Chapter 17/Taxation and Resource Allocation
CHAPTER 17
TAXATION AND RESOURCE ALLOCATION
Chapter 17 begins by describing the U.S. tax structure, and then analyzes it in terms of equity,
efficiency, excess burden, and incidence. It deals with several current controversies in taxation,
including the debate over repealing the Bush tax cuts.
CHAPTER OUTLINE
THE LEVEL AND TYPES OF TAXATION
Average tax rates have been roughly constant over the past 30 years, at both the federal and
the state and local levels.
Progressive, Proportional, and Regressive Taxes
Taxes can be classified in terms of whether they are progressive, proportional, or regressive.
Under a progressive tax the fraction of income paid in taxes rises as a person’s income
increases.
Direct versus Indirect Taxes
Direct taxes are levied directly on people: primary examples are income taxes and estate
taxes.
THE FEDERAL TAX SYSTEM
The principal federal taxes, in descending order of revenue, are the personal income tax, the
payroll tax, the corporate income tax, and excise taxes.
The Federal Personal Income Tax
The personal income tax is generally progressive, but with many loopholes.
Chapter 17/Taxation and Resource Allocation
The Payroll Tax
The proceeds of this tax are paid into “trust funds” such as Social Security, Medicare, and
The Corporate Income Tax
Excise Taxes
An excise tax is a sales tax on the purchase of a particular good or service.
In the United States, sales taxes are mainly reserved for state and local governments.
The Payroll Tax and the Social Security System
For the most part, Social Security is not a true trust fund, but a pay-as-you-go transfer
system.
The burdens on the payers are increasing over time.
THE STATE AND LOCAL TAX SYSTEM
State and local governments depend mostly on sales, excise and property taxes.
Sales and Excise Taxes
Almost all states and many localities have sales taxes (typically between 5 and 8 percent).
Most states also impose excise taxes on items like tobacco, gasoline, liquor, and other items.
Property Taxes
Property taxes have historically been the central financing source for public schools.
Fiscal Federalism
Under the U.S. system of fiscal federalism, grants (often restricted) are made from higher to
lower levels of government.
Chapter 17/Taxation and Resource Allocation
THE CONCEPT OF EQUITY IN TAXATION
The three principles are horizontal equity, vertical equity, and the benefits principle.
It is often difficult to apply these principles in real situations.
Horizontal Equity
Horizontal equity asserts that equally situated individuals should be taxed equally.
The current tax code frequently violates this principle.
Vertical Equity
The Benefits Principle
According to the benefits principle of taxation, those who reap the benefits from government
services should pay the taxes.
THE CONCEPT OF EFFICIENCY IN TAXATION
Because most taxes induce changes in behavior, the burden of the tax exceeds the revenue
generated, with the result that an excess burden is created.
Tax Loopholes and Excess Burden
When tax loopholes exist, economic choices are distorted by tax considerations and this
impairs economic efficiency.
SHIFTING THE TAX BURDEN: TAX INCIDENCE
The “flypaper” theory of incidence is often wrong.
That is, people who pay a tax are often able to shift its burden to other people.
The Incidence of Excise Taxes
The incidence is determined not by who physically pays the tax, but by the elasticities of
The Incidence of the Payroll Tax
Economists view payroll tax as an excise tax on labor.
Chapter 17/Taxation and Resource Allocation
WHEN TAXATION CAN IMPROVE EFFICIENCY
Some taxes that change behavior are nevertheless good because they help to achieve some
EQUITY, EFFICIENCY, AND THE OPTIMAL TAX
All taxes have some negative effects in terms of efficiency and equity.
PUZZLE REVISITED: WHY WE CAN’T SIMPLIFY THE TAX CODE
Tax simplification means closing loopholes and many loopholes are politically popular.
MARGIN DEFINITIONS
Progressive Tax: one in which the average tax rate paid by an individual rises as income rises.
Proportional Tax: one in which the average tax rate is the same at all income levels.
Regressive Tax: one in which the average tax rate falls as income rises.
Average Tax Rate: the ratio of taxes to income.
Chapter 17/Taxation and Resource Allocation
Social Security System: raises funds from the payroll tax and pays Social Security benefits to
retirees.
Property Tax: tax levied on the assessed values of properties, such as houses and office
buildings.
MAJOR IDEAS
1. Taxes in the United States have been quite constant as a percentage of gross domestic
product since the early 1970s.
2. The federal government raises most of its revenue by direct taxes, such as the personal
and corporate income taxes and the payroll tax. Of these, the payroll tax is increasing
most rapidly.
3. The Social Security system relied successfully on pay-as-you-go financing for decades.
In recent years, however, it has been accumulating a large trust fund to be used to pay
benefits to the baby boom generation when it retires. But experts do not think that this
Chapter 17/Taxation and Resource Allocation
8. When people change their behavior on account of a tax, they often shift the burden of the
tax onto someone else. This is why the “flypaper theory of incidence”—the belief that the
burden of any tax sticks where Congress puts it—is often incorrect.
9. The burden of a sales or excise tax normally is shared between the suppliers and the
consumers. The manner in which it is shared depends on the elasticities of supply and
demand.
ON TEACHING THE CHAPTER
Instructors may choose whether to emphasize the institutional, descriptive part of this chapter or
the analytical part. Most will be attracted to the analytical part, but it is worth remembering that
beginning students have probably come to this class with almost no knowledge of the magnitude
and types of taxation in the United States.
One might begin by posing some basic questions to the students, such as how much U.S.
income is taxed, how the U.S. tax rate compares with other countries, and what taxes are
imposed by what levels of government—as well as whether the students consider the current
level of taxation to be too high, too low, or just about right. Their answers to these questions will