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208
WHAT’S NEW IN THE SIXTH EDITION:
All tables have been updated to the most recently available numbers. Discussion of transfer
payments to the poor and unemployed has been added. Information on the Obama healthcare
reform bill has been added. Two new
In the News
boxes on “The Temporarily Disappearing
Estate Tax” and “The Value Added Tax” have been added.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ how the U.S. government raises and spends money.
CONTEXT AND PURPOSE:
Chapter 12 is the third chapter in a three-chapter sequence on the economics of the public sector.
Chapter 10 addressed externalities. Chapter 11 addressed public goods and common resources. Chapter
12 addresses the tax system. Taxes are inevitable because when the government remedies an
THE DESIGN OF THE TAX
SYSTEM
12
Chapter 12/The Design of the Tax System ❖ 209
KEY POINTS:
• The U.S. government raises revenue using various taxes. The most important taxes for the federal
government are individual income taxes and payroll taxes for social insurance. The most important
taxes for state and local governments are sales taxes and property taxes.
• 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:
I. A Financial Overview of the U.S. Government
B. Table 1 compares the tax burden for several major countries, as measured by the central
government’s tax revenue as a percentage of the nation’s total income.
Table 1
In order 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
C. The Federal Government
1. Receipts
a. Table 2 reports the receipts of the federal government in 2009.
b. Total receipts were $2,105 billion or $6,846 per person.
e. Other important revenue sources include payroll taxes (social insurance taxes), the
corporate income tax, and excise taxes.
2. Spending
a. Table 4 reports where the federal government spent its budget in 2009.
b. Total spending was $3,518 billion or $11,441 per person.
3. Definition of budget deficit: an excess of government spending over government
receipts.
Table 2
Table 4
Table 3
Chapter 12/The Design of the Tax System ❖ 211
D.
Case Study: The Fiscal Challenge Ahead
1. In 2009, the federal government had a budget deficit of $1,413 billion.
E. State and Local Government
1. Receipts
a. Table 5 reports the receipts from state and local governments for 2007.
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.).
212 ❖ Chapter 12/The Design of the Tax System
d. State and local governments also levy individual and corporate income taxes.
e. State governments also receive funding from the federal government.
2. Spending
a. Table 6 shows how state and local governments spent their budgets in 2007.
B. Deadweight Losses
1. Taxes lead to deadweight losses because they lower total surplus.
2.
Case Study: Should Income or Consumption Be Taxed?
a. Because interest income is taxed, the current income tax laws discourage saving.
3.
In the News: The Temporarily Disappearing Estate Tax
a. The U.S. tax on large estates expired in January 2010 and is expected to resume in
January 2011.
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.
Table 6
Provide students with several examples of how taxes lead to an inefficient outcome.
Chapter 12/The Design of the Tax System ❖ 213
2. Many taxpayers spend resources hiring accountants and tax lawyers.
a. People often need help filling out complex tax forms.
D. Marginal Tax Rates versus Average Tax Rates
1. Definition of average tax rate: total taxes paid divided by total income.
E. Lump-Sum Taxes
1. Definition of lump-sum tax: a tax that is the same amount for every person.
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.
ALTERNATIVE CLASSROOM EXAMPLE:
Income = $100,000
Tax Brackets Tax Rate:
$0–$20,000 0%
214 ❖ Chapter 12/The Design of the Tax System
a. Three tax systems: proportional, regressive, and progressive.
b. Definition of proportional tax: a tax for which high-income and low-income
taxpayers pay the same fraction of income.
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
1. The burden of a tax is not always borne by who pays the tax bill.
3.
Case Study: Who Pays the Corporate Income Tax?
a. The corporate income tax is popular among voters because a corporation is nonhuman
and faceless.
Table 7
Table 8
Chapter 12/The Design of the Tax System ❖ 215
D.
In the News: The Value Added Tax
1. As government deficits grow, policymakers look for new revenue sources such as a value
added tax.
IV. Conclusion: The Trade-off Between Equity and Efficiency
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
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:
Ask the students to answer the following questions. Give them time to write an answer, then
discuss their answers before moving to the next question:
A. Analyze these taxes using the benefits principle.
D. Which tax would you choose to finance education? Explain.
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
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
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
revenue. One tax system is more efficient than another if the same amount of tax revenue
can be raised at a lower cost.
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.
C. Vertical equity
1. A sales tax on food
Regressive—lower income households spend a larger portion of their income on
food.
D. Which Tax?
No single tax satisfies all equity concerns. If market distortions are also considered,
Chapter 12/The Design of the Tax System ❖ 217
3. The benefits principle is the idea that people should pay taxes based on the benefits they
receive from government services. It tries to make public goods similar to private goods by
making those who benefit more from the public good pay more for it. The ability-to-pay
principle is the idea that taxes should be levied on a person according to how well that
person can shoulder the burden. It tries to equalize the sacrifice each person makes toward
paying taxes.
Questions for Review
2. The two most important sources of revenue for the U.S. federal government are individual
income taxes (about 43% of total revenue) and social insurance taxes (about 42%).
3. Corporate profits are taxed first when the corporate income tax is taken out of a
4. The burden of a tax to taxpayers is greater than the revenue received by the government
6. 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.
8. 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
218 ❖ Chapter 12/The Design of the Tax System
Problems and Applications
1. The federal government had a budget deficit in 2010. 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 1960, state and
local government revenue was 33% of total government revenue; by 2008, it had risen
to almost 49%.
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.
b. If benefits per retiree were frozen, total expenditures would rise quickly, along with the
number of retirees. To pay for the increased expenditures, tax payments per worker
would rise, because the number of workers isn't growing as rapidly as the number of
retirees.
4. If you earn $20,000 a year, then you pay federal income taxes in two parts: 10% on the first
$8,375 of income and 15% on the amount above $8,375. Thus, your federal income taxes
are ($8,375 0.10) + ($11,625 0.15) = $837.50 + $1743.75 = $2,581.25. You also pay
$20,000 0.153 = $3,060 in federal payroll taxes and $20,000 0.04 = $800 in state
income taxes, for a total tax bill of $6,441.25. Your average tax rate is $6,441.25/$20,000 =
0.322 = 32.2%. Your marginal tax rate is 0.15 + 0.153 + 0.04 = 0.343 = 34.3%.
5. Excluding food and clothing from the sales tax is justified on equity grounds because poor
people spend a greater proportion of their income on those items. By exempting them from
Chapter 12/The Design of the Tax System ❖ 219
6. a. An individual must pay taxes on the asset only when he or she sells it. Thus, this tax law
affects the individual’s decision of whether to keep or sell the asset. Tax revenues on
accrued capital gains are only received by the government when an individual actually
sells the asset. Lowering the tax rate on capital gains may induce individuals to sell
assets that they have been holding to avoid paying the taxes on the accrued capital
gains.
7. If the state raises its sales tax from 5% to 6%, it is not plausible that sales tax revenue will
increase 20%. The increase in the tax rate is 20%, so the only way tax revenue could
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.
10. a. For the proportional tax system, the average tax rate is 25% whether a person earns
income of $50,000, $100,000, or $200,000.
For the regressive tax system, the average tax rate is 30% for someone earning
$50,000, 25% for someone earning $100,000, and 20% for someone earning $200,000.
For the progressive tax system, the average tax rate is 20% for someone earning
220 ❖ Chapter 12/The Design of the Tax System
$50,000, 25% for someone earning $100,000, and 30% for someone earning $200,000.
b. For the proportional tax system, the marginal tax rate as income rises from $50,000 to
$100,000 is the increase in taxes ($12,500) divided by the increase in income ($50,000)
= 25%. The marginal tax rate as income rises from $100,000 to $200,000 is the increase
in taxes ($25,000) divided by the increase in income ($100,000) = 25%.
c. In the proportional tax system, the average tax rate equals the marginal tax rate. In the
regressive tax system, the marginal tax rate is less than the average tax rate and both
tax rates decline as income rises. In the progressive tax system, the marginal tax rate is
11. a. If the deduction for mortgage interest were eliminated, fewer people would desire to
hold mortgages or purchase homes. This would impact housing markets and housing
values. The removal of this deduction will likely improve vertical equity because higher
income households tend to hold larger mortgages and thus currently get larger
deductions. It would also improve horizontal equity because individuals in similar
circumstances would be treated equally, whether or not they own their home, have a
mortgage, or rent. Efficiency would improve for two reasons: less distortion in incentives
and a smaller amount of paperwork in filing taxes.
