Sources of Government Revenue Chapter 9 Chapter 9.

Sources of Sources of Government Government RevenueRevenue

Chapter 9Chapter 9

The Economics of The Economics of TaxationTaxation

Section 1Section 1

I.I. Economic Impact of TaxesEconomic Impact of Taxes

A.A. Taxes affect the factors of Taxes affect the factors of production and, therefore, resource production and, therefore, resource allocation.allocation.

B.B. A tax placed on a good at the A tax placed on a good at the factory raises production costs factory raises production costs (supply curve shifts to the left); if (supply curve shifts to the left); if demand stays the same, the demand stays the same, the equilibrium price goes up. equilibrium price goes up.

The Economics of The Economics of Taxation Taxation

C. C. Taxes affect the economy by encouraging or Taxes affect the economy by encouraging or discouraging certain activities.discouraging certain activities.

D.D. A sin tax is a high-percentage tax that raises A sin tax is a high-percentage tax that raises revenue while reducing consumption of a socially revenue while reducing consumption of a socially undesirable product.undesirable product.

E. E. Taxes affect productivity and economic growth by Taxes affect productivity and economic growth by changing the incentives to save, invest, and work.changing the incentives to save, invest, and work.

F. F. The incidence of a tax is the final burden of the The incidence of a tax is the final burden of the tax: it is easier for a producer to shift the incidence tax: it is easier for a producer to shift the incidence of a tax to the consumer if the demand is of a tax to the consumer if the demand is 9inelastic; the more elastic the demand, the more 9inelastic; the more elastic the demand, the more likely the producer will absorb a greater portion of likely the producer will absorb a greater portion of the tax.the tax.

Discussion QuestionDiscussion Question

In your opinion, how effective is a In your opinion, how effective is a sin tax?sin tax?

II. Criteria for Effective TaxesII. Criteria for Effective Taxes Taxes are effective when they are equitable, Taxes are effective when they are equitable,

simple, and efficient. simple, and efficient. Criterion 1: equity or fairness; fairness is Criterion 1: equity or fairness; fairness is

subjective, but taxes are considered fairer if subjective, but taxes are considered fairer if they have fewer loopholes—exceptions, they have fewer loopholes—exceptions, deductions, and exemption.deductions, and exemption.

Criterion 2: simplicity; tax laws should be easy Criterion 2: simplicity; tax laws should be easy to understand.to understand.

Criterion 3: efficiency, which means it is easy Criterion 3: efficiency, which means it is easy to administer and is successful at generating to administer and is successful at generating revenue.revenue.


How might Congress have better How might Congress have better analyzed the potential efficiency analyzed the potential efficiency of the 1991 luxury tax on yachts of the 1991 luxury tax on yachts and small aircraft before passing and small aircraft before passing the tax law?the tax law?

III. Two Principles of TaxationIII. Two Principles of Taxation The benefit principle states that The benefit principle states that

those who benefit from those who benefit from government goods and services government goods and services should pay in proportion to the should pay in proportion to the amount of benefits they receive.amount of benefits they receive.

The limitations of this principle The limitations of this principle are that many government are that many government services provide the greatest services provide the greatest benefit to those who can least benefit to those who can least afford them and that benefits are afford them and that benefits are hard to measure.hard to measure.

The ability-to-pay principle is the belief The ability-to-pay principle is the belief that people should be taxed according that people should be taxed according to their ability to pay, regardless of the to their ability to pay, regardless of the benefits they receive.benefits they receive.

The ability-to-pay principle is based on The ability-to-pay principle is based on two ideas: that societies cannot always two ideas: that societies cannot always measure the benefits derived from measure the benefits derived from government spending, and that people government spending, and that people with higher incomes suffer less with higher incomes suffer less discomfort in paying taxes than people discomfort in paying taxes than people with lower incomes.with lower incomes.


How would you measure the How would you measure the benefits for a proposed tax?benefits for a proposed tax?

IV. Types of TaxesIV. Types of Taxes A proportional tax is one that imposes A proportional tax is one that imposes

the same percentage on everyone, the same percentage on everyone, regardless of income.regardless of income.

A progressive tax is one that imposes A progressive tax is one that imposes a higher percentage of tax on persons a higher percentage of tax on persons with higher incomes. with higher incomes.

A regressive tax is one that imposes a A regressive tax is one that imposes a higher percentage on low incomes higher percentage on low incomes than on high incomes.than on high incomes.


What benefits does the What benefits does the government enjoy in having a government enjoy in having a progressive income tax?progressive income tax?

The Federal Tax The Federal Tax SystemSystem

Section 2Section 2I.I. Individual Income TaxesIndividual Income Taxes The federal government The federal government

collects about 48 percent of its collects about 48 percent of its revenue from the individual revenue from the individual income tax.income tax.

The Federal Tax The Federal Tax SystemSystem Taxes are typically withheld from Taxes are typically withheld from

individual’s paychecks, with employers individual’s paychecks, with employers sending the taxes directly to the Internal sending the taxes directly to the Internal Revenue Service.Revenue Service.

Individuals file a tax return on or before Individuals file a tax return on or before April 15, each year; if taxes withheld are April 15, each year; if taxes withheld are more than the taxes owed, the individual more than the taxes owed, the individual receives a refund; if not, the individual receives a refund; if not, the individual makes a payment of the tax balance.makes a payment of the tax balance.

The individual income tax is a progressive The individual income tax is a progressive tax because individuals earning higher tax because individuals earning higher incomes pay higher tax rates.incomes pay higher tax rates.


Why do you suppose the Why do you suppose the individual making $100,000 per individual making $100,000 per year pays about the same tax year pays about the same tax rate as the person making rate as the person making $35,000 per year?$35,000 per year?

II. FICA TaxesII. FICA Taxes The Federal Insurance Contributions The Federal Insurance Contributions

Act (FICA) tax pays for Social Security Act (FICA) tax pays for Social Security and Medicare.and Medicare.

FICA is the second largest source of FICA is the second largest source of government revenue.government revenue.

The FICA tax is a regressive tax. Social The FICA tax is a regressive tax. Social Security is partly a proportional tax Security is partly a proportional tax and partly a regressive tax.and partly a regressive tax.


Why do you think some Why do you think some Americans call the Social Security Americans call the Social Security tax the “tax of the middle and tax the “tax of the middle and lower classes”?lower classes”?

III. Corporate Income TaxesIII. Corporate Income Taxes Corporations pay a tax on their Corporations pay a tax on their

profits because they are profits because they are considered legal entities.considered legal entities.

Corporate tax is the third largest Corporate tax is the third largest source of government revenue.source of government revenue.


How would you evaluate the How would you evaluate the effectiveness of the corporate effectiveness of the corporate income tax based on the fairness, income tax based on the fairness, simplicity, and efficiency test?simplicity, and efficiency test?

IV. Other Federal TaxesIV. Other Federal Taxes The excise tax is a regressive tax The excise tax is a regressive tax

on the manufacture or sale of on the manufacture or sale of selected items.selected items.

The estate tax deals with the The estate tax deals with the transfer of property when a transfer of property when a person dies.person dies.

The gift tax is placed on large donations of The gift tax is placed on large donations of money or wealth and is paid by the money or wealth and is paid by the donator.donator.

A custom duty is a charge levied on goods A custom duty is a charge levied on goods brought in from other countries.brought in from other countries.

The Reagan administration implemented The Reagan administration implemented user fees for the use of goods or services.user fees for the use of goods or services.

User fees are an example of taxation User fees are an example of taxation based on the benefit principle.based on the benefit principle.


Why do you suppose customs Why do you suppose customs duties are no longer a large duties are no longer a large source of government revenue?source of government revenue?

State and Local Tax State and Local Tax Systems Systems

I.I. State Government :Revenue SourcesState Government :Revenue Sources Intergovernmental revenues are funds Intergovernmental revenues are funds

collected by one level of government collected by one level of government that are distributed to another levelthat are distributed to another level

Intergovernmental revenues are the Intergovernmental revenues are the largest source of revenues for state largest source of revenues for state and local governments—about one-and local governments—about one-fourth of all state revenues.fourth of all state revenues.

A sales tax is one levied on consumer A sales tax is one levied on consumer purchases for nearly all products.purchases for nearly all products.

State and Local Tax State and Local Tax Systems Systems

Employee retirement contributions Employee retirement contributions make up the third largest source of make up the third largest source of income.income.

Individual income tax revenues make up Individual income tax revenues make up the fourth largest source of income.the fourth largest source of income.

Other sources of revenue include Other sources of revenue include interest earnings on surplus funds; fees interest earnings on surplus funds; fees from state owned colleges, universities, from state owned colleges, universities, and schools; corporate income taxes, and schools; corporate income taxes, and hospital fees.and hospital fees.


Why is the sales tax an easy way Why is the sales tax an easy way for states to collect from for states to collect from consumers?consumers?

II. Local Government Revenue SourcesII. Local Government Revenue Sources Intergovernmental revenues are Intergovernmental revenues are

generally earmarked for education and generally earmarked for education and public welfare; they make up the public welfare; they make up the largest source of local government largest source of local government revenue.revenue.

Property taxes are levied on tangible Property taxes are levied on tangible and intangible products; they make up and intangible products; they make up the second largest source.the second largest source.

Local governments receive revenues Local governments receive revenues from government-owned public from government-owned public utilities and state-owned liquor stores.utilities and state-owned liquor stores.

Some towns and cities have a sales Some towns and cities have a sales tax, which is collected along with the tax, which is collected along with the state’s sales tax.state’s sales tax.

Other sources of local income include Other sources of local income include hospital fees, personal taxes, and hospital fees, personal taxes, and public lotteries.public lotteries.

III. Examining Your PaycheckIII. Examining Your Paycheck Looking at your payroll withholding Looking at your payroll withholding

statement will help you identify many statement will help you identify many of your state and local governments’ of your state and local governments’ revenue sources.revenue sources.

Additional dedications can be added to Additional dedications can be added to payroll for retirement contributions, payroll for retirement contributions, purchasing savings bonds, or credit purchasing savings bonds, or credit unionsunions

Current Tax IssuesCurrent Tax Issues Section 4 Section 4

I.I. Tax ReformTax Reform Under the Reagan Under the Reagan

administration, the Economic administration, the Economic Recovery Act of 1981 reduced Recovery Act of 1981 reduced taxes for individuals and taxes for individuals and businesses.businesses.

By the mid-1980s, Americans By the mid-1980s, Americans believed the tax code favored believed the tax code favored the rich and powerful.the rich and powerful.

Current Tax IssuesCurrent Tax Issues

In 1986 Congressional tax reform In 1986 Congressional tax reform limited the tax brackets to 15 percent limited the tax brackets to 15 percent and 28 percent.and 28 percent.

The Omnibus Budget Reconciliation The Omnibus Budget Reconciliation Act of 1993 added two higher income Act of 1993 added two higher income tax brackets (36 and 39.6 percent), tax brackets (36 and 39.6 percent), but its goal was more to assist in but its goal was more to assist in balancing the federal budget than in balancing the federal budget than in adjusting rates for income levels.adjusting rates for income levels.

Current Tax IssuesCurrent Tax Issues

By 1997 the government had high tax By 1997 the government had high tax revenues, so the Taxpayer Relief Act revenues, so the Taxpayer Relief Act was passed giving tax credits for was passed giving tax credits for children and educational expenses, children and educational expenses, and reduced rates to people with and reduced rates to people with capital gains from long-term capital gains from long-term investments in stocks and bonds.investments in stocks and bonds.

By 2001, the government faced a By 2001, the government faced a surplus. President Bush backed tax surplus. President Bush backed tax reduction, and the result was a $1.35 reduction, and the result was a $1.35 billion, ten-year tax cut.billion, ten-year tax cut.

II. The Value-Added TaxII. The Value-Added Tax A value-added tax (VAT) places a tax on the A value-added tax (VAT) places a tax on the

value that manufacturers add to a good at value that manufacturers add to a good at each stage of production.each stage of production.

Advantages to the VAT: the tax levied on the Advantages to the VAT: the tax levied on the total amount of sales less the cost of inputs; total amount of sales less the cost of inputs; the incidence of the tax is widely spread the incidence of the tax is widely spread among the manufactures involved; it is east to among the manufactures involved; it is east to collect; it would encourage people to save.collect; it would encourage people to save.

Disadvantages of the VAT: taxpayers are Disadvantages of the VAT: taxpayers are unlikely to notice increases in VAT taxes; it unlikely to notice increases in VAT taxes; it would compete with state sales taxes; would compete with state sales taxes; politicians would lose some power in promoting politicians would lose some power in promoting pet projects.pet projects.

III. The Flat TaxIII. The Flat Tax A flat tax is a proportional tax on individual A flat tax is a proportional tax on individual

income after a specified income threshold income after a specified income threshold has been reached.has been reached.

Advantages of the flat tax: it would be simple Advantages of the flat tax: it would be simple to report; it would close or minimize tax to report; it would close or minimize tax loopholes; it reduces the need for tax loopholes; it reduces the need for tax accountants and much of the IRS; it could accountants and much of the IRS; it could lead to savings of up to $100 billion.lead to savings of up to $100 billion.

Disadvantages of the flat tax: it removes the Disadvantages of the flat tax: it removes the behavior incentive in the tax code; it benefits behavior incentive in the tax code; it benefits those with high incomes; it shifts tax policy those with high incomes; it shifts tax policy away from the ability-to-pay principle.away from the ability-to-pay principle.

IV. The Inevitability of Future IV. The Inevitability of Future ReformsReforms

The complex tax code guarantees The complex tax code guarantees future attempts to simplify it. future attempts to simplify it.

Unexpected economic slowdowns Unexpected economic slowdowns could cause tax revenues to fall.could cause tax revenues to fall.

Unexpected political events may require Unexpected political events may require unplanned expenditures, such as unplanned expenditures, such as Congress voting to spend $40 billion to Congress voting to spend $40 billion to rebuild New York City and the air traffic rebuild New York City and the air traffic system after 9-11.system after 9-11.

Tax reform is likely to continue because Tax reform is likely to continue because each political administration abruptly each political administration abruptly changes policies to suit its agendachanges policies to suit its agenda

Politicians are reluctant to give up the Politicians are reluctant to give up the power they have in adjusting the power they have in adjusting the current complex system.current complex system.


What advice would you give your What advice would you give your congressperson about future tax congressperson about future tax reforms?reforms?

Sources of Government Revenue Chapter 9 Chapter 9.

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