The Economics of Taxation

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Main Idea

Taxes are the single most important way of raising revenue for the government.

Reading Strategy

Graphic Organizer As you read the section, complete a graphic organizer similar to the one below by listing the criteria for taxes to be effective. Then, define each of the criteria in your own words.

Key Terms sin tax, incidence of a tax, tax loophole, individual income tax, sales tax, benefit principle of taxation, ability-to-pay principle of taxation, proportional tax, average tax rate, progressive tax, marginal tax rate, regressive tax


After studying this section, you will be able to:

1. Explain the economic impact of taxes.

2. List three criteria for effective taxes.

3. Understand the two primary principles of taxation.

4. Understand how taxes are classified.

Applying Economic Concepts

Equity Read to find out what role equity, or fairness, plays in administering taxes.


Tax Freedom Day

Foundation [made public] its annual calculation of Tax Freedom Day. It is May 11th this year, the latest date ever. When Tax Freedom Day is May 11th across the country,

mean, it American's paycheck starting the money ^ continue doing so until May 11 to collect enough to fund government at all levels.

—Tax Foundation, April 15, 1999

Many tax dollars go to national defense.

An enormous amount of money is required to run the federal, state, and local governments of the United States. In 1999, all three levels of government collected approximately $2.8 trillion-or about $10,300 for every man, woman, and child in the United States. Whether we count the dollars, or the days needed to earn the dollars as illustrated in the cover story, it all adds up to a staggering sum.

Total revenue collections by all levels of government have grown dramatically over the years. Figure 9.1 shows that these revenues, even when adjusted for inflation and population growth, increased by nearly 800 percent since 1940.

Economic Impact of Taxes

■M Taxes and other governmental revenues ^Ur influence the economy by affecting resource allocation, consumer behavior, and the nation's productivity and growth. In addition, the burden of a tax does not always fall on the party being taxed, because some of the tax can be transferred to others.


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Total Government Receipts Per Capita, Adjusted for Inflation

0% 1940

950-1999 - Spen

ding bv\

( all levels of government J

/i990s - Econo

mic growth

^^ (

and higher marginal tax . rates contribute to ^.increased revenues.^^

1950 1960 1970 1980 1990

Source: Bureau of Economic Analysis and the Department of the Census, various forms


1950 1960 1970 1980 1990

Source: Bureau of Economic Analysis and the Department of the Census, various forms


Using Graphs Total receipts by all levels of government have increased significantly over time. What information does the graph show for the period 1980 to 2000?

Visit and click on Textbook Updates—Chapter 1 for an update of the data.

Visit and click on Textbook Updates—Chapter 1 for an update of the data.

Resource Allocation

Behavior Adjustment

The factors of production are affected whenever a tax is levied. A tax placed on a good or service at the factory raises the cost of production, which shifts the supply curve to the left. If demand remains unchanged, the equilibrium price of the product goes up.

People react to the higher price in a predictable manner-they buy less. When sales fall, some firms cut back on production and some productive resources-land, capital, labor, and entrepreneurs-will have to go to other industries to be employed.

In 1991, for example, Congress enacted a luxury tax on expensive cars, private aircraft, yachts, and other costly items in order to raise additional tax revenue from the wealthy. Because the demand for luxury goods was elastic, however, higher prices drove customers away, and unemployment soared in some of these industries.

Often taxes are used to encourage or discourage certain types of activities. For example, homeowners are allowed to use interest payments on mortgages as tax deductions-a practice that encourages home ownership. Interest payments on other consumer debt, such as credit cards, is not deductible-a practice that makes credit card use less attractive.

The so-called sin tax-a relatively high tax designed to raise revenue and reduce consumption of a socially undesirable product such as liquor or tobacco-is another example of how a tax can be used to change behavior. Canada used a sin tax in the 1980s when it quadrupled the tobacco tax, pushing the price of a pack of cigarettes to more than $4, and reducing cigarette consumption by one-third.

Efforts to tax tobacco in the United States, however, show that tobacco, because of its addictive nature, is still an inelastic product. For example, it is



Figure 9.2


estimated that a $1 tax per pack is not enough to significantly affect consumption—and thus the government could raise billions of dollars in tax revenues.

Productivity and Growth

Finally, taxes can affect productivity and economic growth by changing the incentives to save, invest, and work. Some people think that taxes are already so high that it affects their incentive to work. Why, they argue, should a person earn additional income if much of it will be paid out in taxes?

While these arguments have validity, it is difficult to tell if we have reached the point where taxes are too high. For example, even the wealthiest individuals pay less than half of their taxable income to state and local governments in the form of income taxes. Are these taxes so high that they do not have the incentive to earn an additional $10 million because they can only keep half? Would they work any harder if income taxes only took thirty percent of their income? Or, would they work just as hard if they paid seventy percent of the extra income in taxes?

While we do not have exact answers to these questions, we do know that there must be some level of taxes at which productivity and growth would suffer. This is just one of many reasons why people favor lower taxes.

The Incidence of a Tax

The party being taxed is not always the one that bears the burden of a tax. For example, suppose a city wants to tax a local utility company to raise revenue. If the utility is able to raise its rates, consumers will likely bear most of the burden in the form of higher utility bills. If a company's rates are regulated, and if the company's profits are not large enough to absorb the tax increase, shareholders may receive smaller dividends—placing the burden of the tax on the owners. Another alternative is that the company may postpone a pay raise—shifting the burden of the tax to its employees.

The incidence of a tax—or the final burden of the tax—can be predicted with the help of supply and demand analysis. Examine the demand curve in Panel A of Figure 9.2. You see that it is relatively more elastic than the one shown in Panel B, although the supply curves are exactly the same in both. A $1 tax

Shifting the Incidence of a Tax

A Elastic Demand

S + tax



$15.60 /W____


* ( $1 tax on \

■ 1

^ V producer V ^ D



O Inelastic Demand

5.8 6 Quantity

Using Graphs A tax on the producer increases the cost of production and causes a change in supply. Less of the tax can be shifted back to the taxpayer if demand is elastic, as in A. More of the tax can be shifted to the taxpayer if demand is inelastic, as in B. Who is likely to bear the greater burden—the producer or the consumer—if a tax is placed on medicine?




Taxable Income Taxable income is the amount of income that is subject to taxation by the state and federal government. It is the adjusted gross income of wages, salaries, dividends, interest, capital gains, etc., less allowable adjustments deductions, which include but are not limited to contributions to retirement accounts, business expenses, and capital losses.

You might believe that a tax is fair only if everyone pays the same amount. Your friend concludes, on the other hand, that a tax is fair only if wealthier people pay more than those with lower incomes.

There is no overriding guide that we can use to make taxes completely equitable. However, it does make sense to avoid tax loopholes-exceptions or oversights in the tax law that allow some people and businesses to avoid paying taxes. Loopholes are a fairness issue, and most people oppose them on the grounds of equity. Taxes generally are viewed as being fairer if they have fewer exceptions, deductions, and exemptions.

on the producer in Panel A increases the price of the product by 60 cents-which means that the producer must have absorbed the other 40 cents. On the other hand, the demand curve in Panel B is relatively inelastic. Here we can see that the exact same tax on the producer results in a 90-cent increase in price, which means that the producer must have absorbed the other 10 cents. The figure clearly shows that it is much easier for a producer to shift the incidence of a tax to the consumer if the consumer's demand curve is relatively inelastic. The more elastic the demand curve, the greater the portion of the tax that will be absorbed by the producer.

In the case of the 1991 luxury tax on private aircraft, the burden of the tax fell on the producer because the demand for small private aircraft was relatively elastic. The unemployment that resulted in the aircraft industry, along with the costs of coping with the unemployment, convinced Congress to remove the tax.

Criteria for Effective Taxes l||n Some taxes will always be needed, so we want to make them as effective as possible. To do so, taxes must meet criteria: they must be equitable, simple, and efficient.


The first criterion is equity or fairness. Most people feel that taxes should be impartial and just. Problems arise, however, when we ask, what is fair?


A second criterion is simplicity. Tax laws should be written so that both the taxpayer and the tax collector can understand them. This task is not easy, but people seem more willing to tolerate taxes when they understand them.

The individual income tax-the tax on people's earnings—is a prime example of a complex tax. The entire code is thousands of pages long, and even the simplified instructions the Internal Revenue Service (IRS) sends out to taxpayers are lengthy and often difficult to understand. As a result, many people dislike the individual income tax code, in part because they do not fully understand it.

A sales tax—a general tax levied on most consumer purchases—is much simpler. The sales tax is paid at the time of purchase, and the amount of the tax is computed and collected by the merchant. Some goods such as food, child care, and medicine may be exempt, but if a product is taxed then everyone who buys the product pays it.



Student Web Activity Visit the Economics: Principles and Practices Web site at and click on Chapter 9—Student Web Activities for an activity on the individual income tax.




A third criterion for an effective tax is efficiency. A tax should be relatively easy to administer and reasonably successful at generating revenue.

The individual income tax satisfies this requirement fairly well. Whenever someone is paid, the employer withholds a portion of the employee's pay and sends it to the IRS. At the end of the year, the employer notifies each employee of the amount of tax withheld. Because most payroll records are now computerized, neither the employer nor the employee is unduly burdened by this withholding system.

Other taxes, especially those collected in toll booths on state highways, are considerably less private aircraft in 1991. According to the IRS, only $53,000 in luxury tax revenues were collected that year because so few planes were sold. This turned out to be less than the unemployment benefits paid to workers who lost jobs in that industry. This is the reason Congress quickly repealed the luxury tax on small aircraft.

Two Principles of Taxation

Taxes in the United States are based on two principles that have evolved over the years. These principles are the benefit principle and the ability-to-pay principle.

efficient. The state invests millions of dollars in heavily reinforced booths that span the highway. The cost to commuters, besides the toll, is the wear and tear on their automobiles. After giving a few quarters and dimes to the attendant, drivers take off again to repeat the process a few miles down the road.

Efficiency also means that the tax should raise enough revenue to be worthwhile. If it does not, or if it harms the economy in other ways, the tax has little value. One example is the luxury tax on small

Benefit Principle

Many taxes are based on the benefit principle of taxation: Those who benefit from government goods and services should pay in proportion to the amount of benefits they receive.

Think about the taxes you pay for gasoline. Because the gas tax is built into the price of gasoline at the pump, people who drive more than others pay more gas taxes—and therefore pay for

Principles of Taxation

Ability Pay Principle
Ability-tO-Pay The veterinarian (left) and the firefighters (right) both have to pay taxes. According to the ability-to-pay principle, how is the amount each person has to pay determined?


more of the upkeep of our nation's highways. Taxes on truck tires operate on the same principle. Because heavy vehicles like trucks are likely to put the most wear and tear on roads, the tire tax is another way to tie the cost of repair and upkeep to the user.

The benefit principle has two limitations. The first is that many government services provide the greatest benefit to those who can least afford to pay for them. People who receive welfare payments or live in subsidized housing, for example, usually have the lowest incomes. Even if they could pay something, they would not be able to pay in proportion to the benefits they receive.

The second limitation is that the benefits often are hard to measure. Are people who pay for gas the only ones who benefit from the roads built with gas taxes? What about property owners whose property increases in value because of the improved access? What about hotel and restaurant owners who profit from tourists arriving by car or bus? These people may buy very little gasoline, but they still benefit from the facilities that the gas tax helps provide.

Ability-to-Pay Principle

The second principle is the ability-to-pay principle of taxation—the belief that people should be taxed according to their ability to pay, regardless of the benefits they receive. An example is the individual income tax, which requires individuals with higher incomes to pay more than those with lower incomes.

The ability-to-pay principle is based on two factors. First, it recognizes that societies cannot always measure the benefits derived from government spending. Second, it assumes that people with higher incomes suffer less discomfort paying taxes than people with lower incomes.



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