Chapter 12 The Design Of The Tax SystemThe Federal GovernmentThe U.S. federal government collects about two-thirds of the taxes in our economy.The largest source of revenue for the federal government is the individual income tax.The Federal GovernmentIndividual Income TaxesThe marginal tax rate is the tax rate applied to each additional dollar of income.Higher-income families pay a larger percentage of their income taxes.The Federal GovernmentThe Federal Government and TaxesPayroll Taxes: tax on the wages that a firm pays its workers.Social Insurance Taxes: taxes on wages that is earmarked to pay for Social Security and.Excise Taxes: taxes on specific goods like gasoline, cigarettes, and alcoholic beverages.The Federal GovernmentFederal Government SpendingGovernment spending includes transfer payments and the purchase of public goods and services.Transfer payments are government payments not made in exchange for a good or a service.Transfer payments are the largest of the governments expenditures.The Federal GovernmentFederal Government SpendingExpense Category.Social SecurityNational DefenseIncome SecurityNet interestMedicareHealthOtherThe Federal GovernmentBudget SurplusA budget surplus is an excess of government receipts over government spendingBudget DeficitA budget deficit is an excess of government spending over government spendingThe Federal GovernmentFinancial Conditions of the Federal BudgetA budget deficit occurs when there is an excess of government spending over government receipts.Government finances the deficit y borrowing from the public.A budget surplus occurs when government receipts are greater than government spending.A budget surplus may be used to reduce the governments outstanding debts.State and Local GovernmentsState and local governments collect about 40 percent of taxes paid.ReceiptsSales TaxesProperty TaxesIndividual Income TaxesCorporate Income TaxesFederal GovernmentOtherState and Local GovernmentsSpendingEducationPublic WelfareHighwaysOtherState and Local GovernmentsPolicymakers have two objective in designing a tax systemEfficiencyEquityTaxes and EfficiencyOne tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers.An efficient tax system is one that imposes small deadweight losses and small administrative burdens.Taxes and EfficiencyThe Cost of Taxes to TaxpayersThe tax payment itselfDeadweight lossesAdministrative burdensTaxes and EfficiencyBecause taxes distort incentives, they entail deadweight losses.The deadweight loss of a tax is the reduction of the economic well-being of taxpayers in excess of the amount of revenue raised by the government.Deadweight LossesComplying with tax laws creates additional deadweight losses.Taxpayers lose additional time and money documenting, computing, and avoiding taxes over and above the actual taxes they pay.The administrative burden of any tax system is part of the inefficiency it creates.Administrative BurdensThe average tax rate is total taxes paid divided by total income.The marginal tax is the extra taxes paid on an additional dollar of income.Marginal Tax Rates versus Average Tax RatesA lump-sum tax is a tax that is the same amount for every person, regardless of earnings or any actions that the person might take.Lump-Sum TaxesHow should the burden of taxes be divided among the population?How do we evaluate whether a tax system is fair?Taxes and EquityPrinciples of TaxationBenefits principleAbility-to-pay principleTaxes and EquityThe benefits principle is the idea that people should pay taxes based on the benefits they receive from government services.An example is a gasoline tax:Tax revenue from a gasoline tax are used to finance our highway system.People who drive the most also pay the most toward maintaining roads.Benefits PrincipleAbility-to-Pay PrincipleThe ability-to-pay principle is the idea that taxes should levied on a person according to how well that person can shoulder the burden.The ability-to-pay principle leads to two corollary notions of equity.Vertical equityHorizontal equityAbility-to-Pay Principle Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts.For example, people with higher incomes should pay more than people with lower incomes.Ability-to-Pay PrincipleVertical Equity and Alternative Tax SystemA proportional tax is one for which high-income and low-income taxpayers pay the same fraction of income.A regressive tax is one for which high-income pay a smaller fraction of their income than do low-income taxpayers.A progressive tax is one for which high-income pay a larger fraction of their income than do low-income taxpayers.Ability-to-Pay PrincipleHorizontal Equity Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amounts.For example, two families with the same number of dependents and the same income living in different parts of the country should pay the same federal taxes.Case Study: Horizontal Equity and the Marriage TaxMarriage affects the tax liability of a couple in that tax law treats a married couple as a single taxpayer.When a couple gets married, they stop paying taxes as individuals and start paying taxes as a family.If each has a similar income, their total tax liability rises when they get married.Tax Incidence and Tax EquityThe difficulty in formulating tax policy is balancing the often conflicting goals of efficiency and equity.The study of who bears the burden of taxes is central to evaluating tax equity.This study is called tax incidence.Tax Incidence and Tax EquityThe difficulty in formulating tax policy is balancing the often conflicting goals of efficiency and equity.The study of who bears the burden of taxes is central to evaluating tax equity.This study is called tax incidence.Tax Incidence and Tax EquityFlypaper Theory of Tax IncidenceAccording to the flypaper theory, the burden of a tax, like a fly on flypaper, sticks wherever it first lands.SummaryThe U.S. government raises revenue using various taxes.Income taxes and payroll taxes raise the most revenue for the federal government.Sales taxes and property taxes raise the most revenue for the state and local government. SummaryEquity and efficiency are two most important goals of the tax system.The efficiency of a tax system refers to the costs in imposes on the taxpayers.The equity of a tax system concerns whether the tax burden is distributed fairly among the population. SummaryAccording to the benefits principle, it is fair for people to pay taxes based on the benefits they receive from the government.According to the ability-to-pay principle, it is fair for people to pay taxes based on their capability to handle the financial burden. SummaryThe distribution of tax burdens is not the same as the distribution of tax bills.Much of the debate over tax policy arises because people give different weights to the two goals of efficiency and equity.