Taxes and Taxation

Why are there taxes? •Main reason: to

raise revenue for the government

What are some other reasons for taxation?

• To encourage some kinds of economic activity (e.g., home ownership -- see the mortgage interest deduction)

• To discourage consumption of some items (alcohol, tobacco)

• To reprice items in the economy. When the government pays farmers a subsidy for a crop, for instance, the government is using taxpayers’ money to price items differently than would be the case in a free market economy.

• To redistribute income and/or wealth

If taxes are a necessary evil, what principles should guide the design of a good tax system?

Adam Smith and his four principles of taxation

• 1. Equity (i.e., fairness)

• 2. Certainty or predictability

• 3. Convenience (for the contributor to pay the tax)

• 4. Efficiency

Equity • Equity in taxation concerns fairness, the

idea that the tax system should be fair

• Something to consider: Do taxes impose the same burdens on those in different economic circumstances?

• Who should pay taxes?

• Two different, competing criteria.

1. The ability-to-pay principle. People with higher incomes should pay more tax.

2. The benefits-received principle. Those who benefit from a particular government program should pay for it.

Deadweight loss of taxation (caused by an inefficient tax) • “A deadweight loss occurs when

the cost to consumers and producers from a tax – due to lost productivity or sales – is larger than the size of the tax revenue it generates.” (Econ Alive, p. 235)

• A deadweight loss usually means that someone is worse off (in terms of cost) while no one is better off (in terms of benefit).

• In the diagram to the right, D and E represent deadweight loss.

Different types of taxation

•Proportional taxes

•Progressive taxes

•Regressive taxes

Proportional (or flat) tax

• A proportional tax is a tax that takes the same share of income at all income levels.

• If for example we had a proportional income tax for individuals in the United States right now, say 20%, Bill Gates and a worker at a fast-food restaurant would pay tax at the same rate.

• An advantage: Proportional taxes (aka flat taxes) are simpler to figure out and administer than other kinds of taxes

• A disadvantage: It doesn’t seem fair that a billionaire and a poor person should pay tax at the same rate.

• Look at the graph on the right: which line (A, B, C or D) represents a proportional tax?

Progressive tax

• A progressive tax is a tax that takes a larger share of income as income increases.

• It is based on the ability-to-pay principle.

• Supporters of progressive taxes say that it is fairer.

• Opponents say that it really isn’t fair. In fact, it penalizes those who work hard to gain more income.

Regressive tax

• A regressive tax is a tax that takes a smaller share of income as income increases.

• A proportional tax can also be regressive if it takes a bigger bite out of the incomes of poor people than rich people.

• A sales tax is usually regressive. A VAT (or value-added tax) is often regressive also.

Different kinds of taxes

Income tax (personal and corporate) • Personal income tax is a tax assessed on someone’s

annual income.

• It can be levied by federal, state and local governments.

• At the federal level it is a progressive tax.

• Corporate income tax, on the other hand, is applied to the profits of corporations. Like the individual income tax, it is progressive at the federal level.

• Critics of this tax on business allege that it is simply passed on to consumers. It diminishes business activity.

• Some critics claim that the corporate income tax in the U.S. is too high compared to other countries and should be reduced.

The inheritance (or estate) tax

• An inheritance or estate tax is a tax that is levied on some or all of the estate (property and possessions) that a person leaves behind at death. The heirs must pay the tax.

• These taxes are essentially the same; the main difference is that they are called estate taxes at the federal level and estate or inheritance taxes at the state level.

• Estate taxes are progressive; the more you inherit, the higher the rate of tax.

Luxury tax and Excise tax

• Luxury taxes are levied on the sale of luxury items (yachts and private jets, e.g.). They are progressive taxes.

• Excise taxes are usually levied on goods the government wants to regulate (e.g., alcohol and tobacco). These taxes are sometimes called sin taxes. They are generally regressive taxes.

Property tax • Property taxes are commonly

levied on real estate (buildings, land, etc.).

• Some states levy them on cars, motorcycles and boats also.

• They are a major source of funding for schools.

Sales tax

• A sales tax is paid for by the customer when he or she purchases various goods or services.

• It is generally regressive.

• It is levied by states and some cities.

User fees and tolls •User fees and tolls are

charged for the use of public facilities and services.

•User fees are also required for permits and licenses.

Different parts of the federal budget

• The federal budget is composed of two main parts: mandatory spending and discretionary spending.

• What does mandatory spending mean?

• What does discretionary spending mean?

These expenditures are made over a fiscal year • The fiscal year is a 12-

month accounting period that is used by businesses and other organizations.

• The federal government begins its fiscal year every year on October 1.

Fixed or mandatory spending (entitlements, etc.)

• Mandatory spending are government expenditures that are fixed by law and can only be changed by new laws.

• It is different from discretionary spending.

• Examples of mandatory spending include Social Security, Medicare, interest on the national debt, and food stamps.

Discretionary spending

• Discretionary spending are expenditures that can be raised or lowered as a legislature sees fit.

• Examples of discretionary spending include military (or defense) expenditures and education.

Problems with the Federal Budget

• What are some of the main problems with the federal budget?

• 1. Expenses exceed revenues.

• 2. Long-term debt is getting worse.

• 3. Too much is spent on some things and not enough on others. (Opinions will vary.)

What are some possible solutions to the long-term budget deficit?

•Cut expenses •Increase revenue (via tax increases, etc.)

State and local taxes and expenditures

• State and local budgets reflect different priorities and obligations compared to the federal budget.

• For one thing, they devote a significant portion of their budget to education.