INTRODUCTION Taxes affect production as well as distribution. This creates a potential tradeoff between the goal of equity and the goal of efficiency. The chapter focuses on the following questions: How are incomes distributed in the United States? How do taxes alter that distribution? How do taxes affect the rate and mix of output? TAXES: EQUITY VS. EFFICIENCY Chapter 18 2 PERSONAL INCOME WEALTH Personal income (PI) is income received by households before payment of personal taxes. Personal income is not a complete measure of income. Many goods and services are distributed directly as in-kind income. In-kind income - Goods and services received directly, without payment in a market transaction. The distribution of money income is not synonymous with the distribution of goods and services. 3 the distribution of wealth is also important in determining access to goods and services,. Wealth - The market value of assets. Wealth represents a stock of potential purchasing power. Income statistics tell us how this year s flow of purchasing power (income) is being distributed. 4 THE SIZE DISTRIBUTION OF INCOME THE LORENZ CURVE Size distribution of income is the way total personal income is divided up among households or income classes. It tells us the shares of personal income received by various household income classes. Income share is the proportion of total income received by a particular group. The Lorenz curve is a graphic illustration of the cumulative size distribution of income. It contrasts complete equality with the actual distribution of income. The greater the area between the Lorenz curve and the diagonal, the more inequality exists. 5 6
THE LORENZ CURVE THE LORENZ CURVE The ratio of the shaded area in the Lorenz curve to the area of the triangle formed by the diagonal is called the Gini coefficient. The Gini coefficient is a mathematical summary of inequality based on the Lorenz curve. 7 Cumulative Percentage of Income 100 90 80 Inequality gap 70 60 Absolute equality 50 40 Actual distribution B 30 27.5 C 20 10 A 3.6 0 10 20 30 40 50 60 70 80 90 100 Cumulative Percentage of People 8 THE CALL FOR INTERVENTION To many people, large and increasing inequality represents a form of market failure. Market failure An imperfection in the market mechanism that prevent optimal outcomes. The government could promote greater equality by levying higher taxes on the rich and providing more generous transfer payments to the poor. Progressivity is achieved by imposing increasing marginal tax rates on higher incomes. THE FEDERAL INCOME TAX The federal income tax is designed to be progressive. Progressive tax - A tax system in which tax rates rise as incomes rise. Progressivity is achieved by imposing increasing marginal tax rates on higher incomes. Marginal tax rate - The tax rate imposed on the last (marginal) dollar of income. 9 10 CHANGES IN MARGINAL TAX RATES EFFICIENCY CONCERNS 80% 70% 60% 50% 70% Top personal income tax rates A progressive tax system raises concerns about efficiency. High marginal tax rates may reduce the incentive to work, produce, or invest. 40% 30% 39.6% 38.6% 37.6% 35% 20% 10% 1980 1987 1993 1995 2000 2004 2006 11 12
TAX ELASTICITY The degree of conflict between equity and efficiency depends on how responsive market participants are to higher tax rates. This response is summarized using the tax elasticity of supply. The tax elasticity of supply is the percentage change in quantity supplied divided by the percentage change in tax rates. TAX ELASTICITY In today s range of taxes, the average household s elasticity of labor supply is between 0.15 and 0.30. If taxes increase by 20 percent, the quantity of labor supplied would drop by 3 to 6 percent. 13 14 EQUITY CONCERNS Critics raise questions about how well the federal income tax promotes equity. What appears to be a progressive tax structure in theory turns out to be a lot less progressive in practice. LOOPHOLES Thousands of people with million-dollar incomes pay not taxes. The progressive tax rates described in the tax code apply to taxable income, not to all income. 15 The purpose of itemized deductions is to encourage specific economic activities and reduce potential hardships. 16 LOOPHOLES These deductions may violate the principles of vertical or horizontal equity. Vertical equity Principle that people with higher incomes should pay more taxes. Horizontal equity Principle that people with equal incomes should pay equal taxes. NOMINAL VS. EFFECTIVE TAX RATES The loopholes created by exemptions, deductions, and tax credits create a distinction between gross economic income and taxable income. This distinction, in turn, requires us to distinguish between nominal tax rates and effective tax rates. 17 18
NOMINAL VS. EFFECTIVE TAX RATES The nominal tax rate is calculated by dividing taxes paid by total income.* The effective tax rate is calculated by dividing taxes paid by taxable income.* NOMINAL VS. EFFECTIVE TAX RATES The gap between the nominal tax rate and the effective tax rate is a reflection of loopholes in the tax code. It is also the source of vertical and horizontal inequities. *THESE TERMS ARE SWITCHED IN THE BOOK THROUGHOUT CHAPTER 18. PLEASE NOTE THE CHANGE. 19 20 TAX-INDUCED MISALLOCATIONS Tax loopholes not only foster inequity but encourage inefficiency as well. Tax preferences induce resource shifts into taxpreferred activities. A SHRINKING TAX BASE As deductions, exemptions, and credits accumulate, the tax base shrinks. The tax base is the amount of income or property directly subject to nominal tax rates. The tax arithmetic is simple: Tax revenue = average tax rate X tax base 21 22 EXAMPLE: THE 1986 TAX REFORM ACT RATE REDUCTIONS The basic features of the Tax Reform Act (TRA) of 1986 included: Loophole closing. Reductions in marginal tax rates. Fewer tax brackets. Tax relief for the poor. Shift from personal to corporate taxes. The elimination or reduction of scores of tax preferences increased the tax base by almost 25 percent. By doing so, the TRA eliminated many sources of vertical and horizontal inequities. 23 By broadening the tax base, the TRA made it possible to reduce tax rates. The cut in the top tax rate from 50 to 28 percent was intended to stimulate a greater supply of labor and capital. 24
1990 AND 1993 TAX INCREASES Some critics of the 1986 TRA reforms claimed that it was a giveaway to the rich. The 1990 and 1993 tax increases resulted in creating five tax brackets instead of three. The top marginal tax rate was raised to 39.6 percent. THE BUSH TAX CUTS (2001-2010) President Bush made tax cuts his top priority after he was elected. Reduce marginal tax rates to encourage more production. Provide tax incentives to encourage more education, saving, and family development. 25 26 REDUCED MARGINAL RATE The lowest marginal rate was lowered to 10 percent to increase the disposable income of lowincome workers and give them more incentive to work. The highest marginal tax rate was reduced to 35 percent. EDUCATION INCENTIVES To increase college enrollments, the bill provides a $3,000 tax credit for college tuition. The tax credit induces only a small change in college enrollments, yet introduces both horizontal and vertical inequities. 27 28 FAMILY INCENTIVES To encourage marital stability, the bill reduces the marriage penalty in the standard deduction. To help defray the cost of raising children, the child tax credit was increased. SAVING INCENTIVES To encourage saving, the Tax Relief Act of 2001 raised the limit on retirement savings accounts and phased out the estate tax. 29 30
PAYROLL, STATE, AND LOCAL TAXES The federal income tax is only one of many taxes the average taxpayer must pay. Sales taxes and property taxes are both regressive. A regressive tax is a tax system in which tax rates fall as incomes rise. Sales taxes and property taxes are regressive because poor people pay a larger percentage of their income on these taxes than do the rich people. TAX INCIDENCE Tax incidence is the distribution of the real burden of a tax. The burden of property taxes is reflected in higher rents. Landlords tend to pass along to tenants any property taxes they must pay. People who rent apartments pay higher rents because of property taxes. 31 32 PAYROLL TAXES INCIDENCE OF A PAYROLL TAX Labor demand reflects the marginal revenue product (MRP) of labor. Marginal revenue product (MRP) The change in total revenue associated with one additional unit of input. MRP sets a limit to the wage an employer is willing to pay. Fewer workers are employed and the net wage is reduced when a payroll tax is imposed. Wage Rate (dollars per hour) w 1 w 0 w 2 S + tax Supply of labor Demand for labor 33 0 L 1 L 0 Quantity of Labor (labor-hours per time period) 34 TAXES AND INEQUALITY The regressivity of the Social Security payroll tax and of many state and local taxes offsets most of the progressivity of the federal income tax. When all is said and done, the tax system as a whole ends up being nearly proportional. TAXES ON THE RICH FOR TOP 1 PERCENT OF HOUSEHOLDS Share of Income 13% Share of Taxes Federal income tax 26% All federal taxes 18% 35 All federal, state, and local taxes 16% 36
THE IMPACT OF TRANSFERS The government completes the redistribution process by transferring income to consumers. Income transfers are payments to individuals for which no current goods or services are exchanged. Examples include Social Security, welfare, and unemployment benefits. Direct transfers welfare benefits, social security payment and unemployment insurance are more likely to be progressive. 37 THE IMPACT OF TRANSFERS Most indirect transfers education, agricultural stability are less likely to be progressive and may even be regressive in some cases. To many people, the apparent ineffectiveness of the tax-transfer-system to redistribute income is a mark of government failure. 38 THE COSTS OF GREATER EQUALITY The greatest potential cost of a move toward greater equality is the reduced incentives it might leave in its wake. The essential economic problem that absolute income equality poses is that it breaks the market link between effort and reward. The argument for preserving income inequalities is thus anchored in a concern for productivity. THE BENEFITS OF GREATER EQUALITY Although the potential benefits of inequality are impressive, there is a tradeoff between efficiency and equality. The first economic argument for greater equality is that the present degree of inequality is more than necessary to maintain work incentives. 39 40 THE BENEFITS OF GREATER EQUALITY The second argument is that low-income earners might actually work harder if incomes were distributed more fairly. Finally, if greater equality was achieved via tax simplification, a more efficient allocation of resources might result. A FLAT TAX? One of the most debated proposal to replace the present federal income tax system is the flat tax. Flat tax is a single-rate tax system. The key features of a flat tax include: Replacing the current system of multiple tax brackets and rates with a single tax rate that would apply to all taxable income. Eliminating all deductions, credits and most exemptions. 41 42
SIMPLICITY A major attraction of the flat tax is its simplicity. The current 1400-page tax code that details all the provisions of the present system would be scrapped. All 437 IRS tax forms would be replaced by a single postcard-sized form. By scrapping all the deductions, the flat tax would treat everyone equally and eliminate horizontal and vertical inequities. Some progressivity could also be preserved with a flat tax by offering personal exemptions. EFFICIENCY Proponents of a flat tax claim it enhances efficiency as well as equity. With a simplified flat tax, all the labor resources used to prepare tax returns could be put to uses that are more productive. 43 44 THE CRITIQUE As proposed by Dick Armey, the flat tax would not apply to all income. Income on savings and investments would not be taxed so that saving, investment and economic growth is encouraged. This proposal creates vertical and horizontal inequities. Someone receiving $1 million in interest and dividends could escape all income taxes, while a family earning $50,000 would have to pay. The transition to a flat tax would entail a wholesale reshuffling of wealth and income. 45 TAXES: EQUITY VS. EFFICIENCY End of Chapter 18