Chapter 20 - Taxation and the public budget. In this chapter you will learn: 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?...
Chapter 20 Taxation and the Public Budget © 2014 by McGraw-Hill Education What will you learn in this chapter? • 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 © 2014 by McGraw-Hill Education Why tax? • Recall that taxes have two effects: – Raise revenue – Change the behavior of buyers and sellers Price S Price paid by consumers Tax Price received by sellers Raises revenue… D D Quantity © 2014 by McGraw-Hill Education …and changes behavior • 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 Principles of taxation Each tax considered must compare trade-offs between revenue and inefficiency Price ($) 100 Tax creates a new demand curve $20 below… 90 …which moves equilibrium to a lower quantity 80 S 70 60 • 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 Deadweight loss is surplus lost due to the reduced quantity 50 40 30 D1 20 10 D2 Quantity of jeans (millions of pairs) © 2014 by McGraw-Hill Education Principles of taxation The size of deadweight loss is determined by the price elasticity of supply and demand Original demand DWL = $60 Less elastic demand DWL = $40 58 50 $20 Price S S 62 50 42 More elastic demand DWL = $80 Price Price 54 50 $20 38 D1 $20 D1 34 D2 26 30 Quantity D1 D2 D2 24 30 Quantity Deadweight loss (DWL) 22 30 Quantity • 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 © 2014 by McGraw-Hill Education Principles of taxation • 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 not find it fair – Size of the tax is limited by the poorest citizens’ ability to pay © 2014 by McGraw-Hill Education Principles of taxation • 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 © 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 © 2014 by McGraw-Hill Education Tax effects As the tax rate increases, revenue will: Price effect Tax rate (%) Quantity effect 100 + = Revenue before tax increase 90 + = Revenue after tax increase • 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 80 70 T2 60 Tax rate increases … 50 T1 40 30 20 … and quantity decreases 10 10 12 14 16 18 20 Quantity (millions) © 2014 by McGraw-Hill Education Diminishing returns to revenue Given these two opposing effects, there is a maximum tax revenue generated for a given tax 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: Up to a point, Increasing the tax rate increases total revenue Past that point, increasing the tax rate decreases total revenue – The more inelastic supply and demand are, the larger the tax rate required to reach the revenue-maximizing point is X% 0% 100% Tax rate â 2014 by McGraw-Hill Education ã This curve is sometimes referred to as the Laffer curve 10 Incidence: Who ultimately pays the tax? • 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 © 2014 by McGraw-Hill Education 11 Active Learning: Who pays the tax? For each of the following goods, identify whether the tax burden would mostly fall on buyers or sellers Mountain bikes with an elasticity of supply of 1.32 and an elasticity of demand of -3.5 Cigarettes with an elasticity of supply of 2.5 and an elasticity of demand of -.24 Soft drinks with an elasticity of supply of and an elasticity of demand of -2.5 © 2014 by McGraw-Hill Education 12 Incidence: Who ultimately pays the tax? 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 65% $20k $60K $200k $50K 30% 25% 20% $13K $5K 6.5% $4K Rate Amount Proportional Rate Amount Regressive Rate Amount Progressive Proportional/flat tax • Same tax rate • Differing amounts of taxes paid Progressive tax • Low-income pay lower rate than high-income • High-income pay more taxes • Low-income pay less taxes Regressive tax • Low-income pay higher rate than high-income • High-income pay less taxes • Low-income pay more taxes Must weigh positive judgments about the efficiency of the proposed tax and normative judgments about the “fairness” of its incidence © 2014 by McGraw-Hill Education 13 A taxonomy of taxes • The U.S government has several sources of tax revenue • Over 90% of tax revenue comes from three sources: – Personal income tax: 40% of all tax revenue – Payroll tax: 40% of all tax revenue – Corporate income tax: 10% of all tax revenue © 2014 by McGraw-Hill Education 14 A taxonomy of taxes The rate of taxation between taxes differs over time % of GDP 21 Excise taxes Other 2012* 0.5% 1% 18 2.3% 15 12 Corporation income taxes 6.2% Payroll taxes 1940 1950 © 2014 by McGraw-Hill Education 8.5% Personal income taxes 1960 1970 1980 1990 2000 2010 15 A taxonomy of taxes • The income tax is charged on the earnings of individuals and corporations • The U.S income tax is based on expected annual income – If actual earnings are less than expected earnings, individuals receive a tax refund – If actual earnings are greater than expected earnings, individuals must pay the difference to the government • The U.S income tax is progressive – Higher income earners pay taxes at higher rates – Defined by income tax “bracket.” © 2014 by McGraw-Hill Education 16 A taxonomy of taxes • Each tax bracket has its own tax rate, called the marginal tax rate – Individuals pay different amounts of taxes on each bracket of income earned • The U.S personal income tax bracket provides the means to calculate one’s tax bill Single Tax Bracket ($) – 8,700 Marginal Tax Rate (%) 10 8,701 – 35,350 15 35,351 – 86,650 25 85,651 – 178,650 28 178,651 – 388,350 33 388,350+ 35 © 2014 by McGraw-Hill Education 17 Active Learning: Calculating tax bills Suppose an individual earned $40,000 in 2010 • Calculate the tax bill using the following table • What would be the average tax rate? Single Tax Bracket ($) 10 15 35,351 – 86,650 25 85,651 – 178,650 28 178,651 – 388,350 33 388,350+ © 2014 by McGraw-Hill Education Marginal Tax Rate (%) – 8,700 8,701 – 35,350 35 18 A taxonomy of taxes • 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 © 2014 by McGraw-Hill Education 19 A taxonomy of taxes • 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 © 2014 by McGraw-Hill Education 20 Corporate income tax and other taxes • 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 © 2014 by McGraw-Hill Education 21 Active Learning: Distinguishing types of taxes For each of the following scenarios, identify the type of tax that must be paid John buys two houses when house values are low and sells them when values rise While on vacation, Sarah buys gum and pays an additional 8% in taxes Camille pays her local tax authority 2% of the value of her home © 2014 by McGraw-Hill Education 22 The public budget • 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 Country (world ranking) 65% Cuba (6) 57% Norway (13) 45% Germany (30) 41% United Kingdom (44) 34% Japan (78) 25% Argentina (126) United States (184) Uganda (195) Pakistan (201) 16% 14% 13% • 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 % of GDP © 2014 by McGraw-Hill Education 23 The public budget • 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 © 2014 by McGraw-Hill Education 24 The public budget U.S budget shifts in response to national events % of budget 100 90 80 Function % of Budget (2012) Other 2.7 70 Veterans affairs 3.3 60 Education and social services 3.1 50 Physical resources 4.7 40 Net interest 9.1 30 Income security 15.0 20 National defense 18.2 Social Security 20.5 Health expenditures 23.4 10 1940 1950 1960 1970 1980 1990 2000 2010 • During World War II, defense was priority • In recent years, health and social security spending has increased © 2014 by McGraw-Hill Education 25 The public budget • 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 Surpluses and deficits in recent U.S history Billions of $ 400 200 Recession period 236.2 -149.7 -200 -400 -600 -412.7 -800 -1,000 -1,200 -1,400 -1,600 1980 1984 1988 1992 1996 2000 Fiscal year 2004 -1,412.7 2008 2012 • 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 © 2014 by McGraw-Hill Education 26 The future of social security Presently, the revenue stream for Social Security is greater than the outlays paid in benefits % of GDP Actual The future of Social Security Projected Outlays Revenue Surplus Deficit 1990 2000 2010 2020 2030 Year 2040 2050 2060 • 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 © 2014 by McGraw-Hill Education 27 Summary • 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 © 2014 by McGraw-Hill Education 28 Summary • 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 © 2014 by McGraw-Hill Education 29 Summary • 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 © 2014 by McGraw-Hill Education 30 10 ... Surpluses and deficits in recent U.S history Billions of $ 400 200 Recession period 236.2 -1 49.7 -2 00 -4 00 -6 00 -4 12.7 -8 00 -1 ,000 -1 ,200 -1 ,400 -1 ,600 1980 1984 1988 1992 1996 2000 Fiscal year 2004 -1 ,412.7... 2014 by McGraw-Hill Education 23 The public budget • The relationship between public revenues and public spending is messy – Spending eventually has to be covered by revenues – Most public spending... health and social security spending has increased © 2014 by McGraw-Hill Education 25 The public budget • In many years, governments spend more than they bring in – Causes a budget deficit, and the