Chapter 20: Taxation and the Public Budget

11© 2014 by McGraw-Hill Education Chapter 20 Taxation and the Public Budget 2© 2014 by McGraw-Hill Education • What the major public policy goals of taxation are. • How deadweight loss and administrative costs contribute to the inefficiency of a tax. • How taxes effect business revenue. • What differences exist between proportional, progressive, and regressive taxes. • What sources of tax revenue exist in the United States. • What the public budget is and what relationship exists between revenues and expenditures. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education Price Quantity S D1 • Recall that taxes have two effects: – Raise revenue. – Change the behavior of buyers and sellers. Why tax? Tax 1. Raises revenue Price paid by consumers Price received by sellers 2. and changes behavior.D2 • As a tax is levied on consumers, the demand curve shifts down by the amount of the tax. • Raises revenue for the government. • Changes behavior of buyers and sellers. 24© 2014 by McGraw-Hill Education Deadweight loss is surplus lost due to the reduced quantity. Each tax considered must compare trade-offs between revenue and inefficiency. Principles of taxation 0 10 20 30 40 50 60 70 80 90 100 1 2 4 5 6 7 Price ($) Quantity of jeans (millions of pairs) D1 S 2. which moves equilibrium to a lower quantity. D2 3 1. Tax creates a new demand curve $20 below • Taxes cause changes in behavior and a deadweight loss to occur. – A $20 tax on jeans shifts the demand curve downward. – Deadweight loss is the loss of total surplus that occurs because the quantity of a good that is bought and sold is below the market equilibrium quantity. – Inefficiency is loss in total surplus. 5© 2014 by McGraw-Hill Education The size of deadweight loss is determined by the price elasticity of supply and demand. Principles of taxation DWL = $80DWL = $40 DWL = $60 Deadweight loss (DWL) D1 D2 S Original demand Quantity Price 50 0 30 D1 D2 More elastic demand Quantity Price 50 0 30 • The more elastic demand leads to a larger reduction in quantity under a tax, which leads to larger deadweight loss. • Deadweight loss is minimized under inelastic goods. 30 D1 D2 S Less elastic demand Quantity Price 50 0 $20 62 42 26 $20 54 34 22 $20 58 38 24 6© 2014 by McGraw-Hill Education • If deadweight loss is minimized by taxing activities that people will continue to engage in, a tax on people just existing should minimize deadweight loss. • A lump-sum (head) tax charges the same amount to each taxpayer regardless of their economic behavior or circumstances. – Highly efficient. – People do not find it fair. – Size of the tax is limited by the poorest citizens’ ability to pay. Principles of taxation 37© 2014 by McGraw-Hill Education • The second inefficiency is the administrative burden, which includes the logistical costs of implementing a tax. – Resource costs for government agencies (such as the IRS) and for taxpayers (in the form of lawyers and filling out forms). • The more complex the tax is, the higher the administrative burden will be. Principles of taxation 8© 2014 by McGraw-Hill Education Tax effects • There are two opposing effects when a tax increases: – The price effect increases tax revenue. – The quantity effect decreases tax revenue. • The tax revenue raised is equal to: Tax revenue = Tax per unit × Number of units sold • The tax revenue calculation is an after-the-fact analysis. • Taking the number of units sold without a tax and multiplying by the tax rate is incorrect. – It doesn’t account for individuals’ changes. 9© 2014 by McGraw-Hill Education Tax effects • Increase, as the government gets more revenue per units sold. • Decrease, as fewer units are sold. • The net effect on revenue depends on whether the quantity effect outweighs the price effect. Price effect + = Revenue before tax increase = Revenue after tax increase+ As the tax rate increases, revenue will: T2 1. Tax rate increases Quantity effect 2. and quantity decreases Tax rate (%) Quantity (millions) T1 0 10 20 30 40 50 60 70 80 90 100 2 4 6 8 10 12 14 16 18 20 410© 2014 by McGraw-Hill Education Diminishing returns to revenue • As the tax rate increases from 0, the price effect dominates the quantity effect and revenue rises. • After the maximum, the tax rate is so high that the quantity effect dominates the price effect and revenue falls. • The revenue-maximizing tax rate depends on the elasticity of supply and demand: – The more inelastic supply and demand are, the larger the tax rate required to reach the revenue-maximizing point is. • This curve is sometimes referred to as the Laffer curve.Tax rate Up to a point, Increasing the tax rate increases total revenue. Past that point, increasing the tax rate decreases total revenue. R ev en ue X% 0% 100% Given these two opposing effects, there is a maximum tax revenue generated for a given tax. 11© 2014 by McGraw-Hill Education • Policy-makers and taxpayers are concerned not only with what a tax does, but also with who pays it. • The incidence of a tax tells who bears the burden of a tax. – The statutory incidence tells who is legally obligated to pay the tax to the government. – The economic incidence tells who loses surplus as a result of the tax. – The statutory incidence has no effect on the economic incidence. • The side of the market that is more price-inelastic bears more of the tax burden. • Policy-makers can levy a tax, but have little power in shifting the tax burden between buyers and sellers. Incidence: Who ultimately pays the tax? 12© 2014 by McGraw-Hill Education For each of the following goods, identify whether the tax burden would mostly fall on buyers or sellers. Active Learning: Who pays the tax? 1. Mountain bikes with an elasticity of supply of 1.32 and an elasticity of demand of -3.5. 2. Cigarettes with an elasticity of supply of 2.5 and an elasticity of demand of -.24. 3. Soft drinks with an elasticity of supply of 1 and an elasticity of demand of -2.5. 513© 2014 by McGraw-Hill Education Policy-makers can affect the relative economic incidence of a tax burden by varying the tax rates between rich and the poor. • Suppose two people earn $20,000 and $200,000, respectively. Incidence: Who ultimately pays the tax? Progressive Rate 20% 30% Regressive Rate 65% 6.5% Amount $5K $50K Amount $4K $60K Amount $13K Proportional Rate 25% $20k $200k Proportional/flat tax • Same tax rate. • Differing amounts of taxes paid. Progressive tax • Low-income pay lower rate than high-income. • High-income pay more taxes. • Low-income pay less taxes. Regressive tax • Low-income pay higher rate than high-income. • High-income pay less taxes. • Low-income pay more taxes. Must weigh positive judgments about the efficiency of the proposed tax and normative judgments about the “fairness” of its incidence. 14© 2014 by McGraw-Hill Education • The U.S. government has several sources of tax revenue. • Over 90% of tax revenue comes from three sources: – Personal income tax: 40% of all tax revenue. – Payroll tax: 40% of all tax revenue. – Corporate income tax: 10% of all tax revenue. A taxonomy of taxes 15© 2014 by McGraw-Hill Education The rate of taxation between taxes differs over time. A taxonomy of taxes 3 0 6 9 12 15 18 21 1940 1950 1960 1970 1980 1990 2000 2010 2012* 0.5% 1% 2.3% 6.2% 8.5% % of GDP Personal income taxes Payroll taxes Corporation income taxes Excise taxes Other 616© 2014 by McGraw-Hill Education • The income tax is charged on the earnings of individuals and corporations. • The U.S. income tax is based on expected annual income. – If actual earnings are less than expected earnings, individuals receive a tax refund. – If actual earnings are greater than expected earnings, individuals must pay the difference to the government. • The U.S. income tax is progressive. – Higher income earners pay taxes at higher rates. – Defined by income tax “bracket.” A taxonomy of taxes 17© 2014 by McGraw-Hill Education • Each tax bracket has its own tax rate, called the marginal tax rate. – Individuals pay different amounts of taxes on each bracket of income earned. • The U.S. personal income tax bracket provides the means to calculate one’s tax bill. A taxonomy of taxes Single Tax Bracket ($) Marginal Tax Rate (%) 0 – 8,700 10 8,701 – 35,350 15 35,351 – 86,650 25 85,651 – 178,650 28 178,651 – 388,350 33 388,350+ 35 18© 2014 by McGraw-Hill Education Suppose an individual earned $40,000 in 2010. • Calculate the tax bill using the following table. • What would be the average tax rate? Active Learning: Calculating tax bills Single Tax Bracket ($) Marginal Tax Rate (%) 0 – 8,700 10 8,701 – 35,350 15 35,351 – 86,650 25 85,651 – 178,650 28 178,651 – 388,350 33 388,350+ 35 719© 2014 by McGraw-Hill Education • The personal income tax does not distinguish incomes by their sources, except for capital. • The capital gains tax is applicable on all income earned/lost by buying and selling of investments. • Taxed at a lower rate than most other income. • Assets owned for longer than one year are taxed at a lower rate than those held for a short time. • Sale of a house that was used as a primary residence is taxed at a lower rate than other real estate. A taxonomy of taxes 20© 2014 by McGraw-Hill Education • In the U.S., part of one’s income is taxed based on wages (and not other sources of income). • Payroll taxes (FICA) are applied to paychecks. – Charged in equal parts to employees and employers. – Pays for current Social Security and Medicare benefits. – Regressive, as earners over $110,000 pay a smaller rate and only on wages. • Evidence suggests that most of the tax burden falls on employees in the form of lower wages. A taxonomy of taxes 21© 2014 by McGraw-Hill Education • Corporations also pay taxes, the most prominent being the corporate income tax. • A sales tax is charged on the value of a good or service being purchased. – Major source of revenue for state governments. – No U.S. federal sales tax. – Excise tax is a sales tax on a specific good or service. • A property tax is charged on the estimated value of a home or other property. – Local tax authorities assess property values every few years and levy a fraction of the value as the tax. Corporate income tax and other taxes 822© 2014 by McGraw-Hill Education For each of the following scenarios, identify the type of tax that must be paid. 1. John buys two houses when house values are low and sells them when values rise. 2. While on vacation, Sarah buys gum and pays an additional 8% in taxes. 3. Camille pays her local tax authority 2% of the value of her home. Active Learning: Distinguishing types of taxes 23© 2014 by McGraw-Hill Education • The tax revenue received by the government is included with other sources of revenue to finance government spending. • Comparing tax revenue as a percent of GDP provides one way to compare taxes across countries. The public budget % of GDP Country (world ranking) 13% 14% 16% 25% 34% 41% 45% 57% 65% Pakistan (201) United States (184) Uganda (195) Argentina (126) Japan (78) United Kingdom (44) Germany (30) Norway (13) Cuba (6) • Low-income countries tend to collect less in taxes as a percentage of GDP • High-income countries tend to collect more. • The U.S. is an extreme exception. 24© 2014 by McGraw-Hill Education • The relationship between public revenues and public spending is messy. – Spending eventually has to be covered by revenues. – Most public spending is not tied directly to government revenue, nor particular taxes. • Spending can be categorized by whether Congressional approval is required. – Discretionary spending requires approval each year. • Includes spending on the military, public construction and road building, and scientific and medical research. – Entitlement spending is a permanent law that benefits individuals with a certain characteristic or factor. • Age, income, and disability are examples of characteristics. • Social Security, Medicare, and welfare programs are the vast majority of federal expenditures. The public budget 925© 2014 by McGraw-Hill Education U.S. budget shifts in response to national events. The public budget % of budget 0 10 20 30 40 50 60 70 80 90 100 1940 1950 1960 1970 1980 1990 2000 2010 Function 3.1Education andsocial services Other 2.7 Veterans affairs 3.3 % of Budget (2012) Net interest 9.1 Income security 15.0 National defense 18.2 Social Security 20.5 Health expenditures 23.4 4.7Physicalresources • During World War II, defense was priority. • In recent years, health and social security spending has increased. 26© 2014 by McGraw-Hill Education • In many years, governments spend more than they bring in. – Causes a budget deficit, and the difference between spending and revenue must be financed by issuing debt. – A budget surplus occurs when spending is less than revenue. • Commonly calculated as a percentage of national GDP. • The U.S. has sustained more deficits than surpluses in recent years. The public budget Billions of $ Fiscal year Recession period -149.7 -412.7 -1,412.7 236.2 -1,600 -1,400 -1,200 -1,000 -800 -600 -400 -200 0 200 400 1980 1984 1988 1992 1996 2000 2004 2008 2012 Surpluses and deficits in recent U.S. history • The debt is equal to the sum of all annual budget deficits and surpluses. • It can be difficult to balance a public budget every year. • Many economists suggest balancing the budget over the business cycle. 27© 2014 by McGraw-Hill Education Presently, the revenue stream for Social Security is greater than the outlays paid in benefits. The future of social security % of GDP Year Outlays Actual Projected Revenue 0 1 2 3 4 5 6 7 1990 2000 2010 2020 2030 2040 2050 2060 Deficit Surplus The future of Social Security • Funds can be withdrawn from the Social Security Trust to make up the difference between revenue and outlays for several more decades. • Trust fund is projected to run out in 2037. 10 28© 2014 by McGraw-Hill Education • The most important goal of taxation is to raise public revenue; it is also used to changes the behavior of market participants. • Each tax source has its own trade-off between efficiency and tax incidence. • Two sources of inefficiency associated with taxation: – Deadweight loss is the reduction in total surplus that results when the number of trades that occur decreases due to the tax. – Administrative burden includes the time and money spent by the government, as well as by individuals. Summary 29© 2014 by McGraw-Hill Education • Changing a tax rate has a price effect and a quantity effect. • At some point, taxes become so high that raising taxes reduces total revenue. • Incidence describes who bears the burden of paying a tax. – A proportional tax charges all taxpayers the same percentage of income. – A progressive tax charges low-income earners a smaller percentage of their income than high-income earners. – A regressive tax charges low-income earners a larger percentage of their income than high-income earners. Summary 30© 2014 by McGraw-Hill Education • The vast majority of tax revenue in the U.S. comes from personal income and payroll taxes; a significant minority comes from corporate income taxes. • Government spending is not tied directly to government revenue. • The majority of federal spending is entitlement spending. • When government revenues are less than spending, a budget deficit occurs. Summary