring every hat to

bear a stamp on the inside showing it was legal.

b. The “Flatulence Tax”: Proposed, but ultimately not adopted, in New

Zealand to help reduce methane emissions from livestock.

c. The Window Tax: Levied by English King William III on the number of

windows in a house, which tended to be more numerous in wealthier homes.

d. The Cowardice Tax: Introduced in medieval England and applied to people

who refused to defend the country at the request of the king.

Answer:

a. Unless the hats in question caused a great style scandal (causing a

b. Methane emissions contribute to global warming, which reduces utility

c. Like hats, windows do not typically affect the utility of non-users.

d. Depending upon the military goal in question, the cowardice tax could

have made it more costly for people to shirk the duty of protecting their

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