208
WHAT’S NEW IN THE SEVENTH EDITION:
All tables have been updated to the most recently available numbers. A new
In the News
box
on “Tax Expenditures” has been added.
LEARNING OBJECTIVES:
how the U.S. government raises and spends money.
the efficiency costs of taxes.
why studying tax incidence is crucial for evaluating tax equity.
the trade-off between efficiency and equity in the design of a tax system.
CONTEXT AND PURPOSE:
perform these functions.
The purpose of Chapter 12 is to build on the lessons learned about taxes in previous chapters. We
have seen that a tax reduces the quantity sold in a market, that the distribution of the burden of a tax
depends on the relative elasticities of supply and demand, and that taxes cause deadweight losses. We
expand the study of taxes in Chapter 12 by addressing how the U.S. government raises and spends
THE DESIGN OF THE TAX
SYSTEM
12
Chapter 12/The Design of the Tax System ❖ 209
KEY POINTS:
The efficiency of a tax system refers to the costs it imposes on taxpayers. There are two costs of
taxes beyond the transfer of resources from the taxpayer to the government. The first is the
deadweight loss that arises as taxes alter incentives and distort the allocation of resources. The
second is the administrative burden of complying with the tax laws.
When considering changes in the tax laws, policymakers often face a trade-off between efficiency
and equity. Much of the debate over tax policy arises because people give different weights to these
two goals.
CHAPTER OUTLINE:
A. Figure 1 shows the level of government revenue in the United States, including federal, state,
2. The government’s revenue from taxation has grown at a faster rate than the economy’s level
of income.
B. Table 1 compares the tax burden for several major countries, as measured by the government’s
tax revenue as a percentage of the nation’s total income.
1. The United States has a low tax burden compared to most other advanced economies.
Figure 1
Table 1
For this material to be relevant, you will want to update it from time to time. Data on
government receipts and expenditures can be found easily on the Internet or through
the most recent edition of the Economic Report of the President.
210 ❖ Chapter 12/The Design of the Tax System
2. Many European nations have much higher taxes, which finance a more generous social safety
net.
C. The Federal Government
1. Receipts
c. The largest source of revenue is the individual income tax.
corporate income tax, and excise taxes.
2. Spending
c. The largest category of expenditure is for income security, which includes Social Security,
unemployment insurance payments, and welfare payments. The second largest expense
d. The next largest category of spending is national defense.
3. Definition of budget deficit: an excess of government spending over government
receipts.
4. Definition of budget surplus: an excess of government receipts over government
spending.
Table 2
Table 4
Table 3
Activity 1—Alphabet Soup: The Role of the Government
Type: In-class assignment
Topics: The role of government
Materials needed: None
Time: 15 minutes
Class limitations: Works in any size class
Chapter 12/The Design of the Tax System ❖ 211
D.
Case Study: The Fiscal Challenge Ahead
1. From 2009 to 2012, the U.S. federal government had budget deficits that exceeded $1 trillion
2. Long-term projections of the government’s budget show that this is expected to rise
dramatically in the decades ahead.
a. The population ages 65 and older is growing; thus, Medicare and Social Security
expenditures will rise as well.
are affected by the rising cost of medical care.
E. State and Local Government
1. Receipts
a. Table 5 reports the receipts from state and local governments for 2011.
b. Total receipts were $2,064 billion or $6,615 per person.
Table 5
Purpose
This assignment shows that many government activities exist in a market economy.
Instructions
Ask the students to list as many government-provided goods and services as possible. They
should include activities at the federal, state, and local levels.
Then ask them to list all the “alphabet” agencies (FBI, CIA, USDA, etc.).
The most important question to ask is “WHY?” Why, in a predominantly market economy,
does the government play so many roles?
Common Answers and Points for Discussion
Students should be able to list dozens of government activities and nearly as many agencies.
The rationale for government action can include:
Creating an institutional framework for markets (laws, courts, money, SEC)
Addressing market failure (national defense, education, highways, EPA)
Addressing monopoly (antitrust, public utilities, FTC)
Addressing equity and income distribution (Social Security, food stamps)
Macroeconomic stability (fiscal policy, monetary policy)
Financing the above activities (taxes, bonds, IRS).
Figure 2
212 ❖ Chapter 12/The Design of the Tax System
property taxes.
d. State and local governments also levy individual and corporate income taxes.
e. State governments also receive funding from the federal government.
2. Spending
b. The largest category of spending was education, while the second largest category was
health programs.
II. Taxes and Efficiency
with tax laws.
B. Deadweight Losses
1. Taxes lead to deadweight losses because they lower total surplus.
a. Because interest income is taxed, the current income tax laws discourage saving.
b. If consumption (instead of income) is taxed, this disincentive disappears.
C. Administrative Burden
1. The current tax system is quite burdensome because of the large amount of paperwork
required both when filling out tax forms and keeping records throughout the year.
a. People often need help filling out complex tax forms.
Table 6
Provide students with several examples of how taxes lead to an inefficient outcome.
Some examples to discuss include an inefficient shifting of productive activity from
the market sector to the household sector, diminished saving, and increased leisure.
For most undergraduate students, this burden may seem somewhat trivial. Use some
real-world examples of actual compliance costs to underscore this important aspect
of taxation. Use some personal examples if appropriate.
Chapter 12/The Design of the Tax System ❖ 213
b. Individuals may also want to learn how to arrange their affairs to reduce their tax
burden.
D. Marginal Tax Rates versus Average Tax Rates
2. Definition of marginal tax rate: the amount that taxes increase from an additional
dollar of income.
3. The average tax rate measures the sacrifice made by a taxpayer; the marginal tax rate
measures how much the tax system distorts incentives.
E. Lump-Sum Taxes
2. For this type of tax, the marginal tax rate is equal to zero.
4. However, a lump-sum tax would take the same amount from the poor and the rich, which
most people would view as unfair.
III. Taxes and Equity
A. The Benefits Principle
1. Definition of benefits principle: the idea that people should pay taxes based on the
benefits they receive from government services.
2. This principle tries to make public goods similar to private goods.
3. An example of this would be the tax on gasoline, especially if revenues from the tax are used
to build or maintain roads.
B. The Ability-to-Pay Principle
ALTERNATIVE CLASSROOM EXAMPLE:
Income = $100,000
Tax Brackets Tax Rate:
$0–$20,000 0%
$20,001–$50,000 15%
$50,001 + 25%
Tax liability = (0.15)($30,000) + (0.25)($50,000)= $4,500 + $12,500 = $17,000
Average tax rate = $17,000/$100,000 = 17%
Marginal tax rate = 25%
214 ❖ Chapter 12/The Design of the Tax System
2. Definition of vertical equity: the idea that taxpayers with a greater ability to pay
taxes should pay larger amounts.
b. Definition of proportional tax: a tax for which high-income and low-income
taxpayers pay the same fraction of income.
c. Definition of regressive tax: a tax for which high-income taxpayers pay a
d. Definition of progressive tax: a tax for which high-income taxpayers pay a
larger fraction of their income than do low-income taxpayers.
3. Definition of horizontal equity: the idea that taxpayers with similar abilities to pay
taxes should pay the same amount.
C. Tax Incidence and Tax Equity
2. Example: tax on fur coats. This will ultimately affect those who sell and produce the fur coats
because the quantity of fur coats demanded will fall due to the increase in price.
a. The corporate income tax is popular among voters because a corporation is nonhuman
and faceless.
c. An increase in corporate taxes means an increase in the cost of producing the product.
Firms will cut back production (which lowers supply and raises the price to the consumer)
and possibly lay off workers (which causes unemployment, lower wages, or both).
D.
In the News: Tax Expenditures
2. This article from
The New York Times
discussing the benefits of eliminating tax expenditures
and the politics associated with such a proposal.
Table 7
Table 8