N.

GREGORY MANKIW NINTH EDITION

PRINCIPLES OF
ECONOMICS

CHAPTER
The Design
12 of the Tax System
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
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 IN THIS CHAPTER
• What are the largest sources of tax
revenue in the U.S.?
• What are the efficiency costs of taxes?
• How can we evaluate the equity of a tax
system?

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 Introduction
• ‘A government can sometimes improve
market outcomes’
– Providing public goods
– Regulating the use of common resources
– Remedying the effects of externalities
• The government
– Raises revenue through taxation
– To perform its many functions

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 Review from previous chapters
• Lessons about taxes :
– A tax on a good reduces the market quantity
of that good
– The burden of a tax is shared between
buyers and sellers depending on the price
elasticities of demand and supply
– A tax causes a deadweight loss
– Taxes can increase efficiency when they are
used to internalize externalities and thereby
correct market failures
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 Government revenue as a percentage of GDP, U.S.

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 An Overview of U.S. Taxation
• Government revenue has increased
– As percentage of total income
– As economy’s income has grown
• Government’s revenue from taxation
has grown even more
• 1902: 7% of income
• Recent years: 30% of income

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 Government revenue as a percentage of GDP:
international comparisons

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 Taxes Collected by the Federal Government
• Personal income taxes
– On wages, interest, dividends, profits
(small businesses it operates)
• Payroll taxes (social insurance taxes)
– On the wages that a firm pays its workers
– Mostly earmarked to pay for Social
Security and Medicare
• Corporate income taxes
• Other taxes
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 Receipts of the federal government: 2019 Q1

Amount Amount Percent

(billions) per person of receipts
Personal
current taxes $1,660.7 $5,075.99 46.7%
Social
insurance 1,377.2 4,209.47 38.7
Taxes on
corporate
income 159.9 488.74 4.5
Others 361.5 1,104.94 10.2
Total $3,559.3 $10,879.14 100.0%

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 The federal income tax rates: 2019
The marginal
On taxable income…
tax rate is…
From $0 to $9,700 10%
From $9,701 to $39,475 12%
From $39,476 to $84,200 22%
From $84,201 to $160,725 24%
From $160,726 to $204,100 32%
From $204,101 to $510,300 35%
From $510,301 and above 37%

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 EXAMPLE 1: Calculating your tax burden
In 2019, Kayla has earned $49,000 and Malik
$39,000 in income. Based on the Federal
Income Tax Rates for 2019, calculate their
2019 tax liability.
• Kayla will pay: 10% of $9,700 + 12% of (39,475-
9,700) + 22% of (49,000 – 39,475)
= 970 + 3,573 + 2,095.50 = $6,638.50
• Malik will pay: 10% of $9,700 + 12% of (39,000-
9,700)
= 970 + 3,516 = $4,486
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 Receipts of the state and local government: 2019 Q1
Amount Amount Percent
(billions) per person of receipts
Property taxes $567.2 $1,733.67 21.5%
Sales taxes 427.7 1,307.28 16.2
Personal income
taxes 405.3 1,238.82 15.4
Excise taxes 197.8 604.58 7.5
Corporate income
taxes 65.1 198.98 2.5
Federal
government 578 1,766.68 21.9
Other 395.8 1,209.78 15.0
Total $2,636.9 $8,059.79 100.0%

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 Taxes and Efficiency
• Policymakers’ objectives:
– Equity and efficiency
• Costs of taxes to taxpayers
– Tax payment itself
– Deadweight losses
• Taxes distort the decisions that people make
– Administrative burdens
• Taxpayers bear as they comply with the tax
laws

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 Deadweight Losses
• ‘People respond to incentives’
• Taxes distort incentives
– Cause people to allocate resources
according to tax incentives rather than
true costs and benefits
• Deadweight loss
– The fall in taxpayers’ well-being exceeds
the revenue the government collects

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 EXAMPLE 2: How taxes cause deadweight losses
Sydney places a $30 value on an ice-cream cake,
and Zaid places a $35 value on it. P = $25. Each
wants to buy one. Calculate total surplus. What is
changing if the government imposes a $6 tax on ice-
cream cakes? No tax With $6 tax
Price $25 25 + 6 = $31
Sydney’s surplus 30 – 25 = $5 Cannot buy
Zaid’s Surplus 35 – 25 = $10 35 – 31 = $4
Tax revenue $6
Total surplus 5 + 10 = $15 4 + 6 = $10
DWL $5

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 Should income or consumption be taxed?
• Income tax reduces the incentive to save:
– If income tax rate is 25%, then 8%
interest rate is 6% after-tax interest rate.
– The lost income compounds over time.
• Some economists advocate taxing
consumption instead of income
– Would restore incentive to save.
– Better for individuals’ retirement income
security and long-run economic growth.

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 Should income or consumption be taxed?
• Consumption tax-like provisions in the U.S.
tax code include Individual Retirement
Accounts, 401(k) plans.
– People can put a limited amount of
saving into such accounts.
– The funds are not taxed until withdrawn
at retirement.
• Europe’s Value-Added Tax (VAT) is like a
consumption tax

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 Administrative Burden
• Administrative burden
– Includes the time and money people
spend to comply with tax laws
– Encourages the expenditure of resources
on legal tax avoidance
• e.g., hiring accountants to exploit “loopholes”
to reduce one’s tax burden
– Is a type of deadweight loss
– Could be reduced by simplifying tax laws

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 ASK THE EXPERTS
Top Marginal Tax Rates
“Raising the top federal marginal tax on earned personal
income to 70 percent (and holding the rest of the current
tax code, including the top bracket definition, fixed) would
raise substantially more revenue (federal and state,
combined) without lowering economic activity.”

Source: IGM Economic Experts Panel, January 16, 2019.

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 Marginal Tax Rates vs. Average Tax Rates
• Average tax rate
– Total taxes paid divided by total income
– Measures the sacrifice a taxpayer makes
• Marginal tax rate
– The extra taxes paid on an additional
dollar of income
– Measures the incentive effects of taxes
on work effort, saving, etc.

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 EXAMPLE 3: Calculating average tax rate
In Example 1, Kayla earned $49,000 and Malik
$39,000 in income. Based on the Federal Income
Tax Rates for 2019, their 2019 tax liability was
$6,638.50 for Kayla and $4,486 for Malik. What is
their (individual) average tax rate?
The average tax rate is:
• For Kayla 100×6638.50/49000 = 13.55%
• For Malik 100×4486/39000 = 11.50%

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 Lump-Sum Taxes
• Lump-sum taxes
– Same amount of tax for every person
– Most efficient tax possible
– Does not distort incentives: no DWL
– Minimal administrative burden
– Why are they rare in the real world?
• Not equitable: It takes the same amount from
the poor and the rich

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 EXAMPLE 4: Lump-sum taxes
Kayla earned $49,000 and Malik $39,000 in income.
Each is taxed by a lump-sum tax of $10,000.
Calculate the average and marginal tax rates for
Kayla and Malik.
• Kayla’s average tax rate: 100×10,000/49,000 =
20.4%
• Malik’s average tax rate: 100×10,000/39,000 =
25.6%
• The marginal tax rate for both both is 0%
– If their income is increasing, the additional tax
they have to pay is $0.
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 Taxes and Equity
• Equity
– Another goal of tax policy
– Distributing the burden of taxes “fairly”
• Agreeing on what is “fair” is much harder
than agreeing on what is “efficient”
– Yet, there are several principles people
apply to evaluate the equity of a tax
system

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 The Benefits Principle
• The benefits principle
– People should pay taxes based on the benefits
they receive from government services
– Tries to make public goods similar to private
goods
– Example: gasoline taxes
– Wealthy citizens should pay higher taxes: they
benefit more from public services
• Police, fire protection, national defense,
antipoverty programs

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 The Ability-to-Pay Principle
• The ability-to-pay principle
– Taxes should be levied on a person
according to how well that person can
shoulder the burden
• All taxpayers should make an “equal
sacrifice”
• A $10,000 tax bill is a bigger sacrifice for a
poor person than a rich person.
– Vertical equity
– Horizontal equity
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 Vertical Equity
• Taxpayers with a greater ability to pay
taxes should pay larger amounts
– Richer taxpayers should pay more than
poorer taxpayers
• How much more should the rich pay?
– Focus of the debate over tax policy

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 Three Tax Systems
• Proportional tax:
– High-income and low-income taxpayers pay the
same fraction of income
• Regressive tax:
– High-income taxpayers pay a smaller fraction of
their income than do low-income taxpayers
• Progressive tax:
– High-income taxpayers pay a larger fraction of
their income than do low-income taxpayers

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 Three tax systems

Regressive Proportional Progressive

% of % of % of
income tax tax tax
income income income

$50,000 $15,000 30% $12,500 25% $10,000 20%

100,000 25,000 25 25,000 25 25,000 25

200,000 40,000 20 50,000 25 60,000 30

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 The burden of federal taxes, 2014

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 Horizontal Equity
• Horizontal equity
– Taxpayers with similar abilities to pay
taxes should pay the same amount
– Special provisions that alter a family’s tax
based on its specific circumstances
– Problem: Difficult to agree on what factors,
besides income, determine ability to pay

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 Active Learning 1: Taxes and marriage
The income tax rate is 25%. The first $20,000
of income is excluded from taxation. Tax law
treats a married couple as a single taxpayer.
Makena and David each earn $50,000.
A. If Makena and David are unmarried and
living together, what is their combined tax
bill?
B. If Makena and David are married, what is
their tax bill?

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 Active Learning 1: Answers
A. If unmarried, Makena and David each pay
0.25 x ($50,000 – 20,000) = $7,500
Total taxes = $15,000 = 15% of their joint
income.
B. If married, they pay
0.25 x ($100,000 – 20,000) = $20,000
or 20% of their joint income.

The $5,000 increase in the tax bill is called the

“marriage tax” or “marriage penalty.”

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 Active Learning 2: Taxes and marriage, again
The income tax rate is 25%. For singles, the
first $20,000 of income is excluded from
taxation. For married couples, the exclusion is
$40,000. Daniel earns $0. Ciara earns
$100,000.
A. If Daniel and Ciara are living together
unmarried, what is their combined tax bill?
B. If Daniel and Ciara are married, what is
their tax bill?

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 Active Learning 2: Answers
A. If unmarried, Daniel pays $0 in taxes.
Ciara pays:
0.25 x ($100,000 – 20,000) = $20,000
Total taxes = $20,000 = 20% of their joint
income.
B. If married, they pay
0.25 x ($100,000 – 40,000) = $15,000
or 15% of their joint income.
The $5000 decrease in the tax bill is called
the “marriage subsidy.”

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 Tax Incidence and Tax Equity
• Tax incidence
– Who bears the burden of taxes
– Central to evaluating tax equity
– Person who bears the burden a tax is not
always the person who gets the tax bill
from the government
• Taxes alter supply and demand
– Alter equilibrium prices
– Indirect effects
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 EXAMPLE 5: Taxes and equity
• A tax on fur coats
– May appear to be vertically equitable: “Rich
people buy furs”
– But furs are a luxury with very elastic
demand
– The tax shifts demand away from furs,
hurting the people who produce furs (who
probably are not rich)
• When evaluating tax equity, must take tax
incidence into account.
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 Who pays the corporate income tax?
People pay all taxes
• Tax on a corporation
– Corporation – more like a tax collector than
taxpayer
– Burden of the tax ultimately falls on people:
owners, customers, or workers of the
corporation
– Workers and customers bear much of the
burden of the corporate income tax
– Is popular: it appears to be paid by rich
corporations
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 Who pays the corporate income tax?
• Suppose the government levies a tax on
automakers:
– Owners receive less profit, may respond over
time by shifting their wealth out of the auto
industry.
– The supply of cars falls
• Car prices rise, car buyers are worse off.
– Demand for auto workers falls
• Wages fall, workers are worse off.

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 The Trade-off Between Equity and Efficiency
• Equity and efficiency
– The two most important goals of a tax system
– Often conflict, especially when equity is judged
by progressivity
– Political leaders differ in their views on this
tradeoff
• Economics can help us:
– Identifying the trade-offs that society faces
– Avoid policies that sacrifice efficiency without
enhancing equity

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 The History of Tax Policy – 1
• Before 1980
– 50% marginal tax rate on the earnings of the
richest Americans
– 70% marginal tax rate on interest income
• 1981, 1986, president Ronald Reagan
– 28% marginal tax rate on the richest Americans
• 1993, president Bill Clinton
– 40% marginal tax rate on the richest Americans

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 The History of Tax Policy – 2
• 2003, president George W. Bush
– 35% marginal tax rate on the richest
Americans
• 2013, president Barack Obama
– 40% marginal tax rate on the richest
Americans
• 2018, president Donald Trump
– 37% marginal tax rate on the richest
Americans
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 THINK-PAIR-SHARE
You are having a political debate with a
friend. The discussion centers on taxation. You
show your friend some data from your
economics textbook that suggests that the
average American paid about $11,000 in
federal income tax in 2017. Your friend says, “If
$11,000 per person is what it takes to run this
country, then I think that it would be much
simpler if we just billed each American $11,000
and eliminated the complex tax code.”

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 THINK-PAIR-SHARE
A. What type of tax is your friend suggesting? What is
its appeal?
B. Is this type of tax supported by the “benefits
principle” of tax equity? Explain
C. Is this type of tax supported by the “ability-to-pay”
principle of tax equity? Is it vertically equitable? Is it
horizontally equitable?
D. Your friend agrees that the tax is not equitable, so
she now suggests that we simply tax rich
corporations since they can clearly afford it and then
people wouldn’t have to pay any taxes. Is she
correct? Who would actually pay the taxes? Explain.
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 CHAPTER IN A NUTSHELL
• The U.S. government raises revenue using various
taxes.
– The most important taxes for the federal
government are personal income taxes and
payroll taxes for social insurance.
– The most important taxes for state and local
governments are sales taxes and property
taxes.

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 CHAPTER IN A NUTSHELL
• The efficiency of a tax system refers to the costs it
imposes on taxpayers.
– The transfer of resources from the taxpayer to
the government.
– The deadweight loss that arises as taxes alter
incentives and distort the allocation of
resources.
– The administrative burden of complying with the
tax laws.

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 CHAPTER IN A NUTSHELL
• The equity of a tax system: whether the tax burden
is distributed fairly among the population.
– The benefits principle: it is fair for people to pay
taxes based on the benefits they receive from
the government.
– The ability-to-pay principle: it is fair for people to
pay taxes based on their capability to handle the
financial burden.
– The distribution of tax burdens is not the same
as the distribution of tax bills.
• There is a trade-off between efficiency and equity.
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