Taxation

Objectives of This Lecture

• Discuss the economics and nature of taxes.

• An unbiased approach.

• Assist students to see that:– Taxation is a complicated issue.– There is no such thing as a “best tax”.

• Question: How do we pay for public goods?

Taxation: A Brief History• Matthew, the tax collector.

– “Tax farming”.– Tax collectors = sinners.

• The French:– An important cause of the French revolution.– Contributed to the downfall of Napoleon.

• The English:– After the “Glorious Revolution”, Parliament stripped the King of the

right to tax.– The wig and powder tax.

• The United States:– The Boston tea party make is a coffee drinking nation.– Our constitution specifically states who has the right to tax.– The “Whiskey Rebellion”.

Adam Smith’s Maxims of Taxation

Source: Smith, Adam, The Wealth of Nations, The Modern Library, 2000, pp 888-890

Smith’s Maxims of Taxation (No.1)

• “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.

The expense of government to the individuals of a great nation, is like the expense of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate.”

Smith’s Maxim of Taxation (No. 2)

“The tax which each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, the quantity to be paid, ought to be clear and plain to the contributor, and to every other person.

Where it is otherwise, every person subject to the tax is put more or less in the power of the tax-gatherer, who can either aggravate the tax upon any obnoxious contributor, or extort, by the terror of such aggravation, some present or perquisitie to himself.”

Smith’s Maxim of Taxation (No. 3)“Every tax ought to be levied at the time, or in the

manner, in which it is most likely to be convenient for the contributor to pay it.

A tax upon the rent of land or of houses, payable at the same term at which such rents are usually paid, is levied at the time when it is most for the likely to be convenient for the contributor to pay; or when he is most likely to have the wherewithal to pay. Taxes upon such consumable goods as are articles of luxury, are all finally paid by the consumer, and generally in a manner that is very convenient for him.”

Smith” Maxims of Taxation ( No. 4)

“Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what is brings into the public treasury of the state”.

Smith’s Additional Comment

“An injudicious tax offers a great temptation to smuggling. But the penalties of smuggling must rise in proportion to the temptation.

The law, contrary to all the principles of justice, first creates the temptation, and then punishes those who yield to it; and it commonly enhances the punishment too in proportion to the very circumstances which ought certainly to alleviate it, the temptation to commit the crime.”

Tax Features

Smith’s Tax Philosophy:• Equality.

• Certainty.

• Convenience of payment.

• Economy of collection.

Modern Tax Philosophy:• Is distribution of the

tax burden fair?• Are taxes designed to

minimize “frictions” or distortions?

• Is the system understandable to the payers?

• Is the tax system operated at as low a cost as possible?

What Do We Tax

• Income.– Wages.– Interest and dividends.

• Consumption.– Sales tax.– Excise tax.

• Wealth.– Property (Personal and real).– Capital gains.– Inheritance.

What Do We Tax - Continued

Tax base: The measure of value on which a tax is levied. (Page 377 in text.)

Examples:

• All income after deductions above X amount.– Federal income tax.

• The value of your home.– County real estate tax.

• The value of your automobile.– Personal property tax.

Principles of Taxation

• The goal of economic efficiency.

• The benefits received principle.

• The ability to pay principle.

• The horizontal and vertical equity principles.

• The progressive and regressive tax concepts.

• The goal of attaining social objectives.

Taxes and Economic Efficiency

A tax is efficient if it imposes a small excess burden relative to the tax revenue it raises.

• Excess burden is the efficiency loss to the economy that results from a tax causing a reduction in the quantity of a good produced.– Do high taxes discourage the start of new businesses?– Do high taxes encourage people to leave the formal labor

force?– Do high taxes alter incentives to work, save, or invest?

• A tax that is neutral with respect to economic decisions is preferable to one that distorts economic dedcisions.

Tax Efficiency & Tax BurdenWe begin

with a

common

supply

and

demand

diagram.

Tax Efficiency and Tax Burden, Con’t.When we

include the

tax on the

item the

supply curve

shifts left and

the price

increases.

Tax Efficiency and Tax Burden, Con’t.

Tax Efficiency and Tax Burden, Con’t.

Tax Efficiency and Tax Burden, Con’t.With the new

higher price and

the lower quantity

demanded, we

see that producers

are producing less

and receiving a

lower price.

Therefore, high

taxes lead to

lower production.

Benefits Received Principle

A theory of fairness holding that taxpayers should contribute to government (in the form of taxes) in proportion to the benefits that they receive from public expenditures. (Page 381)

Examples;• Toll roads and bridges.• Federal highway trust fund.• Landing fees at an airport.

The tax side and the expenditure side are connected.

Problem: How does society pay for public goods?

Ability to Pay Principle

A theory of taxation that holds that citizens should bear tax burdens in line with their ability to pay.

The tax side and the expenditure side are viewed separately.

Ability To Pay Principle - Continued

• Regressive tax (Page 379 in text.):– A tax whose burden, expressed as a percentage of

income, falls as income increases.– Example: A retail sales tax.

• Progressive tax (Page 378 in text.):– A tax whose burdens, expressed as a percentage of

income, increases as income increases.– Example: Individual income tax.

• Proportional tax (Page 378 in text.)– A tax whose burden is the same proportion of income for

all households.– Example: A flat tax.

Ability To Pay Principal - Continued

Horizontal equity (Page 387 in text.):

• The principle of horizontal equity holds that those with equal ability to pay should bear equal tax burden.

Vertical equity (Page 387 in text.)

• The principle of vertical equity holds that those with greater ability to pay should pay more.

Social Goals and Taxation

There are citizens who believe that one of the legitimate purposes of a tax system is to promote social goals.

• Redistribution of income.– John Maynard Keynes.– Franco Modigliani.

• Promote economic growth.– Deduction of mortgage interest on income taxes.– Deductions for number of children on income taxes.

• Sin taxes.– Liquor taxes.– Tobacco taxes.

Features of an Income Tax

• A tax on income.• A tax on flow.• Generally considered progressive.• Contains both horizontal and vertical equity.• An ability to pay tax.• Generally considered to be anti-growth since tax

payers are taxed twice.• Types:

– Federal tax: A marginal tax above a certain level.– Missouri Tax: Marginal to a point and then proportional.– City of St. Louis: A proportional tax.

Marginal Tax RatesSingle Tax Payer – 2005 Rates

Average Tax Rate

Features of Real Estate Taxes• A tax on stock.• A tax on wealth.• There is vertical equity:

– Those who have the most pay the most.• There is no horizontal equity:

– The tax is not uniform city to city.• It is an ability-to-pay tax.• Is it regressive?

– Lower income households pay a larger percentage of their income.– However, studies show that upper income people pay a higher

percentage of their income on housing that do lower income people.

Keynesian Rate/Receipts Curve

Laffer Rate/Receipts Curve

Supply SideTenets of Taxation

• Beyond some point, high marginal tax rates on personal income can reduce people’s willingness to work.

• High marginal tax rates discourage people from investing in education and improving their work related skills.

• High marginal tax rates encourage people to work in the underground economy.

(Source: Page 331, McKenzie, Richard B., Macroeconomics, Houghton Mifflin Co, 1986)

When Do Tax Cuts Matter

(Chapter 14 in the Readings Book)

When Do Tax Cuts Matter

The concept of marginal utility:

As a general rule, people maximize their own utility:– They make choices that maximize their

satisfaction.– They look at the marginal cost and marginal

benefit.– They consider what is happening today as well as

what they believe will happen in the future.

When Do Tax Cuts Matter

Therefore:• Temporary tax cuts have temporary benefits.

– Any change in behavior will be short lived.– If the income tax is cut for next year but not the

year after: ═> People will work hard next year, but not the next year after that.

• Permanent tax cuts affect peoples’ futures, and they pick up on that.

=> Permanent tax cuts affect peoples’ utility, and , therefore, their behavior.

Cairo Egypt, picture taken 1-6-10

Hauser’s Law• In 1993, William Kurt Hauser, a San Francisco

economist, said, “ No matter what the tax rates have been, in post war America tax revenues have remained at about 19.5% of GDP.”

• The data show that the tax yield has been independent of marginal tax rates over this period, but tax revenue is directly proportional to GDP.

• The implication, based on actual data, is that if the government wants to increase tax revenue, we need to increase GDP.

• Note the difference between tax avoidance and tax delinquency.

Hauser’s Law, Con’t.

Hauser’s Law, Con’t.