Tax Principles

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Tax Principles

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois

Econ 214
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Topics for today

• Whats interesting about taxes?
• Why should taxes matter to you?
• Tax fairness or equity
• Benefit principle
• Ability to pay principle
• Ask the candidates

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Taxes are as old as civilization

• Ancient Egyptians set the taxes by the level of
  the Nile.
• In Roman times, taxes on inheritances
  distinguished the relationship between the
  deceased and the decedent.
• In Medieval France, taxes were set by the number
  of windows in a house.
• In Colonial America, a tax on tea incited a war.

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Taxes are the main way governments fund themselves
Taxes are compulsory payments to
government. Alternatives to taxation

• Confiscation
• Borrowing
• Printing money
• Inflation

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Taxes are a tool for social change

• Taxes can be used to encourage some types of
  behavior (contributing to charity, buying a
  house, having kids) and discourage other behavior
  (drinking, smoking, polluting).
• Taxes can be used to change the overall
  distribution of income.

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Taxes change human behavior

• High tax rates reduce the reward for working,
  saving, and taking risks.
• Taxes on goods and services change peoples
  consumption patterns.
• Taxes on assets affect asset values and distort
  investment plans.

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Who said this?
Two things in life are certain, death and taxes.
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Federal taxes
Excise 4
Corporate 11
Other 4
Payroll 41
Personal Income 40
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State and Local Taxes
Payroll 8
Other 12
Property 21
Sales 24
Income 14
Federal Grants 21
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Illinois taxes

• Illinois ranks 29th in per capita taxes but 45th
  in taxes per 1,000 income.
• Illinois is a high property tax state (ranks
  10th) and a low income tax state (ranks 29th).

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Why should you care about taxes?

• They will be a big part of your budget.
• Tax freedom day this year is May 3.
• They will be a major factor in many of the
  decisions you make.
• Issues of tax policy are important to you as a
  voter.

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Tax issues in the news

• What should be done about the marriage penalty,
  the extra tax that two-earner couples pay when
  they marry?
• Should the estate tax be eliminated?
• When taxes are cut, should the cut favor high or
  low income taxpayers?

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What is a good tax?

• Equity -- a tax should be distributed fairly
• Efficiency -- a tax should raise revenues with
  minimal loss of efficiency in the private sector
• Administrative ease -- a tax should be relatively
  easy to administer and comply with

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Taxes and equity
Dont tax you. Dont tax me. Tax that fella
behind the tree. Senator Russell Long
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Two concepts of tax equity

• Benefit principle taxes should be distributed
  according to how people benefit from government
  expenditures
• Ability-to-pay principle taxes should be
  distributed according to the capacity of
  taxpayers to pay them

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Equity in the market
P
DDMDP
(horizontally)
MC S
DP
DM
Turkeys
Whats a fair price for a turkey?
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Equity with public goods
Whats a fair price (tax) for national defense?
P
MBP
What are these tax prices called?
MBM
MC
Lindahl prices They are also called benefit taxes.
National defense
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Examples of benefit taxes

• Gasoline tax revenues earmarked for the highway
  trust fund
• Payroll tax revenues fund the Social Security
  Program
• Property tax revenues fund schools and other
  local public goods

Benefit principle financing of government
supplied goods should be linked to the benefits
citizens receive from consuming them.
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Why dont benefit taxes work very well in
practice?

• Free rider problem people wont reveal their
  preferences for public goods so it is hard to tax
  them
• Benefit taxes cant be used to fund transfer
  programs
• Benefit taxes may violate the second principle of
  tax equity ability to pay

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Ability-to-pay principle
Taxes should be distributed according to ability
or capacity to pay them.

• Horizontal equity -- those with identical
  abilities should pay the same taxes
• Vertical equity -- those with greater ability
  should pay higher taxes

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Should taxes be progressive?

• With a progressive tax
• High income people pay a higher proportion of
  their income in tax than do low income people.
• The marginal tax rate exceeds the average tax
  rate.
• Progressive taxes promote greater equality in the
  distribution of income.

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Tax rates
Tax rate

• ATR Total taxes paid/Income
• MTR ? Total taxes paid/ ? Tax base

MTR
35
25
ATR
15
Income
A tax is progressive if the MTR gt ATR
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Tax progressivity
Average tax rate
Progressive MTRgtATR
Proportional MTRATR
Regressive MTRltATR
Income
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Lorenz curve
100
What effect will a progressive tax have on the
Lorenz curve? On the Gini coefficient?
Line of Equality
Cumulative of income
100
Cumulative of families
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Example of a regressive tax
Tax rate
Guess the tax!
MTR
15.3
Social Security Payroll Tax
ATR
76,200
Earnings
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Why doesnt the ability-to-pay principle work
very well in practice?

• Ability to pay is hard to measure
• family size
• special circumstances illness, casualty losses
• work effort
• The ability-to-pay principle gives no guidance as
  to how much more the rich should pay than the poor

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Who should pay higher taxes?
This rich guy whose annual income is 100,000 or
this poor but happy looking fellow whose income
is 30,000 a year?
Would a tax of 3,000 on the poor guy and 5,000
on the rich guy be fair? What do you think?
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For and against progressivity
For
Against

• A rich person suffers the loss of a tax dollar
  less than does a poor person.
• A rich person benefits proportionately more from
  government than does a poor person.

• Progressive taxes involve high marginal tax
  rates, which may discourage work and saving.
• Progressive taxes may be harder to administer and
  comply with than flat rate taxes.

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Ask the candidates
GORE
BUSH

• Reduce marriage penalty
• Eliminate estate tax
• Cut all income tax brackets and cap the top
  bracket at 33

• Reduce marriage penalty
• Target tax relief for spending on education,
  saving, low-income housing

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Soap Box
The Soap Box this week explores the principle of
horizontal tax equity, that taxpayers in equal
economic circumstances should pay equal taxes.
Suppose two taxpayers each have an income of
50,000 per year. Think of a circumstance that
in your opinion would justify one taxpayer paying
a higher tax than the other. Which taxpayer
should pay the higher tax and why? Lets see how
many exceptional circumstances that we can
identify.
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Next time
Thurs Excess Burden of Taxation Chapter 11,
401- 413 (Skip indifference curve analysis)