Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Customizable

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All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

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Chapter 15: Taxes - Efficiency and Fairness

Figure 15.1: Here is the Pentagon building in Washington D.C. Think about how taxes affect the United States Department of Defense.​ [1]
"Taxes are what we pay for a civilized society."
       -Oliver Wendell Holmes Jr., U.S. Supreme Court Justice [1]
“The art of taxation consists in so plucking the goose as to achieve a maximum of feathers with the minimum of hissing.”
         Jean-Baptiste Clobert, Louis XIV’s finance minister [2]

Challenge: The Tax Cut and Jobs Act in 2017 significantly changed tax law in the U.S.  As a student intern to your newly-elected representative to Congress, you have been asked to brief her on the impact the new law will have on her constituents.  She understands that many people may pay less in taxes.  But she wants to know what they may have to give up.  

15.1 Objectives

After reading this chapter and completing the questions and exercises, you will be able to:

  • Understand the general nature of the most common federal, state, and local tax systems.
  • Discuss the effects of taxes on economic efficiency in labor and goods markets.
  • Discuss the tradeoffs different taxes present in terms of efficiency and equity.
  • Explain the income redistribution impact of taxation.

Adam Smith, in his famous An Inquiry into the Nature and Causes of the Wealth of Nations, offered three economic reasons for a government to exist and, by extension, collect taxes to fund its existence. These reasons are to defend a nation from invasions from other nations, to protect the individuals within a nation by creating and enforcing appropriate laws, and to fund public projects that would not be supported by private individuals but are beneficial to the nation as a whole. Taxes, however, are not all equal. Taxes take away benefits from some people and government expenditure provides benefits to other people. At times, the process appears unfair. At other times, the process may appear to unduly interfere with economic activity. Both issues of fairness and interference (or what we will call efficiency) play critical roles in understanding and comparing different types of taxes.

15.2 Why Are Taxes Mandatory?

Figure 15.2: Adam Smith, Wealth of Nations 1. "The first duty of the sovereign, that of protecting the society from the violence and invasion of other independent societies, can be performed only by means of a military force."2. "The second duty of the sovereign, that of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice, requires two very different degrees of expense in the different periods of society. " 3." The third and last duty of the sovereign or commonwealth, is that of erecting and maintaining those public institutions and those public works, which though they may be in the highest degree advantageous to a great society, are, however, of such a nature, that the profit could never repay the expense to any individual, or small number of individuals; and which it, therefore, cannot be expected that any individual, or small number of individuals, should erect or maintain."





(Wealth of Nations Book 5, Chapter 1, sections 1-3). [2]

Few people really enjoy paying taxes. However, many of the things that taxes pay for would not be funded by private individuals. Some of the things that taxes fund do not appear to be important to all taxpayers all of the time. For example, some people may object to the purchase of a new aircraft carrier. But few would doubt the importance of having a military. People who are healthy may object to government expenditure on health care. But later in life, the same people may rely on Medicare or Medicaid. People who are done with college may object to spending on education. But they may have benefited from Pell grants or government-backed student loans when they were younger. A significant portion of our taxes goes to pay for goods and services for which you and I would not voluntarily pay, yet they are goods and services that we consume. It makes sense to produce those goods. Remember the benefits and costs of public goods? We are better off if those goods are produced. But we will not voluntarily contribute to their production. Thus, if we want public goods, we have to come up with a means of paying for their production.

Another significant portion of our taxes goes to redistribute income from the young to the old, the working to the retired and disabled, and the upper end of the income distribution to the lower end. If we are young, working, or on the upper end of the income distribution, we may not like having our after-tax incomes lowered so that others’ after-tax incomes are increased.

Question 15.01

Adam Smith opposed government taxation and spending.

A

True

B

False

15.3 Government Spending

In Chapter 13: The Economic Role of Government, we explored the economic role of governments. While it is relatively easy to understand why we may want governments at all levels to provide some goods and services, it is far too often forgotten that someone must pay for those services. After all, those government goods and services do require resources to produce them. (Another way to look at it is that when taxes are reduced, we may give up more and better roads, more efficient national defense, better schools, or improved environmental conditions.)

Figure 15.3 provides a summary of federal spending in the U.S. for 2018. A major portion of the federal budget provides income or services to individuals. To provide a comparison, Figure 15.4 shows the distribution of spending at all levels of government for 2016 for four selected countries. Note that different countries make different choices about how to allocate their federal budgets. For example, the United States spends a bigger portion of all of its governments' budgets on health and education than the other countries. South Africa spends a bigger portion of its budget on general public services than the other countries, and Germany spends a bigger part of its budget on wealth transfers than the other countries. These differences represent different values within the different countries.

ECN15_fig15.3_updated.jpg
Figure 15.3: U.S. Federal Expenditures, Percent of Total (2018).
ECN15_figure15.4_updated.jpg
Figure 15.4: Federal, State, and Local Expenditures by Country (2016).

ECN15_table15.5_updated.jpg
Figure 15.5: State and Local Government Expenditures (Percent of Total 2017).

In the U.S., state and local governments allocate much of their budgets to providing public goods. A breakdown of state and local spending (sum of U.S. tax authorities for 2017) is shown in Figure 15.5. In the U.S., state and local governments spend almost two-thirds of what the federal government spends, but those expenditures are much more focused on production of goods and services. Education, public safety (police, corrections, and fire departments), highways, and hospitals are a large portion of that spending.

While state and local spending is typically evenly split, state and local governments emphasize different activities. For example, almost all of elementary and secondary education spending is by local governments, while almost all higher education spending is state-level spending.

Question 15.02

Compare the four countries represented in Figure 15.4. Which of the four countries allocated the largest percentage of its budget toward health and education expenditures?

A

El Salvador

B

Germany

C

South Africa

D

United States of America


Question 15.03

Compare the four countries represented in Figure 15.4. Which of the four countries allocated the largest percentage of its budget to general public services?

A

El Salvador

B

Germany

C

South Africa

D

United States of America


Question 15.04

In Figure 15.5, of the items listed below, on average the single largest expenditure item for state and local governments across the U.S. is _________.

A

Public safety

B

Education

C

Public welfare

D

Highways

15.4 Government Revenues

A comparison of the sources of federal revenues for a selection of four economies is shown in Figure 15.6.​

ECN15_figure15.6_updated.jpg
Figure 15.6: Comparison of Sources of Federal Government Revenue (2016).

Taxes on income, profits, and capital gains dominate revenue in the United States. Other governments rely more heavily on taxes on goods and services.

ECN15_fig15.7_updated.jpg
Figure 15.7: U.S. State and Local Tax Revenues, Percent of Total (2018).

Figure 15.7 presents a summary of state and local government revenues within the U.S. These revenues are dominated by sales taxes, property taxes, and income taxes, with sales tax revenues being the largest portion. Sales taxes are taxes on most consumer purchases. Local revenues are dominated by property taxes. Property taxes are taxes on land and houses; in some areas, cars, boats, and business equipment are included.

Federal grants provide an additional (about 20 percent) source of revenues for state and local governments in the U.S.

Question 15.05

According to Figure 15.7, the largest single source of state and local government tax revenue in the U.S. is _______.

A

The sales tax

B

The property tax

C

The individual income tax

D

The corporate income tax


Question 15.06

According to Figure 15.6, the largest single source of federal government tax revenue in the U.S. is _____________.

A

Taxes on income, profits, and capital gains

B

Taxes on goods and services

C

Taxes on property

D

Taxes on international trade


Question 15.07

Compare the four countries represented in Figure 15.6. Which of the four countries received the largest percentage of its tax revenue from taxes on goods and services (sales taxes)?

A

El Salvador

B

Germany

C

South Africa

D

United States of America


Question 15.08

Compare the four countries represented in Figure 15.6. Which of the four countries receives the largest percentage of its tax revenue from taxes on income, corporate profits, and capital gains?

A

El Salvador

B

Germany

C

South Africa

D

United States of America

15.5 Types of Taxes

One problem governments face is that they must determine how to collect taxes. Theoretically, a government could determine its desired budget, divide by the population, and send the same bill to each inhabitant. This is called a lump-sum tax. Many people would find this approach grossly unfair. Those citizens without jobs, including children and retired individuals, might not be able to afford the tax. At the same time, very wealthy individuals might find the amount trivial. Therefore, most governments choose to tax different types of economic transactions. These transactions, whether they are in the market for goods and services or in labor markets, reveal something about different individuals’ abilities to pay taxes.

Ultimately, all taxes are paid by people. For example, a tax on corporate profits will be paid by some combination of the owners of the business, the workers and suppliers of the business, and the consumers of the products of the business. It is not always clear who will bear the burden of a tax (called tax incidence) when the tax is first imposed. But we can start by thinking of taxes as being levied on a form of income. Types of income are listed in Figure 15.8. Figure 15.9 provides a summary of the relative proportions each form of income makes up in the U.S.

Figure 15.8: Types of Income.

Because most taxes fall on transactions, we can consider different taxes as taxes on either income (from the seller’s perspective) or expenditure (from the buyer’s perspective). It is useful to start by describing the types of taxes that fall on different types of income.

ECN15_fig15.9_updated.jpg
Figure 15.9: Sources of income, percent of total personal income (2018).

15.5.1 Wages, Salaries, and Benefits

Personal income taxes (along with Social Security and Medicaid taxes) dominate federal tax collection. They are collected in the labor market at the point where employers pay employees. For most workers, the taxes are automatically withheld. One of the first (and often somewhat painful) lessons a young worker learns upon receiving his or her initial paycheck is the difference between a before-tax wage and an after-tax wage. In the United States, the tax rate that individuals pay on wages and salaries depends on their total income from all sources. More will be said on this subject below.

While wages and salaries are taxed, many people also receive non-monetary benefits from their employer, particularly if they work full-time. These benefits might include health insurance, discounts on the products the firm produces, discounted meals, or subsidized education. Many of these benefits are not taxed (unless the value of the benefits exceeds a threshold). This difference in tax treatment encourages employers to offer more generous benefits instead of wages.

15.5.2 Proprietor’s Income

The owners of small businesses work for themselves. They do not receive a paycheck, per se. Instead, their income is derived from the profits they make from their own businesses. The U.S. tax code treats this like a salary. After the owner of the business subtracts the cost of running the business, what is left is income. Just like wages and salaries, the tax rate charged depends on the business owner’s total income, including the profits from the business.

15.5.3 Interest and Dividends

When corporations need money to get started or to expand, they can borrow money (by selling bonds) or sell shares of stock. When they pay interest on the loans, the lender receives the interest as income. When a corporation is profitable, it may pay some of those profits in the form of dividends to the people who own the shares of stock. In the U.S. federal tax code, corporate profits are taxed before they get distributed as income. As a consequence, when individuals receive dividends as part of their income, it is taxed at a lower rate than wage or salary income.

15.5.4 Rental Income

Some people rent property (apartments, equipment, or other capital) to others. This rent is also considered a form of income and is taxed as salaries or wages would be, with the exception that the owner of the property is permitted to deduct depreciation in value over time.

15.5.5 Other 

Finally, there are other forms of income that are too numerous to list. But they include disparate sources such as returns from mineral extraction to gambling income to revenue from patents. All of these are considered sources of income and are treated as such.

15.5.6 Units of Account

Taxes can be collected at different points in the economy. Each individual could be responsible for his or her tax returns. Or, we could aggregate at the household level. This simplifies the number of tax returns but introduces complications when it comes to defining what a household is. We could levy taxes at the point of sale of all goods and services. This makes businesses responsible for paying taxes. Most countries use a mix of household taxes and business taxes to raise revenue.

15.5.7 Households

When it comes to gathering taxes, the primary unit of account is the household. The personal income tax is a tax on a family’s income earned from all sources – wages, interest income, dividends, profits from small businesses, rents received, and any other sources. Table 15.1 provides an example of how income taxes are calculated on different levels of income for a single individual. Most states have also adopted income taxes as a means of generating revenues. However, state income taxes are typically much smaller than federal income taxes.

The federal government (and most state governments) defines what income is taxed by taking total income and subtracting exemptions and deductions. Exemptions are amounts that are subtracted from total income based on the number of individuals in a household. For example, in 2017, federal taxpayers may deduct $4,050 for each family member. That means that for a family of three, the first $12,150 of income would be exempt from taxation.

ECN15_table15.1_updated.jpg
Table 15.1: Federal Income Tax Rate Schedule (2018).

Deductions can also be subtracted and are based on interest paid on a home mortgage, charitable contributions, state income taxes paid, and a variety of items the tax law exempts from taxation. Because keeping track of all expenses that can be deducted can be difficult, the Internal Revenue Service (IRS) allows tax filers to take a standard deduction instead. For example, in 2018, the standard deduction for a single individual was $12,000.

In the U.S., marginal tax rates increase as income increases. The marginal tax rate is the tax paid on the next dollar a taxpayer makes. Table 15.1 shows the tax rate for ranges of incomes. The total tax owed is the sum of the taxes for the amount of money a person makes in each range. These ranges are often referred to as “tax brackets.” A person’s average tax rate is the total amount of taxes owed divided by the total income the person makes.

Graphing Question 15.01

Graphing Question 15.02

15.5.8 Households and Businesses:

15.5.8.1 Social Security and Medicare Taxes

ECN15_table15.2_updated.jpg
Table 15.2: Social Security and Medicare Taxes in 2018.

In the U.S., Social Security taxes and Medicaid taxes are called payroll taxes. They differ from income taxes because, by law, employers and employees each pay half of the tax. People who own their own businesses pay both halves of the taxes. Social Security taxes differ for another reason as well. As Table 15.2 describes, Social Security taxes apply only to an individual’s income up to $128,400 a year. Any additional income is not taxed for the purposes of Social Security. While Social Security taxes are smaller percentages than the federal income tax, for many individuals this tax is the largest federal tax paid. Social security taxes are based on a percent of income up to specified levels. So, an individual earning less than $128,400 will pay 7.65% of his or her income in social security and Medicare tax. In addition, the employer is required to pay 7.65%.

15.5.9 Business Taxes:

15.5.9.1 Sales Taxes

A sales tax is used by most states as an important source of revenues – the most important in most states. The tax is a percentage of the amount spent on most goods and some services. As an example, if the sales tax were 6 percent, $6 would be added to a purchase of $100. For a seller, a sales tax is much like an income tax because the seller’s income is derived from the taxed transaction.

15.5.9.2 Value-Added Taxes 

A value-added tax is like a sales tax, but it occurs at each stage of production. When a producer sells an intermediate product to another producer, that transaction is taxed. For example, if Pirelli sells some of their tires to Fiat, there is a tax on the transaction equal to a percent of the value Pirelli added to the materials it purchased to make tires. By the time the final product makes it to a consumer, it has been taxed as if there was a sales tax on the final product. The difference is that the consumer does not see the tax directly. The impact of the tax is hidden in the final price.

15.5.9.3 Tariffs

Tariffs are like sales taxes for imported or exported goods. For most economies, tariffs are a very small part of government revenue.

15.5.9.4 Corporate Profits (or Income) Taxes

There are also taxes on corporate profits. The top Federal corporate marginal tax rate is 35%. However, because a corporation is not a person in anything but a legal sense, the corporate profit tax must be paid by someone. As mentioned above, three general groups of people are impacted by the tax. Owners (the people who would receive dividends, for example) will get less, so they pay part of the tax. The tax may reduce the amount the firm produces, so suppliers of inputs will sell less to the firm – and they pay part of the tax. Finally, the tax may impact the price of the product, so consumers of the product may pay some of the tax.

15.5.9.5 Other Taxes

Common excise taxes are those placed on airline tickets, gasoline, alcohol, cigarettes, and telephone services. These are taxes on specific goods either as a dedicated source of funds for particular spending items (such as gasoline taxes funding road construction) or in order to discourage particular behavior (such as cigarette taxes to deter smoking).

15.5.10 Non-Transactional Taxes

15.5.10.1 Property taxes

Property tax is one tax that is not on a transaction. Property taxes are used by local governments as a primary source of income. Property taxes can be charged on automobiles, boats, and equipment, but the most common form is on real estate. For example, a property tax equal to 1 percent would tax a family $1,000 each year if their home were valued at $100,000. A property tax is often thought of as a tax on accumulated wealth rather than a tax on income.

15.5.10.2 Other Taxes

Inheritance (or estate) taxes reduce the amount of wealth the deceased can pass along to other people. It is often meant as a counterweight to the accumulation of vast wealth. And as a final example, some nations use pollution taxes such as carbon taxes as significant sources of revenue (see Chapter 13: The Economic Role of Government for a review of how such taxes can be used to address problems such as pollution).

Economists often debate which approach to taxation is best. To get a better feel for the advantages and disadvantages of each, we have to learn how to model and compare taxes.

Question 15.09

According to Figures 15.8 and 15.9, what is the largest source of personal income for residents of the U.S.?

A

Corporate profits

B

Rent

C

Wages and salaries

D

Proprietor’s income


Question 15.10

In 2018, a person in the U.S. who earns $25,000 pays a marginal tax rate of ______________% into the Social Security Program, while a person who earns $135,000 pays a marginal tax rate of ______________% into the Social Security Program.

A

6.2, 6.2

B

0, 6.2

C

6.2, 0

D

0, 0


Question 15.11

Sales taxes are which of the following?

A

An important source of revenue for state and local governments but not very important for the federal government in the U.S.

B

An important source of revenue for the federal government but not very important for state and local governments in the U.S.

C

An important source of revenue for the federal government and state and local governments in the U.S.

D

Not very important for the federal government nor state and local governments in the U.S.


Question 15.12

In the U.S. in 2017, an individual who earns $225,000 a year (after standard deductions and exemptions) faces a marginal tax rate of ______________.

A

10%

B

15%

C

25%

D

33%


Question 15.13

In the U.S. in 2017, an individual who earns $225,000 a year (after standard deductions and exemptions) faces an average tax rate of ______________.

A

15%

B

33%

C

26%

D

10%

# Change 2017 to 2018. The correct answer should be 35%. [need to update explanation]

15.6 Modeling Taxes

Although there are many types of taxes, modeling the impact of a tax is not too difficult once you understand how the tax impacts the relationship between buyer and seller. There are two basic taxes presented here. The simplest tax to consider is an excise tax. An excise tax has the same dollar value per unit no matter how many units of the good or service exchange hands and no matter what the market price of the good or service is. For example, Maine levies a $2.00 tax on every package of cigarettes sold within its borders. The other type of tax is a sales tax (or ad valorem tax). It increases the price of a good or service by a percentage. For example, Georgia imposes a sales tax of 7% on most goods sold within its borders. This means that the more expensive a good is, the higher the dollar value of the tax. Figure 15.11 demonstrates how to model an excise tax that is equal to $4 per unit.

Figure 15.11: Excise Tax​


Table 15.3: Excise Tax​

The excise tax represents a cost that comes between the buyer and the seller. For every unit of the good or service that changes hands, a fixed amount must be sent to the government. In this case, the difference is $4.00. This is seen as the vertical distance at each quantity between the supply curve and the supply + tax curve.

Use Figure 15.11 and Table 15.3 to answer the following two questions.

Question 15.14

The market equilibrium quantity without the $4 excise tax is ______________ units. The market equilibrium quantity with the $4 excise tax is ______________ units. The change in equilibrium quantity due to the $4 excise tax is ______________ units.

A

60, 50, -10

B

70, 50, -20

C

60, 40, -20

D

50, 70, 20


Question 15.15

The equilibrium price consumers pay for the product without the $4 excise tax is ______________. The equilibrium price consumers pay with the $4 excise tax is ______________. The change in equilibrium price due to the $4 excise tax is ______________.

A

$12, $16, $4

B

$10, $14, $4

C

$12, $14, $2

D

$14, $12, -$2

Graphing Question 15.03

To model a sales tax, we modify the approach slightly. Instead of shifting the supply curve, we change the slope. For every quantity, we multiply the corresponding price by (1+t) where t represents the percentage tax rate. Figure 15.12 demonstrates how to model a sales tax where the tax rate (t) is equal to 40%).

Figure 15.12: Sales Tax


Table 15.4: Sales Tax

Use Figure 15.12 and Table 15.4 to answer the following two questions.

Question 15.16

The market equilibrium quantity without the 40% sales tax is ______________ units. The market equilibrium quantity with the 40% sales tax is ______________ units. The change in equilibrium quantity due to the 40% sales tax is ______________ units.

A

60, 50, -10

B

70, 50, -20

C

60, 40, -20

D

50, 70, 20


Question 15.17

The equilibrium price consumers pay for the product without the 40% sales tax is ______________. The equilibrium price consumers pay with the 40% excise tax is ______________. The change in equilibrium price due to the 40% sales tax is ______________.

A

$12, $16, $4

B

$10, $14, $4

C

$12, $14, $2

D

$14, $12, -$2

Graphing Question 15.04

By choosing the appropriate tax rates, a sales tax can give the same after-tax results as an excise tax. Because the excise tax is easier to model, we will proceed using the excise tax.

15.7 Comparing Taxes

Taxes are most often evaluated based on how they affect two different aspects of markets: efficiency and fairness. Analyses of the effect on efficiency use concepts we have explored in earlier chapters, so we will start with an examination of the efficiency aspects of taxation. The analyses of effects on equity (or fairness) will require some new concepts, so we will examine equity issues second. One of the results of the analysis is that we will often notice tradeoffs between efficiency concerns and equity concerns.

Question 15.18

Two facets of taxes that economists often use to compare taxes are _________.

A

Efficiency and revenue generation

B

Efficiency and fairness

C

Fairness and trade impact

D

Revenue generation and trade impact

15.8 The Effects of Taxes on Efficiency

In chapter 6, Behind Demand, we discussed the concept of consumer surplus. The idea was to approximate the net benefits consumers gain from purchasing a good or service. That is the difference between the price they have to pay for a good and the price that they would be willing to pay.

Question 15.19

What happens to the total amount of consumer surplus in a market if the cost of production rises? The total amount of consumer surplus:

A

increases

B

decreases

C

does not change

D

one cannot tell

This is only part of the story.  Now, we will expand the concept to producers.  With an upward sloping supply, there is a producer surplus that is parallel to the concept of a consumer surplus.  A producer surplus exists in a market as the difference between the price producers receive and the price they require to be willing to produce that amount of the good.   It can be represented by the area below the market price and above the market supply curve.

For example in Figure 15.13, what would happen if producers were producing 10 units of output? The producer would only have to have a price of $6 to be willing to produce 10 units, yet it would be willing to do so if the price if the price were $9. That difference is the producer surplus.

Figure 15.13: ​Producer Surplus.

Total producer surplus, in this case, would equal the area of the triangle below $9 and above the supply curve:  ($9 - $2) (20) (.5) = $70.

Question 15.20

What happens to the total amount of producer surplus in a market if the demand for the product increases? The total amount of producer surplus:

A

increases

B

decreases

C

does not change

D

one cannot tell

15.8.1 The Effects of Taxes on Consumer and Producer Surpluses

A tax on a good or service will increase the market price and reduce the quantity produced in markets with normal supply and demand conditions.  The increase in the price (including the tax) paid by consumers will mean that some of the consumer surplus received by consumers will go to government in the form of revenues.  There is a loss to consumers, but that loss is a gain to government. 

Figure 15.14: Equilibrium Impact of Tax​


Figure 15.15: Equilibrium Impact of Tax​

If the decision to tax is a rational one, consumers lose benefits from the market, but they and others gain the benefits of the government activity that is financed by the tax. But another part of the consumer surplus will simply be lost with no compensating gains. This loss is known as a deadweight loss. Deadweight loss is a measure of inefficiency created by a tax. It is the difference between what consumers would have been willing to pay for the good or service and the price they have to pay. That difference is lost due to the reduction in production of the good or service. It is equal to the loss in consumer and producer surpluses. If the tax is placed on a perfectly competitive market with a perfectly elastic market supply, there is no further loss.  However, if the market supply is an upward sloping market supply, the outcome is different. 

Figure 15.16: Tax Revenue and Deadweight Loss​


A tax reduces the amount produced as thus eliminates the production that would have been done and would have generated income to the producers above and beyond the level that they would have required to be willing to produce the good.  That is lost and does not show up as a gain anywhere.

The tax reduces the amount received on goods produced by the producer, but that loss is income to the government doing the taxing. 

The producer and consumer surpluses add to a total surplus gained from the production of the good.  However, the reduction in those surpluses due to the reduction in production is not gained by anyone.  This is the total deadweight loss. 

Question 15.21

Compare the effects of a given tax on goods with elastic demands and inelastic demands in terms of amount of revenues raised from the taxes. With an elastic demand, ______ revenue will be raised than with an inelastic demand.

A

more

B

less

C

the same

D

one cannot tell

Question 15.22

With an elastic demand, there will be a ____________ in allocative efficiency then there will be with an inelastic demand.

A

greater increase

B

smaller increase

C

greater decrease

D

smaller decrease

E

the effects will be the same in both cases


Question 15.23

Question 15.23

What will happen to prices and quantities if a tax is placed on a good with an elastic demand? An inelastic demand?

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Question 15.24

Question 15.24

What will happen to prices and quantities if a tax is placed on a good with an elastic supply? An inelastic supply?

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Graphing Question 15.05

Figures 15.17 through 15.20 show examples with relatively inelastic and relatively elastic demand (Figure 15.18 with a relatively elastic demand) and then with relatively inelastic and relatively elastic supply.

Figure 15.17: Inelastic Demand​


Figure 15.18: Elastic Demand​


Figure 15.19: Inelastic Supply​


Figure 15.20: Elastic Supply

Taxes on goods and services with elastic demand or elastic supply will result in larger deadweight losses than taxes of the same amount on goods and services with inelastic demand or inelastic supply. Therefore, they introduce a greater level of allocative inefficiency than taxes on goods with inelastic supply or demand. Another way to think of this comparison is that taxes on goods or services with elastic supply or demand have a higher opportunity cost for each dollar of tax revenue raised. If an elected official is concerned about the allocative efficiency of taxes, she might want to focus on goods and services that have relatively inelastic supply and demand. Whether such taxes are equitable, however, may be a different story.

In addition to considering the impact on equilibrium output of a tax, it is worth thinking about how much tax revenue a tax might generate. There are two things to consider: the size of the market to begin with and the elasticity of supply and demand in the market. First, if a market is small, there is limited opportunity to raise tax revenue. Second, if the supply and demand in a market are elastic, it will be difficult to raise revenue due to suppliers and demanders taking their resources to other markets. This is why one measure of the impact of a tax on a market is to divide the deadweight loss of a tax by the amount of tax revenue the tax would generate.

Graphing Question 15.06

Graphing Question 15.07

Graphing Question 15.08

Graphing Question 15.09

15.8.2 The Efficiency Effects of an Income Tax

Consider a debate between two individuals about income taxes. One argues that we should reduce income taxes, and as a result, we will have an increase in employment. The other argues that income taxes do not have much of a negative effect on employment, so reducing them will not have much of a positive effect on employment. The two graphs below show two different potential representations of a market for labor.

Question 15.25

Question 15.25

Refer to Graphs A and B below. Which individual is right about efficiency? What role does the elasticity of supply of labor play?




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15.8.3 A Focus on Marginal Rates

When considering the effects of a change in income tax on individual decisions, it is appropriate to consider the marginal rate as opposed to the average tax rate. Suppose a married couple with a child was considering whether both should work or the man should stay at home while the woman works. The decision will be partially based on how much the man could earn if he went to work. If he does go to work, the income gained will be the salary, minus the additional costs for transportation, childcare, and the additional taxes owed. The additional taxes owed are not calculated by multiplying the average tax rate the couple pays times the additional income, but by multiplying the marginal rate times the additional income. This can lead to interesting outcomes. One example is that in the United States, an individual with a very low level of income may qualify for a negative tax rate on additional income. You may wonder what led to this policy. Economists discovered that the labor supply of people at the lowest end of the income spectrum tends to be more elastic than people with higher levels of income. Small increases in after-tax income (as would occur with a negative income tax) would encourage these individuals to devote more of their time to the labor market. Once people become attached to the labor market, their elasticity of supply tends to fall. So, as their income rises, the negative tax is phased out. This is how the Earned Income Tax Credit (EITC) in the U.S. tax code works.

Question 15.26

As the elasticity of demand increases, all other things being equal, the impact of a tax on equilibrium quantity does which of the following?

A

Gets larger

B

Gets smaller

C

Is unchanged

D

Is the same as the change in price


Question 15.27

Economists have estimated the elasticity of demand for the following (fairly) common goods:

If the same excise tax were imposed on the sale of each item, which market would experience the largest deadweight loss?

question description
A

Coffee

B

Fresh tomatoes

C

Oysters

D

Toothpicks


Question 15.28

Economists have estimated the elasticity of demand for the following (fairly) common goods:

If the same excise tax were imposed on the sale of each item, which market would experience the smallest deadweight loss?

question description
A

Coffee

B

Fresh tomatoes

C

Oysters

D

Toothpicks

15.9 The Effects of Taxes on Equity

Here, we begin a consideration of fairness. Equity concerns deal with an assessment of the fairness of an allocation of resources among people. Stating what is fair is not easy, and economists are not particularly good at it. Philosophers may be better. But we can introduce some concepts that may aid in our comparison of the fairness of different taxes. In this way, we can have a common vocabulary when we make judgements about how fair different taxes are. All taxes redistribute resources – but not all taxes redistribute resources in the same way. Following are some of the different ways we can analyze fairness issues.

People should be able to anticipate the taxes they will owe if they undertake certain activities. That is to say, taxes should not be random or surprising. Horizontal equity considers how individuals who are in the same economic position (such as same income or same access to resources) are treated by the tax code. One would expect that individuals in similar economic positions should be treated the same when it comes to taxes. A person who discovers she is paying more in taxes than a coworker with the same income might feel as though she has been treated unfairly. However, sometimes differences in how individuals obtain their income may lead to different economic treatment. For example, one individual may receive all of her income in the form of wages. A second individual may receive his income in the form of returns on investments. Although their incomes may be the same, if the tax code treats those forms of income differently, the two individuals might not be taxed the same. This result would not be horizontally equitable.

Vertical equity considers how individuals in different economic situations are treated by the tax code. There are three different ways a tax could treat people with different levels of income (or different levels of economic well-being): The tax code could treat individuals proportionately, progressively, or regressively.

Figure 15.21: Progressive Tax​
Figure 15.22: Regressive Tax​
Figure 15.23: Proportional Tax

A proportional tax is one that takes the same percentage of all incomes. A progressive tax is one that takes a larger percentage of income as income increases. Most income taxes are progressive. Certainly, the U.S. federal income tax is. Figure 15.21 shows that the percentage one pays in taxes increases as income increases.

A tax is regressive if it the amount of the tax is a smaller percentage of income as income increases. It will appear on the surface that a proportional tax is the fairest of the three if every dollar every person earns is taxed at the same rate. However, if an additional dollar means more to a person with low income than a person with high income, a progressive tax would distribute the tax burden based on its impact on taxpayers rather than taxing every dollar equally and ignoring the value of each dollar to its earner. But where does that leave a regressive tax? We return to the labor market for an example. At very high incomes, labor supply can change dramatically – it can start to bend back on itself as people obtain enough income to enjoy more leisure activities. This takes them away from the labor market. As a result, small changes in marginal tax rates might prevent some people from dropping out of the labor market.

A flat tax is a form of a proportional tax. A true flat tax is a tax that sets the marginal tax rate at a constant level for all levels of income. If the marginal rate is the same on every dollar earned, the average rate would also be the same on every dollar earned. However, most flat tax proposals exempt some initial income from taxation to ensure that individuals with low income are overly affected by the tax. As a result, the proposals are not truly proportional. Because of the initial exemptions, the average tax rate rises as income rises, even though marginal rates remain the same on every dollar of income affected by the tax. Therefore, the flat taxes that have been proposed in the U.S. are, in fact, progressive taxes.

The interesting case of Social Security:

The Social Security Act was signed into law by President Roosevelt on August 14, 1935.  A part of the act was a provision for a social insurance program designed to pay retirement benefits for workers aged 65 and older. That program is now what we primarily think of as Social Security. Although the program is designed to pay retirees after they have contributed to the program through the Social Security Trust Fund, it has operated as a “pay-as-you-go” program since the first payments were made in 1937. This means that concurrent contributions were used to fund benefits. Therefore, the program transfers benefits from workers to retirees (although retirees must have contributed to the trust fund to qualify for benefits). This makes it the largest transfer program in the U.S. tax code.
One of the strategies proponents used to pass the law in 1935 was to split the tax between employers and employees. So, while employees pay 6.2% of their income into the trust fund, employers match that and pay 6.2% on the wages they pay (self-employed workers pay both halves of the tax). This is why the Social Security tax is often referred to as a “payroll tax.” This even split of the tax seems fair on the surface. But both sides of the tax create a wedge between the amount of money workers take home and the amount of money the employer must pay for the workers’ labor. The end result is that the tax is really a 12.4% tax on labor.
Finally, the tax that funds the trust fund is considered to be one of the few regressive taxes in the U.S. In 2017, an employee pays 6.2% of his or her income up to $127,200 but nothing on any additional income. Therefore, as income rises past this threshold, the average tax rate falls.
But with all of its blemishes, the idea of the government sponsoring a retirement program for workers is extremely popular. It provides a safety net for people who are retired or may not be able to work for other reasons. (Social Security Administration, "Historical Background and Development of Social Security")

As introduced above, the U.S. income tax is primarily a progressive tax. Marginal and average tax rates rise with income. In contrast, the Social Security tax is regressive. It taxes income up to $127,200 (in 2017) at a 6.2% rate (matched by employers), but income above that threshold is not taxed at all.

Another consideration is whether a tax simply focuses on a person’s income or whether it also considers other sources of well-being. For example, consider a person who has two job offers. The first one offers a salary of $100,000 per year but no additional benefits. The second job offers a salary of $75,000 a year but also offers health insurance, a company gym, and a company car that in total are worth $25,000 a year. If the tax code only taxes income, the second job might be preferable because the benefits would not be taxed. The person who accepts the second job would likely be better off economically than if she had taken the first job. A tax code that focuses on income is said to consider ability to pay.

In contrast to the ability-to-pay principle is the idea that those people who benefit from government spending should be the people who pay for the spending. This principle is known as the benefit principle. For example, if a state builds a new road and establishes toll booths to charge the people who drive on the road, it would be clear that the people who use the new road are the people who are helping fund the road. For some types of government spending, the ability to pay makes sense. For example, a government program that provides food for poor schoolchildren could not be funded by the children who receive the food. By its nature, a program that provides food for children from families without access to resources redistributes from the wealthy to the poor. For other programs, the benefits received approach makes sense. For example, a government program that provides funding for airports could be paid for by those who take advantage of air travel (and shipping). Not all comparisons, however, are as clear. Spending on public school certainly helps students, but it also helps the community that has more intelligent citizens.

Another consideration worth noting is whether you are discussing the fairness of outcomes or the fairness of opportunities. Two people with the same talents and the same opportunities might make different choices that lead them to different levels of income. Reasonable people may disagree as to whether or not that is fair. Similarly, some people may not have the same opportunities as other people and, as a result, earn different levels of income. This, also, may be considered unfair.

Finally, we might consider who benefits from a particular government action that is supported by a particular tax. Consider a tax on gasoline that goes to pay for highway maintenance. At first glance, the problem seems straightforward. The people who drive buy the gasoline that is taxed. Therefore, the people who benefit from good roads are the same people who pay the tax. But consider a twist to the debate: What happens if we discover that wealthy people tend to buy fuel-efficient vehicles (or even electric vehicles) while poor people cannot afford these vehicles so they must purchase more gasoline per mile traveled? If this is the case, then people with lower income would pay more (per mile traveled) to maintain the roads. Although we might agree that the fair thing to do is have people who drive pay for roads, the gasoline tax might be regressive if there is a systematic difference between the types of cars people drive based on income.

Because there is much debate about what is and is not fair under different circumstances, economists often prefer to take a positive approach to analyzing the impact of a tax. We describe what is likely to happen to the market equilibrium quantity and price as a result of a tax. Then we attempt to describe who is likely to bear the burden of the tax. If we accurately describe these potential outcomes, then policymakers will be better able to describe to their constituents what the opportunity costs of any particular tax proposal are.

Question 15.29

In which of the following situations would the idea of vertical equity be violated?

A

Calvin earns $20,000 per year and pays $2,000 in taxes. Martin earns $200,000 a year and pays $20,000 in taxes.

B

Martha earns $50,000 a year and receives work benefits equal to $25,000 a year. She pays $22,500 in taxes. Earl earns $25,000 in wages and receives benefits worth $20,000 a year. He pays $13,500 in taxes.

C

Ali earns $7,000 in wages and $1,000 in benefits per month. He pays $1,750 in taxes each month. Sasha earns $5,000 in wages and $3,000 in benefits per month. She pays $1,250 each month in taxes.

D

Marcus earns $50,000 in income and $20,000 worth of benefits each year. He pays $15,000 in taxes each year. Claudia earns $60,000 running her own business. She receives no additional non-monetary benefits. She pays $18,000 in taxes each year.


Question 15.30

A criticism of the current Social Security program (in the U.S.) that focuses on its equity implications is that it is which of the following?

A

Is funded by a regressive tax

B

Is funded by a progressive tax

C

Distorts individual savings behavior

D

Distorts individual consumption behavior


Question 15.31

Which of the following taxes is regressive?

A

A tax of 25% on the first $100,000 of income and of 20% on any additional income

B

A tax of 15% on capital gains and interest income

C

A tax of 50% on inheritance income

D

A tax of 20% on the first $100,000 of income and 30% on any additional income


Question 15.32

Which of the following taxes is proportional?

A

An equal sales tax on all items except groceries

B

An equal sales tax on all purchases and contributions to savings accounts

C

An equal tax on all wages

D

An equal tax on all inheritances


Question 15.33

Flat tax proposals generally fail to be truly proportional because which of the following is true?

A

The marginal rate increases as people earn more income even though the average rate stays the same

B

They offer exemptions or deductions which create increasing average tax rates

C

The marginal rate decreases as people earn more income even though the average rate stays the same

D

They offer loopholes that create decreasing average tax rates


Question 15.34

Which of the following taxes is progressive?

A

A 15% value-added tax on all stages of production

B

A tax of 20% on the first $100,000 of income and 30% on any additional income

C

A tax of 30% on the first $100,000 of income and 20% on any additional income

D

A tax of 25% on all forms of consumption


Question 15.35

Which of the following would increase the efficiency loss of a progressive income tax?

A

Labor supply gets more elastic as income rises

B

Labor supply gets less elastic as income rises

C

Higher income workers get more services from the government

D

Lower-income workers get more services from the government

15.10 Problems – Applications of Efficiency versus Fairness

If we are going to compare different taxes, we need to consider both efficiency and fairness. Following are some common tax problems that highlight the difficulty that policymakers face.

Suppose that a governor proposes an increased sales tax on food in an attempt to balance the state budget in weak economic times. He argues that the tax will raise significant revenue and not have to be very large. The demand and supply of food is relatively inelastic, and everyone buys food. First, consider the effects of a sales tax on food on the economic efficiency. Use a basic supply and demand model for food. Second, consider the fairness of the tax. It will be useful to consider how much of their budget different people allocate to food.

Figure 15.24: Market for Food​

From the graph, you can demonstrate that a tax imposed on a market where supply and demand are inelastic will have little impact on the efficiency of the market. The quantity in the market will change little. Resources that were allocated to food production will still be allocated to food production.

Although wealthy people buy more food than poor people, as people become wealthier, the proportion of their income devoted to food falls. While at the margin the tax impacts all food purchased the same, on average it will be a higher proportion of a poor person’s income than a wealthy person’s income.

Evaluate a sales tax on luxury yachts.

In 1990, the U.S. government imposed a 10% tax on boats that sold for a price above $100,000. On the one hand, only wealthy people are in the market for yachts that sell for more than $100,000. On the other hand, the demand for yachts is very elastic (but the supply is not – the skills required to make yachts are fairly specific). Analyze the efficiency and fairness aspect of the tax.

The tax on luxury yachts will decrease equilibrium quantity substantially (in fact, some retailers reported that soon after the tax was imposed, sales fell as much as 70%, which would imply a price elasticity of demand of at least |-7|iii). This leads to a great deal of reallocation of resources away from boat-making and into other activities.

Fairness: Here is where economic analysis of a tax is really important: Although the tax was intended to be a tax paid by wealthy individuals, the people who had to bear the burden were the makers of yachts. As wealthy people stopped buying yachts (and used their money on other items), makers of yachts had to lay off workers. The tax was eventually repealed, mainly because of its impact on workers.

Question 15.36

Question 15.36

Is an income tax like the U.S. income tax system proportional, regressive, or progressive? Why?

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Question 15.37

Question 15.37

Is the social security tax system proportional, regressive, or progressive for individuals earning between $10,000 and $60,000? For people earning between $100,000 and $200,000? Why?

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Question 15.38

Question 15.38

Are local and state sales taxes proportional, regressive, or progressive? Why?

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Question 15.39

Question 15.39

Are property taxes proportional, regressive, or progressive? Why?

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Question 15.40

Question 15.40

If the government uses a lottery to raise money to pay for education, would you describe the funding of education as proportional, regressive, or progressive? Explain why.

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15.11 Example − A Look at the 2017 Tax Cut and Jobs Act

​The passage of Public Law no. 115-97, known as the Tax Cut and Jobs Act (TCJA), in 2017 is the first major rewrite of US tax law since the Tax Reform Act of 1986.  The TCJA demonstrates many of the tradeoffs politicians face when they devise tax policy.  In this section, we highlight some of these tradeoffs.  To fully analyze the impact of the new tax law will require time as the economy adjusts to the many changes in the law.  Some people will see their tax bills fall.  Some people will see a decrease in the level of government spending on goods and services.  While it is too early to fully appreciate all the impacts of the new law, some changes can be described up front.  

​15.1.1 Major Changes 

The new legislation changed many aspects of tax law.  Here, we highlight three major changes to tax law.  For individual taxpayers, it decreases the marginal rates most people face.  Then it increases the standard deduction while decreasing allowable itemized deductions and personal exemptions.  Finally, it reduces the tax rate most corporations face. 

​Decrease in marginal tax rates 

The following tables compare the 2017 tax brackets to the 2018 tax brackets after the passage of the new tax law.

Table 15.5: Tax Table Comparison for Individual Tax Payers​


Table 15.6: Tax Table Comparison for Married Couples Filing Jointly​

​The number of tax brackets remains the same with the new tax law.  The impact of the TCJA is to decrease in marginal rates for many.  Individuals in the lowest tax bracket will not see a decrease in their marginal tax rate, and those individuals who earned $157,500 to $191,650 and $200,001 to $416,700 will see their marginal rate increase.   Similarly, most married couples filing jointly will see their tax rates fall or stay the same.   The one exception is for those joint filers who earned incomes in between $400,000 and $416,700.  On average, it is estimated that the changes will increase after-tax income by 2.2%.

Increase in standard deduction but decrease in allowable deductions and the personal exemption

Prior to the passage of the TCJA, taxpayers deduct a personal exemption worth $4,050 per member of a household before calculating taxable income.  The personal exemption is eliminated in the new tax law.  Taxpayers could also deduct certain expenses from their income.  These expenses may represent the cost of earning income such as dues to a union or uniforms required for work, or they might represent taxes already paid to other entities such as property taxes or state income taxes.  Over time, the list of expenditures that are deductible has expanded.  For example, people could  deduct medical expenses, education expenses, and  losses due to theft, fire, or other catastrophes to name a few.  Another deductible expense is the interest on a home mortgage.  It is argued that this makes homeownership more affordable.  The new tax law reduces the amount of mortgage interest that can be deducted.    If a taxpayer chooses to calculate all the expenses that are deductible, that taxpayer is said to “itemize” her deductions.  But, in order to ensure that the tax law remains progressive even for those who do not have many deductions,[JS1]  the tax code allows taxpayers to take a standard deduction.  In 2017, the standard deduction for an individual was $6,350.  The new tax law increased the standard deduction to $12,000 but also reduced what people can deduct if they itemize.  For those who do not choose to itemize, the increase in the standard deduction may significantly reduce their average tax rate and perhaps place them in a lower tax bracket.   But, for some people who itemize, the reductions in what a person can deduct by itemizing may put them in higher tax brackets.  This is most likely to impact people who live in areas with higher than average state income, sales, or property taxes.   It may also adversely impact people who have large medical expenses or face catastrophic property losses.  Furthermore, because income tax in the U.S. is primarily focused on the family as the unit of account, the elimination of the personal exemptions may increase taxable income for larger families. 

The impact of the change in tax law is difficult to generalize.  It depends on that individual’s circumstances and choices about itemizing.  But most people choose not to itemize (according to the IRS, 30.1% of taxpayers itemized in 2013), and   most people will face a lower marginal tax rate and pay less in federal income taxes. 

One way to compare the impact of the change in the tax code is to compare how different families might fare under the changes.  The table below compares four families of four members each.  To keep the comparison as simple as possible, each family is assumed to take the standard deduction rather than itemize, and each family gets four personal exemptions in 2017 but no such exemptions in 2018. 

Table 15.7: Comparison of Tax Bills 2017 to 2018​

​Family 1 has an income at about the rate of poverty in 2017.  Family 2 has an income at about the median income for a family of four.  Family 3 has an income at just over twice the median income for a family of four.  Finally, family 4 has an income that would put them in the top five percent of incomes in the U.S.  It is clear from table 15.6 that the first two families will pay more in taxes while the second two receive reductions in their tax burden. 

Decrease in Corporate (or Capital) Tax Rates

Another dramatic change in the new tax law is a reduction in the tax rates corporations face.  Corporate income or profit taxes can be thought of as taxes on investment in capital.  In 2017, there were eight tax brackets for corporate profits. And a casual glance will show that the rates do not follow a logical pattern.  They are not consistently progressive, regressive, or proportional.  The new tax law creates one corporate tax rate of 21%.  With the exception of corporations earning profits of less than $50,000 per year, this results in lower marginal tax rates for all corporations.  

​15.11.2 Overall Decrease in Tax Revenue

The impact of the new tax law will dramatically decrease overall tax revenue at the federal level.  The impact of the changes in the individual tax structure has wide ranges that depend largely on how fast the economy grows (if the economy grows quickly enough, and people have more income, they may pay more in taxes even if their marginal tax rates are lower).  But, when taken as a whole, tax revenue from households is likely to decrease by roughly $1.3 trillion over the first ten years of the law.  This represents a decrease of about 8.4 percent of tax revenue from personal income.  At the same time, tax revenue from corporations is likely to decrease by roughly $0.4 trillion over the same time period.  This represents about an 11.6 percent reduction in tax revenue from corporate profits.  Together, the reduction in revenue from both sources amounts to  a decrease in tax revenue over ten years of roughly $1.7 trillion.

If Congress were to try to balance the budget over the course of the first ten years that the tax law is to be in effect, it would have to cut annual spending by roughly 5% (ignoring current deficits—an actual balanced budget would require an additional 12% reduction in spending based on 2017 revenue and outlay numbers).[JS1]    This means that the nation as a whole will have to decide what the appropriate size of the federal government ought to be. 

15.11.3 Efficiency Implications of Tax Law Changes

The new tax law impacts economic efficiency in two broad ways.  First, because it decreases overall tax revenue, some deadweight loss associated with the taxation, in general, would be reduced.  How much it would be reduced is impossible to predict in advance because it would depend on each individual’s reaction to the change in taxes. 

The second impact comes from the relative change in the price of capital and labor in production.  The decrease in corporate taxes represents a larger percentage of the tax burden on corporations than the decrease in personal taxes does for households.  In addition, the reductions in household tax rates are scheduled to expire in 2028.  The corporate tax reductions are not.  Therefore, we might expect the after-tax cost of capital to fall relative to the cost of labor.  Recall from Chapter 8 that this change will encourage some producers to invest in more capital relative to labor.  But one other factor should be considered.  If the additional capital makes labor more productive, some producers will choose to invest in more workers as well.  Ultimately, relative effects of these two impacts will depend, again, on how individuals react to the changes brought on by the tax law changes.

15.11.3 Equity Implications of Tax Law Changes

There are multiple ways to look at the vast redistributions of income that occur due to the new legislation.  First, most U.S. citizens will pay less in taxes due to the changes.  But much of the savings will go to those who earn the most.  Given that the changes reduce marginal (and average) tax rates for most individuals and the fact that the tax code affected by the changes was largely progressive, it was inevitable that the bulk of the tax savings would go to the wealthiest taxpayers.  They shoulder most of the income tax burden to start with.  But, as is shown in  Table 15.7 below[JS2] , the effect of tax changes will reduce the progressivity of the tax code. 

Table 15.7: Average Impact of Tax Law Changes by Income Quintile​

​This observation highlights one of the tradeoffs inherent in devising tax law: often different goals conflict.  The efficiency gained by lowering taxes will be paid for with lower government revenue and fewer government services or an increase in government borrowing as well as an increase in the inequality of after-tax income.

15.11.4 Summary

Offering a definitive assessment of a new tax law can be difficult because, typically, many aspects of the law change at once.But this chapter has provided the tools to look at the TCJA with a critical eye.There are clear opportunity costs to lowering tax rates.It is up to citizens to determine if what they get is worth what they give up once they analyze the various aspects of the tax law. 

15.12 Summary

  • The primary purpose of taxes is to pay for the goods and services we have decided to produce through local, state, and federal governments.
  • Our primary federal taxes are based on income – personal income taxes and social security taxes.
  • Our primary state and local taxes are taxes based on consumption (sales taxes), property (primarily real estate), and income.
  • Taxes based on purchases and income reduce economic efficiency in markets for goods and services and in markets for labor.
  • The elasticities of demand and supply affect the extent of the reduction in efficiency due to changes in taxes.
  • Fairness of tax systems can be evaluated by using
    • Ability-to-pay principle
    • Benefits received
    • Horizontal equity concerns
    • Vertical equity concerns
  • Taxes can be proportional, progressive, or regressive. It is not always obvious which category a tax falls in.
  • There are often trade-offs between the effects of a tax on fairness of the income distribution and allocative efficiency.

15.12 Key Concepts

Ability-to-pay principle

Average tax rate

Benefit principle

Consumer surplus

Deadweight loss

Economic efficiency of various taxes

Elasticity and its effect on tax efficiency

Excise tax

Horizontal equity

Income tax

Marginal tax rate

Producer surplus

Progressive tax

Property tax

Proportional tax

Regressive tax

Sales tax

Social security tax (payroll tax)

Tax revenue

Trade-off between fairness and efficiency

Vertical equity

15.13 Glossary

Ability-to-pay principle: The principle based on the idea that one should pay for government services according to one's ability. We define that ability most often as the amount of income or amount of wealth.

Average tax rate: The total tax paid divided by the total amount of income.

Benefit principle: The principle that one should pay taxes according to the benefits received from government goods and services.

Capital gains taxes: A tax on the increase in the value of a financial or real asset. Stocks and bonds are good examples. If an asset is sold, the difference between the purchase price and the sale price is the capital gain and is taxed.

Consumer surplus: The difference between what consumers are willing and able to pay for a good and the amount they have to pay. It can be represented as the area under the market demand curve and above the market price.

Deadweight loss: A measure of the inefficiency created by a tax. It is the difference between what consumers would have been willing to pay for the good or service and the price they have to pay. That difference is lost due to the reduction in production of the good or service. It is equal to the loss in consumer and producer surpluses.

Excise tax: A tax on specific goods and services.

Flat tax: Marginal rates are the same at all levels of income. Often exemptions and standard deductions are proposed at low levels of income.

Horizontal equity: People who have equal incomes should pay the same taxes.

Marginal revenue product: The increase in revenue resulting from the hiring of one additional worker. Price of the product times the marginal product of labor equals the marginal revenue product.

Marginal tax rate: The change in tax paid divided by a change in income.

Payroll tax: Taxes calculated as a percent of an employee’s wage paid by the employer.

Personal income tax: A tax on income an individual or family receives.

Producer surplus: The difference between the price producers receive and the price they require to be willing to produce that amount of the good.It can be represented by the area below the market price and above the market supply curve.

Progressive tax: The amount of tax paid as a percentage of income increases as one's income increases.

Property tax: A tax on the value of property (usually real estate) owned by businesses and individuals.

Proportional tax: The amount of tax paid as a percentage of income stays the same as one's income increases.

Regressive tax: The amount of tax paid as a percentage of income decreases as one's income increases.

Sales tax: A tax on most goods and services purchased.

Tax revenue: The money raised by imposing a tax on a market.

Transfer payment: A payment or grant from a government to an individual.

Vertical equity: People who earn more should pay at least as much as those who earn less.

Wealth: The value of assets owned minus the liabilities owed.





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Footnotes

i McClelland, Robert and Shannon Mok (2012), A Review of Recent Research on Labor Supply Elasticities. Working Paper 2012-12, Congressional Budget Office, Washington, D.C.

ii Anderson, P.L., R. D. McLellan, J. P. Overton, and G. L. Wolfram (1997), Price Elasticity of Demand. Mackinac Center for Public Policy https://www.mackinac.org/1247.

iii Salpukas, Agis (1992), Falling Tax Would Lift all Yachts. New York Times February 7, 1992.

iv Anderson, et al. (1997)

Answer Keys

Answer to Question 15.23

If demand is relatively elastic, the rise in price due to the tax will be relatively small and the fall in output relatively large. Think of it as the price starting to increase to cover the new costs (of the tax), and as that happens, the quantity demanded falls quickly due to the elastic demand. If demand is inelastic, the rise in price due to the tax will be relatively large and the fall in quantity relatively small.

Click here to return to Question 15.23.











Answer to Question 15.24

If the supply is relatively inelastic, the fall in output will be small and the price increase will be large; if the supply is relatively elastic, the decrease in the quantity will be much larger and the movement in price will be smaller.

Click here to return to Question 15.24.














Answer to Question 15.25

Either could be right, depending upon the elasticity of the labor supply (with elasticity of demand the same). If workers are very sensitive to changes in wages, then there will be a significant reduction in employment as income taxes rise. Thus, reducing income taxes should expand employment. If workers are less sensitive to changes in wages, the effects on the labor market will be less, and the reduction in efficiency is smaller. Reducing income taxes will do little to expand employment. Economists place a lot of importance on understanding the impact of taxes on the labor market. Because there are many different labor markets (workers with specific skills or few skills, teenage workers or middle-age workers, male workers or female workers, to name a few), there are many estimates for both the elasticity of supply and the elasticity of demand for labor. But the majority of the estimates suggest that both labor supply and labor demand for most people under most circumstances is relatively inelastic. A recent survey conducted by the Congressional Budget Office (2012) found that on average, the elasticity of supply for labor is between 0 and 0.3. This would mean that Graph B is more likely to capture the impact of a tax on labor income than Graph A. 

Click here to return to Question 15.25.







Answer to Question 15.36

We have already pointed out that an income tax is likely to be fairly efficient, as labor supply is inelastic. We have also seen that as income rises, the marginal tax rates increase. If we ignore all other aspects about the U.S. income tax system (such as deductions and tax credits), the correct conclusion is that the U.S. income tax system is progressive. The tax takes a larger percentage of income from those with higher incomes. A full evaluation of all of the nuances in the U.S. tax system would require more advanced treatment. But most of the aspects of any tax system that deviate from a simple percent tax on income typically exist to either try to add more efficiency or more fairness to the tax code. 

Click here to return to Question 15.36.











Answer to Question 15.37

The Social Security system is proportional up to the maximum amount of income that is taxed ($127,200 in 2017). Beyond that amount, the Social Security part of the tax does not apply, and thus the tax becomes regressive. So for the U.S. population as a whole, the tax is regressive. For example, an individual who earns $118,500 pays 6.2 percent in social security tax. A person who earns twice that amount pays 6.2 percent on the first $127,200 and zero on the second. The second person pays an average of 3.1 percent of his or her income in social security tax.

Click here to return to Question 15.37.











Answer to Question 15.38

This question is a little tricky and is not quite the same as the question about a tax on food. It depends on how people spend their incomes. If individuals with higher incomes save more, then those individuals will be spending a smaller portion on goods and services that are subject to sales taxes. Thus, they will pay a smaller portion of their incomes in tax – the tax becomes regressive. That is why many states and localities will exempt necessities such as basic food items and rent from sales tax. The effect is to make the sales tax less regressive. But, if all savings eventually get spent on goods and services that are subject to the tax, then over time the tax looks more proportional. 

Click here to return to Question 15.38.












Answer to Question 15.39

Again, it depends on how people spend their incomes. A property tax can be regressive, proportional, or progressive depending upon whether or not individuals with larger incomes spend relatively more or less on housing. If those with higher incomes spend a larger portion of their incomes on housing, the tax is a progressive one. If they spend a smaller portion of their incomes on housing, the tax is a regressive one. Complications enter when you look at what people pay for when they buy a house. Housing prices include the benefits homeowners get from the neighborhood. Houses in better school districts or areas with lower crime rates may cost more than similar houses in worse school districts or areas with higher crime rates.

Click here to return to Question 15.39.











Answer to Question 15.40

The answer depends on who plays the lottery. If every person buys one lottery ticket, it becomes a regressive means of financing education. Low-income individuals would be spending a larger portion of their incomes on the tickets than higher income individuals. If poor people are more likely to buy lottery tickets, then the approach becomes even more regressive. 

Click here to return to Question 15.40.












Image Credits

[1] Image courtesy of DoD photo by Master Sgt. Ken Hammond, U.S. Air Force in the Public Domain.

[2] Image courtesy of Protonk in the Public Domain. 


The amount of tax paid on one more dollar of income.
The total tax paid divided by the amount of income.
A tax on most goods and services purchased.
A tax on the value added of intermediate inputs at each step of the production process.
A tax on specific goods and services.
A tax on the value of property (usually real estate) owned by businesses and individuals.
The difference between what consumers are willing and able to pay for a good and the amount they have to pay. It can be represented as the area under the market demand curve and above the market price.
A producer surplus exists in a market as the difference between the price producers receive and the price they require to be willing to produce that amount of the good. It can be represented by the area below the market price and above the market supply curve.
The loss in consumer and produce surplus less any tax revenue generated from a tax.
Elasticity of demand represents how much consumers change their purchasing behavior when prices change.
Elasticity of supply represents how much producers change their production behavior when prices change.
The key to the answer will depend on the elasticity of (labor) supply.
People who have equal incomes should pay the same taxes.
People who earn more should pay at least as much as those who earn less.
The amount of tax paid as a percentage of income stays the same as one's income increases.
The amount of tax paid as a percentage of income increases as one's income increases.
The amount of tax paid as a percentage of income decreases as one's income increases.
Marginal rates are the same at all levels of income. Often exemptions and standard deductions are proposed at low levels of income.
The principle based on the idea that one should pay for government services according to one's ability. We define that ability most often as the amount of income or amount of wealth
The principle that one should pay taxes according to the benefits received from government goods and services.
Disregard all but the different tax brackets to get the overall picture of the U.S. income tax.
What defines the marginal rates of the Social Security tax.
As income rises, what happens to the proportion of income saved?
How likely is it that people spend a constant proportion of their income on housing?
Who tends to buy lottery tickets, wealthy or poor individuals? What portion of the population is more likely to go to college, wealthy or poor?