195
WHAT’S NEW IN THE EIGHTH EDITION:
The information that was presented in Table 1 in the previous edition is now in a bar chart, Figure 2.
Based on feedback from reviewers, all material in the previous edition on how tax receipts are spent by
federal, state, and local governments has been removed.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
➢ how the U.S. government raises money.
➢ the efficiency costs of taxes.
➢ alternative ways to judge the equity of a tax system.
➢ 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:
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
externality, provides a public good, or regulates the use of a common resource, it needs tax revenue to
KEY POINTS:
• The U.S. government raises revenue using various taxes. The most important taxes for the federal
government are personal income taxes and payroll taxes for social insurance. The most important
taxes for state and local governments are sales taxes and property taxes.
THE DESIGN OF THE TAX
SYSTEM
12
196 ❖ Chapter 12/The Design of the Tax System
• 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.
CHAPTER OUTLINE:
I. An Overview of U.S. Taxation
A. Figure 1 shows the level of government revenue in the United States, including federal, state,
and local governments, as a percentage of total income for the U.S. economy.
1. The role of government has grown substantially over the past century.
2. The government’s revenue from taxation has grown at a faster rate than the economy’s level
of income.
B. Figure 2 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.
C. Taxes Collected by the Federal Government
1. Table 1 reports the receipts of the federal government in 2014.
a. Total receipts were $3.3 trillion or $10,235 per person.
Figure 1
Figure 2
Table 1
For this material to be relevant, you will want to update it from time to time. Data on
government receipts can be found easily on the Internet or through the most recent
edition of the Economic Report of the President.
Chapter 12/The Design of the Tax System ❖ 197
2. Personal income taxes
a. The largest source of revenue is the personal income tax.
3. Payroll taxes
4. Corporate income taxes
a. A corporate income tax is a tax paid by a business set up to have its own legal existence
based on its profit.
5. Other taxes
a. The other category includes excise taxes, estate taxes, and customs duties.
D. Taxes Collected by State and Local Governments
2. The two most important taxes for state and local governments are sales taxes and property
taxes.
3. State and local governments also levy individual and corporate income taxes.
4. State governments also receive funding from the federal government.
II. Taxes and Efficiency
A. Well-designed tax policies minimize the deadweight losses that occur when taxes distort
incentives. They also minimize the administrative burdens that taxpayers face when complying
with tax laws.
B. Deadweight Losses
1. Taxes lead to deadweight losses because they lower total surplus.
Table 3
Table 2
198 ❖ Chapter 12/The Design of the Tax System
2.
Case Study: Should Income or Consumption Be Taxed?
a. Because interest income is taxed, the current income tax laws discourage saving.
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.
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.
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.
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.
ALTERNATIVE CLASSROOM EXAMPLE:
Income = $100,000
Tax Brackets Tax Rate:
Chapter 12/The Design of the Tax System ❖ 199
E. Lump-Sum Taxes
1. Definition of lump-sum tax: a tax that is the same amount for every person.
2. For this type of tax, the marginal tax rate is equal to zero.
3. This is the most efficient type of tax because it does not distort incentives and thus has no
effect on total surplus. There is also little administrative burden with this type of tax.
most people would view as unfair.
III. Taxes and Equity
A. The Benefits Principle
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
1. Definition of ability-to-pay principle: the idea that taxes should be levied on a
person according to how well that person can shoulder the burden.
2. Definition of vertical equity: the idea that taxpayers with a greater ability to pay
taxes should pay larger amounts.
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.
e.
Case Study: How the Tax Burden Is Distributed
– Table 5 shows that the tax burden in
this country is progressive. In addition, studies have shown that, if transfer payments are
also taken into account, the degree of progressivity is substantial.
3. Definition of horizontal equity: the idea that taxpayers with similar abilities to pay
taxes should pay the same amount.
Table 4
Table 5
200 ❖ Chapter 12/The Design of the Tax System
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.
D.
In the News: Tax Expenditures
1. Eliminating tax expenditures, special tax cuts for things like mortgage interest and charitable
giving, could result in lower taxes and fiscal sustainability.
2. This article from
The New York Times
discussing the benefits of eliminating tax expenditures
and the politics associated with such a proposal.
IV. Conclusion: The Trade-off between Equity and Efficiency
Activity—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:
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
Chapter 12/The Design of the Tax System ❖ 201
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.
B. Analyze these taxes using the principle of horizontal equity
C. Classify each tax as progressive, proportional, or regressive
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 whole
receive benefits from education. To the extent that education provides positive
externalities, this tax could be justified on the benefits principle.
B. Are taxes the same for households earning the same income?
None of these taxes is horizontally equitable. They fall disproportionately on
households who buy more food, have school-age children, own vacation homes, and
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
D. Which Tax?
No single tax satisfies all equity concerns. If market distortions are also considered,
202 ❖ 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 personal
income taxes and payroll taxes (social insurance taxes). The two most important sources of
tax revenue for state and local governments are sales taxes and property taxes.
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
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
Chapter Quick Quiz
1. b
Questions for Review
1. Over the past century, the government’s tax revenue has grown more rapidly than the rest of
Chapter 12/The Design of the Tax System ❖ 203
6. Wealthy taxpayers should pay more taxes than poor taxpayers should because: (1) they
Problems and Applications
1. 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 1965, state and
3. 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
taxation, the system makes the rich bear a greater burden of taxation than the poor. From
204 ❖ Chapter 12/The Design of the Tax System
4. 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
6. The effect of the Tax Reform Act of 1986 on interest payments was to reduce consumer debt
7. a. The fact that visitors to many national parks pay an entrance fee is an example of the