N GREGORY MANKIW PRINCIPLES OF ECONOMICS Eighth Edition

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N. GREGORY MANKIW PRINCIPLES OF ECONOMICS Eighth Edition CHAPTE R 12 The Design of

N. GREGORY MANKIW PRINCIPLES OF ECONOMICS Eighth Edition CHAPTE R 12 The Design of the Tax System Premium Power. Point Slides by: V. Andreea CHIRITESCU Eastern Illinois University © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 1

Look for the answers to these questions: • What are the largest sources of

Look for the answers to these questions: • What are the largest sources of tax revenue in the U. S. ? • What are the efficiency costs of taxes? • How can we evaluate the equity of a tax system? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 2

Introduction • ‘A government can sometimes improve market outcomes’ – Providing public goods –

Introduction • ‘A government can sometimes improve market outcomes’ – Providing public goods – Regulating the use of common resources – Remedying the effects of externalities • The government – Raises revenue through taxation – To perform its many functions © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 3

Introduction • Lessons about taxes from earlier chapters: – A tax on a good

Introduction • Lessons about taxes from earlier chapters: – A tax on a good reduces the market quantity of that good. – The burden of a tax is shared between buyers and sellers depending on the price elasticities of demand supply. – A tax causes a deadweight loss. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 4

Government Revenue as a Percentage of GDP: Changes over Time This figure shows revenue

Government Revenue as a Percentage of GDP: Changes over Time This figure shows revenue of the federal government and of state and local governments as a percentage of gross domestic product (GDP), which measures total income in the economy. It shows that the government plays a large role in the U. S. economy and that its role has grown over time. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 5

An Overview of U. S. Taxation • Government revenue - increased – As percentage

An Overview of U. S. Taxation • Government revenue - increased – As percentage of total income – As economy’s income has grown • Government’s revenue from taxation has grown even more • As a nation gets richer – Government - takes a larger share of income in taxes © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 6

Government Revenue as a Percentage of GDP: International Comparisons © 2018 Cengage Learning®. May

Government Revenue as a Percentage of GDP: International Comparisons © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 7

Receipts of the Federal Government: 2016 Q 1 Amount Percent (billions) person of receipts

Receipts of the Federal Government: 2016 Q 1 Amount Percent (billions) person of receipts Personal current taxes $1, 572. 8 $4, 865. 3 45. 0% Social insurance 1, 224. 1 3, 786. 6 35. 1 Taxes on corporate income 410. 6 1270. 2 11. 8 Others 284. 2 879. 1 8. 1 Total $3, 491. 7 $10, 801. 2 100. 0% © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 8

Receipts of the State and Local Government: 2016 Q 1 Amount Percent (billions) person

Receipts of the State and Local Government: 2016 Q 1 Amount Percent (billions) person of receipts Sales taxes Property taxes Personal income taxes $549. 5 466. 3 $1, 699. 8 1, 442. 5 34. 7% 29. 5 419. 0 1, 296. 1 26. 5 Corporate income taxes Other Total 58. 5 88. 3 $1, 581. 6 181. 0 273. 1 $4, 892. 5 3. 7 5. 6 100. 0% © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 9

Taxes and Efficiency • Policymakers – Equity and efficiency • Costs of taxes to

Taxes and Efficiency • Policymakers – Equity and efficiency • Costs of taxes to taxpayers – Tax payment itself – Deadweight losses • Taxes distort the decisions that people make – Administrative burdens • Taxpayers bear as they comply with the tax laws © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 10

Taxes and Efficiency • ‘People respond to incentives’ • Taxes distort incentives – Cause

Taxes and Efficiency • ‘People respond to incentives’ • Taxes distort incentives – Cause people to allocate resources according to tax incentives rather than true costs and benefits • Deadweight loss – The fall in taxpayers’ well-being exceeds the revenue the government collects © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 11

Should income or consumption be taxed? • Income tax reduces the incentive to save:

Should income or consumption be taxed? • Income tax reduces the incentive to save: – If income tax rate is 25%, then 8% interest rate = 6% after-tax interest rate. – The lost income compounds over time. • Some economists advocate taxing consumption instead of income. – Would restore incentive to save. – Better for individuals’ retirement income security and long-run economic growth. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 12

Should income or consumption be taxed? • Consumption tax-like provisions in the U. S.

Should income or consumption be taxed? • Consumption tax-like provisions in the U. S. tax code include Individual Retirement Accounts, 401(k) plans. – People can put a limited amount of saving into such accounts. – The funds are not taxed until withdrawn at retirement. • Europe’s Value-Added Tax (VAT) is like a consumption tax © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 13

Taxes and Efficiency • Administrative burden – Includes the time and money people spend

Taxes and Efficiency • Administrative burden – Includes the time and money people spend to comply with tax laws – Encourages the expenditure of resources on legal tax avoidance • e. g. , hiring accountants to exploit “loopholes” to reduce one’s tax burden – Is a type of deadweight loss © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 14

Taxes and Efficiency • Administrative burden – Could be reduced if the tax code

Taxes and Efficiency • Administrative burden – Could be reduced if the tax code were simplified – But would require removing loopholes, politically difficult © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 15

Taxes and Efficiency • Average tax rate – Total taxes paid divided by total

Taxes and Efficiency • Average tax rate – Total taxes paid divided by total income – Measures the sacrifice a taxpayer makes • Marginal tax rate – The extra taxes paid on an additional dollar of income – Measures the incentive effects of taxes on work effort, saving, etc. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 16

Taxes and Efficiency • Lump-sum taxes – Same amount of tax for every person

Taxes and Efficiency • Lump-sum taxes – Same amount of tax for every person – Example: lump-sum tax = $4000/person Income Average tax rate Marginal tax rate $20, 000 20% 0% $40, 000 10% 0% © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 17

Taxes and Efficiency • Lump-sum taxes – Most efficient tax possible: a person’s decisions

Taxes and Efficiency • Lump-sum taxes – Most efficient tax possible: a person’s decisions do not alter the amount owed • Doesn’t distort incentives, doesn’t cause deadweight losses • Imposes a minimal administrative burden – Perceived as unfair: • Relative to income, the poor pay much more than the rich (even though everybody pays the same in $ terms) © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 18

Taxes and Equity • Equity – Another goal of tax policy – Distributing the

Taxes and Equity • Equity – Another goal of tax policy – Distributing the burden of taxes “fairly. ” • Agreeing on what is “fair” is much harder than agreeing on what is “efficient. ” – Yet, there are several principles people apply to evaluate the equity of a tax system © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 19

Taxes and Equity • The benefits principle – People should pay taxes based on

Taxes and Equity • The benefits principle – People should pay taxes based on the benefits they receive from government services – Tries to make public goods similar to private goods – Example: Gasoline taxes • Amount of tax paid is related to how much a person uses public roads © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 20

Taxes and Equity • The ability-to-pay principle – Taxes should be levied on a

Taxes and Equity • The ability-to-pay principle – Taxes should be levied on a person according to how well that person can shoulder the burden • All taxpayers should make an “equal sacrifice” • A $10, 000 tax bill is a bigger sacrifice for a poor person than a rich person. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 21

Taxes and Equity • Vertical equity – Taxpayers with a greater ability to pay

Taxes and Equity • Vertical equity – Taxpayers with a greater ability to pay taxes should pay larger amounts • Richer taxpayers should pay more than poorer taxpayers • How much more should the rich pay? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 22

The Burden of Federal Taxes © 2018 Cengage Learning®. May not be scanned, copied

The Burden of Federal Taxes © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 23

Three Tax Systems • Proportional tax – High-income and low-income taxpayers pay the same

Three Tax Systems • Proportional tax – High-income and low-income taxpayers pay the same fraction of income • Regressive tax – High-income taxpayers pay a smaller fraction of their income than do low-income taxpayers • Progressive tax – High-income taxpayers pay a larger fraction of their income than do low-income taxpayers © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 24

Three Tax Systems Regressive income tax % of income $50, 000 $15, 000 30%

Three Tax Systems Regressive income tax % of income $50, 000 $15, 000 30% Proportional tax % of income Progressive tax % of income $12, 500 25% $10, 000 20% 100, 000 25 25, 000 25 200, 000 40, 000 20 50, 000 25 60, 000 30 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 25

The Federal Income Tax Rates: 2014 © 2018 Cengage Learning®. May not be scanned,

The Federal Income Tax Rates: 2014 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 26

Taxes and Equity • Horizontal equity – Taxpayers with similar abilities to pay taxes

Taxes and Equity • Horizontal equity – Taxpayers with similar abilities to pay taxes should pay the same amount – Special provisions that alter a family’s tax based on its specific circumstances – Problem: Difficult to agree on what factors, besides income, determine ability to pay © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 27

Active Learning 1 Taxes and marriage, part 1 The income tax rate is 25%.

Active Learning 1 Taxes and marriage, part 1 The income tax rate is 25%. The first $20, 000 of income is excluded from taxation. Tax law treats a married couple as a single taxpayer. Sam and Diane each earn $50, 000. i. If Sam and Diane are living together unmarried, what is their combined tax bill? ii. If Sam and Diane are married, what is their tax bill? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 28

Active Learning 1 Answers If unmarried, Sam and Diane each pay 0. 25 x

Active Learning 1 Answers If unmarried, Sam and Diane each pay 0. 25 x ($50, 000 – 20, 000) = $7500 Total taxes = $15, 000 = 15% of their joint income. If married, they pay 0. 25 x ($100, 000 – 20, 000) = $20, 000 or 20% of their joint income. The $5, 000 increase in the tax bill is called the “marriage tax” or “marriage penalty. ” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 29

Active Learning 1 Taxes and marriage, part 2 The income tax rate is 25%.

Active Learning 1 Taxes and marriage, part 2 The income tax rate is 25%. For singles, the first $20, 000 of income is excluded from taxation. For married couples, the exclusion is $40, 000. Harry earns $0. Sally earns $100, 000. i. If Harry and Sally are living together unmarried, what is their combined tax bill? ii. If Harry and Sally are married, what is their tax bill? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 30

Active Learning 1 Answers If unmarried, Harry pays $0 in taxes. Sally pays: 0.

Active Learning 1 Answers If unmarried, Harry pays $0 in taxes. Sally pays: 0. 25 x ($100, 000 – 20, 000) = $20, 000 Total taxes = $20, 000 = 20% of their joint income. If married, they pay 0. 25 x ($100, 000 – 40, 000) = $15, 000 or 15% of their joint income. The $5000 decrease in the tax bill is called the “marriage subsidy. ” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 31

Taxes and Equity • Tax incidence – Who bears the burden of taxes –

Taxes and Equity • Tax incidence – Who bears the burden of taxes – Central to evaluating tax equity – Person who bears the burden a tax • Not always the person who gets the tax bill from the government • Taxes alter supply and demand – Alter equilibrium prices – Indirect effects © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 32

Taxes and Equity • Example: A tax on fur coats – May appear to

Taxes and Equity • Example: A tax on fur coats – May appear to be vertically equitable – But furs are a luxury with very elastic demand – The tax shifts demand away from furs, hurting the people who produce furs (who probably are not rich) • When evaluating tax equity, must take tax incidence into account. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 33

Who pays the corporate income tax? People pay all taxes • Tax on a

Who pays the corporate income tax? People pay all taxes • Tax on a corporation – Corporation – more like a tax collector than taxpayer – Burden of the tax ultimately falls on people – Workers and customers bear much of the burden of the corporate income tax – Popular because it appears to be paid by rich corporations © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 34

Who pays the corporate income tax? • Suppose the government levies a tax on

Who pays the corporate income tax? • Suppose the government levies a tax on automakers: – Owners receive less profit, may respond over time by shifting their wealth out of the auto industry. – The supply of cars falls, car prices rise, car buyers are worse off. – Demand for auto workers falls, wages fall, workers are worse off. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 35

Trade-off: Equity vs. Efficiency • Equity and efficiency – Most important goals of a

Trade-off: Equity vs. Efficiency • Equity and efficiency – Most important goals of a tax system – Often conflict – Political leaders differ in their views on this tradeoff • Economics can help us: – Better understand the tradeoff – Avoid policies that sacrifice efficiency without any increase in equity © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 36

Summary • The U. S. government raises revenue using various taxes – Federal government:

Summary • The U. S. government raises revenue using various taxes – Federal government: personal income taxes and payroll taxes for social insurance. – State and local governments: sales taxes and property taxes. • The efficiency of a tax system refers to the costs it imposes on taxpayers. – Deadweight loss: taxes alter incentives – Administrative burden of complying with the tax laws. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 37

Summary • The equity of a tax system concerns whether the tax burden is

Summary • The equity of a tax system concerns whether the tax burden is distributed fairly among the population. – Benefits principle: it is fair for people to pay taxes based on the benefits they receive from the government. – Ability-to-pay principle: it is fair for people to pay taxes based on their capability to handle the financial burden. – The distribution of tax burdens is not the same as the distribution of tax bills. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 38

Summary • When considering changes in the tax laws, policymakers often face a trade-off

Summary • 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. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 39