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Chapter 12/The Design of the Tax System ❖ 215
Activity 2—Tax Alternatives
Type: In-class assignment
Topics: Taxes and fairness
Materials needed: None
Time: 20 minutes
Class limitations: Works in any size class
Purpose
The impact of taxes can be examined in a variety of ways. This exercise helps students think
about the different effects of taxes on different goods. Taxes that may be appealing because
they minimize deadweight loss may be undesirable for equity reasons.
Instructions
Tell the class, “The state has decided to increase funding for public education. They are
considering four alternative taxes to finance these expenditures. All four taxes would raise the
same amount of revenue.” List these options on the board:
1. A sales tax on food
2. A tax on families with school-age children
3. A property tax on vacation homes
4. A sales tax on jewelry
A. Analyze these taxes using the benefits principle.
B. Analyze these taxes using the principle of horizontal equity.
C. Classify each tax as progressive, proportional, or regressive.
Common Answers and Points for Discussion
A. Are the taxes related to the benefits received?
1. A sales tax on food: This broad-based tax would be appropriate if citizens, as a
whole, receive benefits from education. To the extent that education provides
positive externalities, this tax could be justified on the benefits principle.
2. A tax on families with school-age children: This tax burden would be borne mainly
by those who have the highest benefits. The exceptions would be families who
choose private schools or home schooling; these households would pay the taxes
but not receive the benefits.
216 ❖ Chapter 12/The Design of the Tax System
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. The two most important sources of tax revenue for the federal government are individual
2. The efficiency of a tax system depends on the costs of collecting a given amount of tax
3. A property tax on vacation homes: This tax is probably the worst from a benefits
perspective. Many vacation homeowners may be from other states and receive
minimal, if any, benefits from supporting education.
4. A tax on jewelry: This tax is also weak from the benefits perspective. There is little
reason to think jewelry buyers would disproportionately benefit from better public
education.
B. Are taxes the same for households earning the same income?
None of these taxes is horizontally equitable. They fall disproportionately on
households who:
1. buy more food.
2. have school-age children.
3. own vacation homes.
4. buy jewelry.
The food tax might be the best from this perspective.
C. Vertical equity
1. A sales tax on food
Regressive—lower income households spend a larger portion of their income on
food.
2. A tax on families with school-age children.
Regressive—lump-sum taxes have a bigger percentage impact on low incomes.
3. A property tax on vacation homes.
Progressive—higher income households are more likely to own vacation homes,
and to own more expensive vacation properties.
4. A sales tax on jewelry
Progressive—higher income households will typically buy more expensive jewelry.
No single tax satisfies all equity concerns. If market distortions are also considered,
the decision becomes more complex. This question can generate good discussion
Chapter 12/The Design of the Tax System ❖ 217
A tax system can be inefficient because of the deadweight losses that result when taxes
distort the decisions that people make and because of the administrative burdens that
taxpayers bear as they comply with tax laws. An efficient tax system has low deadweight
losses and small administrative burdens.
paying taxes.
Vertical equity is the idea that taxpayers with greater ability to pay should pay larger
amounts. Horizontal equity is the idea that taxpayers with similar abilities to pay should pay
the same amount.
actually pay the tax.
Questions for Review
2. Corporate profits are taxed first when the corporate income tax is taken out of a
corporation's income. When the profits are used to pay dividends to the corporation's
shareholders, they are taxed again through individual income tax.
burden on taxpayers.
4. Some economists advocate taxing consumption rather than income because taxing income
discourages saving. A consumption tax would not distort individuals’ saving decisions.
5. The marginal tax rate on a lump-sum tax is zero. This type of tax has no deadweight loss,
because it does not distort incentives.
6. Wealthy taxpayers should pay more taxes than poor taxpayers should because: (1) they
7. Horizontal equity refers to the idea that families in the same economic situation should be
taxed equally. The concept of horizontal equity is hard to apply because families differ in
many ways, so it is not obvious how to tax them equitably. For example, two families with
the same income may have different numbers of children and different levels of medical
expenses.
218 ❖ Chapter 12/The Design of the Tax System
Quick Check Multiple Choice
1. b
2. c
3. a
4. a
5. d
6. c
Problems and Applications
1. The federal government had a budget deficit in 2013. Policymakers expect budget deficits
over the next decade.
2. a. The increase in revenue of the total government is attributable more to increases in state
and local government revenue than to federal government revenue. In 1964, state and
to more than 48%.
b. Personal income taxes accounted for more of the total revenue of federal and state and
local governments in 2012 than in 1964; social insurance taxes accounted for a
substantially greater proportion in 2012 than in 1964; and corporate taxes accounted for
a lower proportion in 2012 than in 1964.
3. a. If the number of retirees is rising and total expenditures are frozen, then benefits per
retiree will decline over time. Because the number of workers is rising, albeit slowly, tax
payments per worker would decline slowly over time.
retirees.
c. If tax payments per worker were frozen, total expenditures would rise slowly, at the
same rate as the growth rate of the number of workers. Because the number of retirees
is rising more rapidly, benefits per retiree would decline over time.
tax payments per worker.
4. If you earn $20,000 a year, then you pay federal income taxes in two parts: 10% on the first
$8,925 of income and 15% on the amount above $8,925. Thus, your federal income taxes
are ($8,925 0.10) + ($11,075 0.15) = $892.50 + $1661.25 = $2,553.75. You also pay
$20,000 0.153 = $3,060 in federal payroll taxes and $20,000 0.04 = $800 in state
0.321 = 32.1%. Your marginal tax rate is 0.15 + 0.153 + 0.04 = 0.343 = 34.3%.
Chapter 12/The Design of the Tax System ❖ 219
If you earn $40,000 a year, then you pay federal income taxes in three parts: 10% on the
first $8,925 of income, 15% for additional income up to $36,425, and 25% for the remaining
+ ($3,575 0.25) = $892.50 + $4,125 + $893.75 = $5911.25. You also pay $40,000
0.153 = $6,120 in federal payroll taxes, and $40,000 0.04 = $1,600 in state income taxes.
Your total tax bill is $13,631.25. Your average tax rate is $13,631.25/$40,000 = 0.341 =
34.1%. Your marginal tax rate is 0.25 + 0.153 + 0.04 = 0.443 = 44.3%.
addition, because the demand for food and clothing is likely to be relatively inelastic, the
deadweight loss from a tax on these goods would be relatively small (when compared with a
tax on a good whose demand is relatively elastic).
gains.
b. Because capital gains are not realized and thus taxed until the investment is sold,
investors can avoid the tax by not selling the investment. When capital gains taxes are
lowered, even temporarily, the investor has an incentive to sell the investment while the
c It is inefficient to tax only realized capital gains because it distorts the incentives an
individual faces with regard to keeping or selling a particular asset. However, it may be
difficult to estimate the rise in the value of an asset prior to its sale.
8. The effect of the Tax Reform Act of 1986 on interest payments was to reduce consumer debt
9. a. The fact that visitors to many national parks pay an entrance fee is an example of the
benefits principle, because people are paying for the benefits they receive.
must pay more tax.
220 ❖ Chapter 12/The Design of the Tax System
