chapter 7 taxation: criteria for evaluating revenue options “taxes are the price we pay for...
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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
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