Chapter 7 Taxation: Criteria for evaluating revenue options

“Taxes are the price we pay for civilization”- 1927, Supreme Court Justice Oliver Wendell Holmes

Lecture Outline: Overview of taxation in the United States Standards for tax policy Taxes and Externalities

Principles underlying taxation Private firms raise revenues through voluntary

exchange for goods and services with consumers Ideally, taxes exist to provide services where the

private market is expected to fail to produce these goods and services

Because of the incentive to free-ride when public goods are produced, government uses coercive payments (taxes) to collect revenues

Tax policy then distributes the cost of paying for these goods and services across society

Government Revenue

Sources of government revenue in the United States income tax, purchase or sales tax, property ownership or transfer

Revenues from charging for services (user fees, etc.) and others sources (lotteries, interest on investments, royalties, etc.) account for a small percent of govt. funds

Special revenues, such as payroll tax on employees for social security are allocated for specific uses only

Most economically advanced countries use a general sales tax, US is unique in relying primarily on an income tax

Taxation policies are a direct result of the political organization of federalism (division of political power and responsibilities among different units of government)

Since sales tax has been the revenue source for local governments, Federal govt. has had to look elsewhere

Similarly, land property taxes would have disproportionally burdened larger states at the expense of smaller states

Thus the reliance is on “direct taxation”, taxation on income rather than use of that income

Where does the US stand in terms of taxation? Compare the US rate of taxation to that of

other industrial counties (table 7-3) Generally, the tax burden is low when

compared to other nations. 28.9% compared to average of 38.4% among industrial nations. (Low of 16% with Mexico, and High of 52% in Sweden).

Ranks among bottom tier with Turkey, Mexico, Korea and Japan

US relies heavier on personal income and corporate than most

Heavier on property taxes And less on goods and services or sales

taxes About average in terms of amounts paid

toward social security

Tax Policy Standards

Politics of taxation tends to be avoidance of the cost, while complaining when not receiving the benefit

Public opinion alone (and indeed direct democracy) would tend to produce very inefficient policies

“Don’t tax you, don’t tax me, tax that fellow behind the tree” (Sen. Russell Long)

Where income tax dollars are spent

General taxation principles

Since taxation removes funds from private decision-makers, whose incentives to make purchasing decisions are directly tied to the benefits they receive from those decisions (and are therefore “efficient”), toward public decision-makers, whose incentives are tied to broad organizational and political goals unrelated to the goods and services the use of those funds provide (and are therefore less “efficient”), any taxation represents a burden on the private economy.

However without some taxation public goods and service would not be provided

So the trick, is to design tax policies that gain revenue from the private sector that do not unduly burden the economy

Four principles that guide taxation in a market economy

1. Equity

2. Revenue consequences

3. Collection costs

4. Economic efficiency

1. Equity

While logical to say taxes should be distributed fairly, defining fairness of the tax burden is rather difficult

Do you think the tax system in this country is fair?

Write how you would define a “fair” taxation system

Two general equity principles1) Benefits Received - defined according to the

taxpayers’ benefits form or usage of a public service

2) Ability to Pay - defined according to taxpayers’ capacity to bear the burden

Benefits received approach Benefits received approach mimics the private

market The higher the payment the greater the benefit When govt. sells a service, citizens pay a user fee

(ex: toll roads, gas tax to pay for roads, ammo tax to pay for wildlife management)

Avoids wasteful over-production when goods are produced at lower than market prices

Does not over-subsidize some goods at the expense of other users

Avoids anti-tax sentiments

Problems with benefits received approach

Pure public goods do not provide an easy way to match benefits with costs

Does not allow re-distributive policiesWhether redirecting funds from the wealth to

the disadvantaged Ex: CA Proposition 63

Or in allowing equal access to nationally produced benefits

Ex: Determining the admittance costs to national parks

Ability-to-pay approach

Argues that regardless of service the greatest burden should be placed on those who can most easily bear the cost

Maintains that the types of goods provided by govt. and the market are fundamentally different and need to be supplied differently

Distribution of benefits should be provided by concerns of equity and fairness

Problems with the ability-to-pay approach

Difficult to determine actual individual level demand without corresponding cost

Over-supply of some types of goods

Horizontal and vertical equity

Horizontal refers to equal treatment of taxpayers who have equal capability to pay taxes

Taxes may not be horizontally fair when they vary by individual preference and taste, or when one sector of the economy has reduced tax burden (ex: fastfood tax, tax breaks for high risk investors)

Vertical equity

Refers to the relative tax burden paid by individuals with different capabilities to pay taxes

Question is how should tax payments differ among high and low income earners

Tax structures can then be categorized as: Proportional – effective tax rates are the

same among all groups (10% across all income levels)

Progressive – higher rates are applied to higher incomes

Regressive – effective tax rates are higher for lower income groups and lower for higher income groups

How much do Americans make?US Income Pyramid

As Percent of Population Income1.2 % $ 719,000

5.9 %11.9 %

23.6 %

22.6 %

22.5 %

$ 276,000$ 188,000

$ 132,000

$ 53,000

$ 35,000

23.3 %

$ 21,000

As Percent of Income

20 %

20 %

20 %

20 %

20105

1%

22.7 %$ 8,400

How much do Americans pay?

Who really pays?

The entity to which a tax burden has been assigned, may be able to shift the tax

The impact may not coincide with the incidence because of tax shifting

While law define the impact, market forces determine the actual incidence

Typically applies to business taxes

Business replies to tax burdens three ways: 1. Forward shifting: the business increases

prices to consumers 2. Backward shifting: reduces the price

paid for resources purchased (wages to employees and for raw materials)

3. Absorption: returns a lower profit to its owners

Shifting has a similar impact

Citizens are also consumers of goods and producers of labor and material for producing those goods

Individual consumers either they pay a higher purchase price when business tax increases

Or receive lower prices for the goods and services they provided to business employers (labor, raw material, etc.)

All taxes are ultimately borne by individuals

If all taxes are ultimately paid by individuals, then why tax businesses?

1. Politically more palatable 2. Taxes can be designed to pay for costs

they produce to society but do not account for in their decision-making

Examples would include high consumption of service (utilities, public safety, court systems) & externalities (environmental damage, pollution, undesirable social or health effects)

3. It is also less costly in terms of collection

Since additional costs will be shifted to consumers, easier to tax the product a the point of sale, than collect from individuals after purchase (ex: luxury taxes)

4. Finally, since all consumers will bear the burden, it may shift tax paying responsibilities to individual outside a specific political jurisdiction

2. Revenue Consequences Tax is only worthwhile if it produces revenues

at a socially acceptable rate Tax revenue equation:

Tax yield (R) = Tax rate (t) times tax base (B)

R=t * BSimple linear relationship If total individual income is 200 million and tax rate

is 1%, then yield is 2 million.So if we increase the rate to 4% the yield is 4

million, right?

Economic impact of taxes on revenues

Linear relationship fails to include reaction to taxpayer

If increase tax burden, less incentive to earn higher incomes and some taxpayers may leave the taxing area

Tax base will also be determined by the tax rate

So the effective tax base is R=t*B(t)

Effect of economic growth on revenue potential As an economy grows, so do the demands

for government services (both at the micro and macro level)

Local economies need to provide more infrastructure and utilities, law enforcement and effective court systems, and more demand for re-distributive policies

Some types of taxes are better able to match revenue raising capabilities with economic growth

The relationship between a 1% change in income to a population and the percent change in revenue is expressed as “elasticity”

Tax-Income Elasticities

Personal income tax 1.75 Corporate tax 1.1 General property tax 0.87 General sales tax 1.0 Motor fuel tax 0.73 Tobacco tax 0.26

3. Collection costs

Costs of collection reduce the amount available to use toward goods and services

Lower the complexity of a tax system, the lower the cost of collection

Tradeoffs exist between equity and collection costs

4. Economic Efficiency

Taxes always have some effect on economic efficiency, distort incentives and change behavior

Creates a “tax wedge”, difference in before and after tax price

Some argue that the best a tax can do is remain neutral and impact the economy as little as possible

Others maintain that taxes can be used to alter incentives to produce favorable market outcomes (such as reducing the generation of externalities)

Types of activities taxed and their effects Work vs. leisure activities – high taxes on overtime will

reduce the incentive to work more and induce an incentive to choose more leisure time

Business operations – firms will organize activities around tax code. (Ex: inventory clearances).

Location – high taxes causes consumers to purchase those items in neighboring areas (liquor, cigarettes, etc.). And businesses to serve mobile consumers locate to gain those customers.

Personal management – since professional conventions are tax-deductible, most conferences tend to locate at resorts

Investment decisions – investments choices are made on after-tax profits and may direct funds to different types of projects (ex: toward municipal bonds)

Loss to an economy caused by a tax can be minimized by: 1. Keeping tax rates low (have broad,

diverse tax systems) 2. Avoiding different tax rates on similar

products 3. Avoiding taxes in markets where buyers

and/or sellers react dramatically to changes in price

Local Taxes and Economic Development

State and local governments have incentives to use tax policies to attract investments for jobs and revenue

Competition makes taxes critical policy variable for impacting local development

Questions regarding how much tax policy really influences development

1. Taxes have a small effect on interregional locations of economic activities. Total tax burden is less important than the specific burden for particular businesses.

2. Within a region taxes have a larger effect 3. Local govts. May offer additional

incentives: abatements, exemptions, credits, etc.

Importance of transparency

Because taxation in a democracy relies on some basic level of public compliance, it is important that people know what happens to the taxes they pay

The greater the transparency, the greater the level of compliance and lower the collection costs

Elements of transparency

Adoption

Administration

Compliance requirements

Payment amount

Taxes and externalities

Emission taxes

Indirect taxes on goods and services