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Chapter 13: Taxes
Chapter Summary:
This chapter focuses on the incentive effects of taxation on both demand
and supply side variables. It begins with a brief historical review of U.S. tax
revenue by source for both federal and local units of government. It then
examines how the burden of the income tax is divided among various income
groups. One of the striking features of the data is the trend in the share of the
income tax burden paid by the upper 50% of households; which account for
Chapter Outline:
I. Taxes in the United States
II. Types of Taxes
IV. Transfer Payments
Teaching Tips:
1. For an empirical study of the optimal design of marginal tax rates, see Gruber
2. One of the objectives of this chapter is to demonstrate the substitution and
income effects of marginal tax rates may have opposite effects on labor supply.
3. A system of low, flat marginal tax rates seems to be catching on in the former
communist block, beginning with Russia’s 13 % rate on personal income. This
presents the question, if the U.S. were to start from scratch, would we design our
that might influence the politics of tax reform.
4. One of the frequent tax cuts provided periodically by the Federal government
is the investment tax credit. The temporary nature of these tax credits creates the
Answers to review questions, pg. 338
1. The average tax rate is the total tax liability/total income, but the marginal tax
rate is the change in tax liability/change in income. In the case of a flat tax that is
2 Theoretically, if the labor supply is sufficiently elastic, the reduction in labor
supplied would reduce the tax “base” so that total taxes collected decrease. This
3. Lower rates of consumption and leisure is a rational response to lower levels
of income. Less leisure implies an increase in the labor supply. In the chapter it
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Answers to problems for discussion, pg. 338-339
4. a. If the elimination of deductions permits government to reduce the marginal
tax rate on labor income, then the substitution effect predicts an increase in
labor income. More labor employed will make capital more productive and
should result in an increase in capacity utilization rates. The net result would
be to raise GDP,Y.
b. There are similarities. Currently, the payroll tax provides a constant
marginal tax rate on labor income, just as the proposed flat tax would.
5. a. The tax on consumption will raise the effective price; it will now take (1+c)
to purchase consumer goods. The household budget constraint can be
written as:
(1+c)C+(1/P)B+K=(w/P)Ls+r(B/P +K) + V-T
d. This change introduces intertemporal substitution effects. Current
consumption is less expensive than future consumption, so current
6. I found the 2004 report contained more details than the 2005 report. The
essential features of the 2001 package included reductions in marginal tax rates
and the increase in child care tax credits, while in 2003 the tax cuts on income
7. a. The increase in nominal wage and interest rates would have pushed
individuals into brackets with higher marginal tax rates.
8. a. Since r=i–, after tax real rate of return is (1–r)*i- . For example, if the tax
rate is 20%, the nominal interest rate is 10% and inflation is 5%, then the after tax
real rate of return is 3% =(.2*.1-.05).
b. The inflation rate will increase. Because of the impact on money demand,
the price level will “jump” in the current period and will settle at a higher rate
9. a. Food stamps reduce the opportunity cost of leisure: labor supply
decreases.
b. The EITC increases the opportunity cost of leisure for those with little
earning power. The substitution effect on labor supply is positive. On the other