THE DESIGN OF THE TAX SYSTEM y Two objectives of policymakers in designing a tax system: o Efficiency o Equity How Federal

Tax System evolved? o Raise Tax Revenue o Be Fair o Influence Behavior: Excise tax on spirits VOLUNTARY COMPLIANCE: THE INTERNAL REVENUE SERVICE(IRS) o A system of cpmliance that relies on individual citizens to report their income freely and voluntarily, calculater their tax liability correctly, and file a tax return on time o Voluntary: the income tax system:  Means that you can minimize your taxes by taking advantage of various deductions and tax credits.  Means that you must tell the IRS what your tax liability is file a tax return  Does not mean that the tax laws don t apply to you THE COST OF TAXES TO TAXPAYERS: o the tax payment itself o Deadweight Losses (DWLs) of a tax  Because taxes distort incentives = DWLs  The reduction of taxpayer s economic well-being by the amount of revenue raised by the government. o Administrative Burdens  Complying w/ tax laws creates DWLs  Taxpayers lose additional time & money documenting, computing, and avoiding taxes over and above the actual taxes they pay  It is part of the inefficiency it creates o The Average Tax Rate = total taxes paid divided by total income o The Marginal Tax Rate = the extra taxes paid on an additional dollar of income o Lump-sum tax = is the same amount for every person regardless of earnings or any actions that the person might take.  Considered efficient taxes because they do not influence a person s decision on how much to work TAXES AND EQUITY o BENEFITS PRINCIPLE:  The idea that people should pay taxes based on the benefits they receive from government services y A Gasoline Tax: Tax revenues from a gasoline tax are used to finance our highway system y People who drive the most also pay the most toward maintaining roads

According to this principle, it is fair for people to pay taxes based on benefits they receive from the government. o ABILITY-TO-PAY PRINCIPLE:  The idea that taxes should be levied on a person according to how well that person can shoulder the burden  It leads to two corollary notions of equity  According to this principle, it is fair for people to pay taxes on their capability to handle the financial burden.  VERTICAL EQUITY: y The idea that taxpayers w/ a greater ability to pay taxes should pay larger amounts (e.g. people w/ higher incomes should pay more than people w/ lower incomes) Alternative Tax Systems (w/in Vertical Equity) y Regressive Tax: tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers y Progressive Tax: a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers y Proportional Tax: a tax for which high-income taxpayers and lowincome taxpayers pay the same fraction of income  HORIZONTAL EQUITY: the idea that taxpayers w/ similar abilities to pay taxes should pay the same amounts (e.g. two families w/ the same # of dependents & the same income living in different parts of the country should pay the same federal taxes. y Marriage Tax: when a couple gets married they stop paying taxes as individuals and start paying taxes as a family; if each has a similar income, their total tax liability INcreases Regressive Tax vs. Progressive Tax? o Regressive tax: tariff and excise tax o Progressive taxes: federal income tax The FAIR TAX: o Eliminate the federal income tax & replace w/ a National Sales Tax o Abolish the Internal Revenue Service o The National Sales Tax rate initially would be 23%, w/ adjustments made to the rate in subsequent years. o Progressive tax to make it fair for low-income Americans  U.S. lawful HHs would receive a monthly rebate, Family Consumption Allowance (FCA), based on family size (regardless of income) at poverty level C, according to the poverty guidelines published by the U.S. Department of Health & Human Services.  Collect only on new purchases ( used purchases tax-free)  Business Purchases tax exempted 

Pros: 1. Easier to understand than the current convoluted income tax systems: the rich spend $ trying to find loopholes to avoid taxes 2. Transparency in government easy to see that everyone pays the same rate on purchases 3. No tax on Income = encourage venture K to invest in an entrepreneurs to help fuel the American Dream jobs could be created w/ this new influx of capital 4. Increased Productivity: current progressive income tax decreases the incentive to work harder & be productive as you move up the ladder higher. 5. Increase the tax base: drug dealers, illegal immigrants pay tax. o Cons: 1. Jobs in the IRS would be lost and tax accountants need to be retrained 2. High sales tax to stay revenue neutral: To bring the same government revenue as the current system. i. The large Sales tax would discourage people from buying things 3. Create as underground economy of people trying to evade taxes i. Intermediate goods (a part of production) would not be taxed. ii. Firms try to claim something as an intermediate good when really it is the o y y FEDERAL TAX BRACKETS: the rate you pay on the "last $" you earn; o Average TAX RATES Real interest rate (r) = Nominal Interest Rate (i) Inflation Rate o Interest rate corrected for the effects on inflation: the difference between i on a loan and the inflation rate o Annual percentage rises in a lender s purchasing power from making a loan Example:  Buy a CD: Deposit $1000 at %10: receives $1100 y Zero inflation CD: $10 buy 110 CD s 10% rise in purchasing power y 6% Inflation CD: $10.60 Buy 104 CD s 4% rise in purchasing power y 10% Inflation CD: $11 Buy 100 CD s No change in purchasing power Nominal interest rate (i) = Inflation Rate + Real Interest Rate o The interest as usually reported w/out a correction for the effects of inflation o Annual percent rises in a lender s dollars from making a loan Inflation rate: measures the percent change in P level from one period to the next o (Price Index in year 2 Price Index in year 1)/Price Index in year 1 Reduced interest due to tax After-tax Nominal Interest Rate After-tax Real Interest Rate Tax exemptions: spouse, dependents Deductions: apply only to specific expenses; e.g. mortgage interest o

y y y y y y

THE LAFFER CURVE: TAX REVENUE & TAX RATE

Total Tax Revenue = Tax Base x Tax Rate

THE FEDERAL BUDGET y Gov t Budget: AUTOMATIC STABILIZERS over business cycle o BUDGET SURPLUS: Tax Rev > Spending o BUDGET DEFICIT: Tax Rev < Spending Gov t SPENDING = G + Transfer Payments + interests on debt NET TAXES (T) = TAX REV -Transfer Payments - interests on debt 4 MAIN SOURCES OF TAX REVENUES o PERSONAL (INDIVIDUAL) INCOME TAXES: Paid by individuals on their income  The marginal tax rate  Higher-income families pay a larger % of their income in taxes o SOCIAL SECURITY INSURANCE (PAYROLL) TAXES: the Federal Insurance Contribution Act (FICA) tax (AKA U.S. payroll (or employment) tax)  Established in 1935 to provide payment to retired workers  Began as pay-as-you-go system  Tax on the wages, paid by both workers and employers to finance: y The Social Security program (AKA the federal Old-age, Survivors, & Disability Insurance (OASDI) program, earmarked y Medicare o CORPORATE INCOME TAXES: paid by companies on their profit  Double Taxation: a situation in which two or more taxes must be paid for the same asset or financial transaction. y Dividend o EXCISE TAXES: specific goods; gasoline, cigarettes, alcoholic beverages 3 CATEGORIES OF EXPENDITURES: o TRANSFER PAYMENTS: payments that are not made in exchange for a currently produced good or service  E.g. Social Security benefit to a person who is elderly; an unemployment insurance benefit to a recently laid off worker o PURCHASES OF GOODS AND SERVICES  By local, state, and federal governments  It includes salaries of government employees, expenditures on public works, etc. o DEBT INTEREST

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POVERTY AND INCOME INEQUALITY

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Poverty: the bottom part of income distribution, below same basic Poverty line: developed by Mollie Orchansky, The social Security administration in 1964 o Typical Household: 30% of household income spent on food o The Department of Agriculture: list of basic nutritional plan for families of different sizes and consumption o Adjust over time for inflation

INEQUALITY: benefits are not distributed equally among society s members; the entire range of income distribution, top to bottom. y Criticism: o About 12% of income spent of food o Not adjusted for society become richer (real gains) only for inflation o Diversity, poor in rural or in city, high (NY,CA) vs. low cost state (WV,MS) o Cash line only; o Ignore In-kind Benefits: not monetary form but form of goods and services: food stamp and Medicaid assistance o Omitted from measures of inequality and poverty, biasing them upward Why? Wages paid Is inequality bad? o The Life Cycle: the regular pattern of income variation over one s life  Young: Poor vs. Middle age: Richer o How much Economic Mobility is there?  People move among income classes  The temporarily poor and the persistently poor y Borrow and save to offset life-cycle income changes y A better measure of inequality in living standards: not on current income, but on Permanent Income (a person s normal income)  Due to a choice Poor families more likely to experience: o Homelessness, drug dependence, health problems, teen pregnancy, illiteracy, unemployment Most people believe government should provide a safety net. Three Macroeconomic Goals 1. Economic Growth 2. Stable Prices 3. Full Employment y y y Economic Stimulus Act 2008 The American Recovery and Reinvestment Act of 2009 Community Reinvestment Act (CRA): origin in 1977

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POLICIES TO REDUCE POVERTY 1. Set prices: cheap food, affordable housing 2. Minimum-Wage Laws: laws that force a set level at which wages cannot fall below a. Causes unemployment 3. Direct subsidy on income Subsidize Businesses: tax credits y EARNED INCOME TAX CREDIT (EITC OR EIC): a refundable tax credit offset the burden of U.S. payroll taxes o Negative Income Tax, Welfare o In-Kind Transfers: food stamps, Medicaid y Government programs that supplement the incomes of the needy o Temporary Assistance for Needy Families (TANF) o Supplemental Security Income (SSI) WHAT IS MONETARY POLICY? y Proper Monetary policies: if An Inflationary gap? If A Recessionary gap? o Inflationary gap: Amount by which Real GDP exceed potential GDP  Proper Monetary Policy: tighter monetary policy y Decreases monetary base decrease money supply y Increases federal funds rate  Contractionary Fiscal Policy y Decrease in Government Spending or/and an Increase in Taxes y AD decreases y The multiplied effect shifts AD0 to AD1 o Recessionary Gap: Amount by which potential GDP exceeds Real GDP  Proper Monetary Policy: buy bonds from the public to increase money supply; looser monetary policy. y Increase Federal Funds Rate increase money supply y Decrease Federal Funds Rate  Expansionary Fiscal Policy The Fed s Target Federal Funds Rate: the short-term interest rate that banks charge one another for loans; the interest rate at which banks make overnight loans to one another. o Direct control of Monetary Base (aka. High Powered Money, outside money)  Highly liquid money that consists of coins, paper money, and commercial banks reserves with the central bank.  M1 & M2: commonly used measures of money stock y M1 Demand deposits, travelers checks, other checkable deposits, currency y M2 Savings deposits, small time deposits, money market mutual funds, a few minor categories + M1 o Indirect control of Money supply

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 Money Supply: the quantity of money available in the economy LOOSER MONETARY POLICY o Increases monetary base increases money supply reduces federal funds rate TIGHTER MONETARY POLICY o Decreases monetary base Decreases money supply increases federal funds rate

WHAT IS FISCAL POLICY? y y Fiscal Policy: the setting of the level of government expenditure and taxation by government policymakers; use of the federal budget. EXPANSIONARY FISCAL POLICY o An increase in Government spending and/or decrease in taxes o Aggregate Dement Increases CONTRACTIONARY FISCAL POLICY o A decrease in government spending and/or increase in taxes o Aggregate Demand decreases Discretionary Fiscal Policy o A fiscal action that is initiated by an act of congress o The government is taking actions to change spending or taxes  Tax cuts passed by congress in 2001  If time correctly and of the correct magnitude, the policy can be used to push the economy to potential GDP

POLICY LIMITATIONS: y Recognition Lag: it takes time to realize when an economic change is occurring (hard to predictmust collect and analyze data), making it hard for economists to influence the outcome with fiscal policy before the changes have already taken hold. Law-Making Lag: It takes time to settle on decisions and pass policies into law, further delaying the implementation. Impact Lag: the time it takes for the policy to affect the overall economy. A key part of the impact lag is the multiplier. An initial change in government spending, taxes, the money supply, interest rates must work through the economy, triggering changes in production and income, which induces changes in consumption, which causes more changes in production and income, which induces further changes in consumption. Activist view of policy: Laissez-faire view of policy- leave economy free of intervention and policy changes. = in summary In practice, discretionary fiscal policy is hampered by 3 time lags: y Recognition Lag The time it takes to figure out that fiscal policy actions are needed.

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Law- Making Lag- The amount of time it takes Congress to pass the laws needed to change taxes or spending. Impact Lag- The time it takes from passing a tax or spending change to implementing the new arrangements and feeling their effects on real GDP

AS, AD AND THE BUSINESS CYCLE y y y y y y y y Recession: a period of declining real incomes and rising unemployment. Depression: a severe recession. Model of Aggregate Demand and Aggregate Supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend. Aggregate Demand (AD): a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level. Aggregate Supply (AS): a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. Natural rate of output: the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate. Stagflation: a period of falling output and rising prices. BUSINESS CYCLE: o AD Fluctuations (p.333)  From changes in consumption  From changes in investment  Changes in government purchases  Changes in net exports o AS Fluctuations  Changes in labor  Changes in capital  Changes in natural resources  Changes in technological knowledge o Recession: Declining real incomes and rising unemployment o Expansion: increase in the money supply o Peak: highest point of production/highest point of inflationary gap between two troughs of real GDP o Trough: lowest point of production/ lowest point of recessionary gap between two peaks of real GDP o Stagflation: a period of falling output and rising prices. o Full employment eqm:  Natural rate of unemployment;  potential GDP achieved  GDP=Output o Above full employment, inflation gap o Below full employment, recessionary gap

THE BENEFITS OF RECESSIONS

 
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May increase efficiency by driving the least efficient firms out of business and by forcing surviving firms to trim waste and manage their resources better. May lead to decrease in inflation Leads to a decrease in the demand for imports, which improves a nation s balance of payments.

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Short Run AS and Long Run AS Curve (p.336): o Price level and real GDP are a vertical curve in long run o Price level and real GDP are a upward sloping curve in short-run Long Run Phillips Curve and Short-Run Philips Curve: Unemployment rate and Inflation o P.386-400 Okun s Law o The relationship between changes in real GDP and corresponding changes in unemployment o For every percentage point the real GDP grows faster than the normal rate of increase in potential output, the unemployment rate decreases by if a percentage point Effects of fiscal policy and Monetary policy to alleviate business cycle

GREAT DEPRESSION (1929-1930S): WHAT CAUSED THE GREAT DEPRESSION? y Possible Reasons: 1. Decrease in the MS 2. Decrease in Consumption 3. Decrease in investment 4. Unexpected deflation 5. Increase in tariff

Prior to Great Depression y Classical Economics o Laissez-faire: Free markets, Balanced Budget o Natural market forces:  Flexible: Prices, Wages, interest Rates  No Need for Government intervention o The Study of how the economy operates at full employment. Say s Law: The doctrine that states that supply creates its own demand o If GDP is $9 trillion, then production is $9 t and generates $9 t income o Create $9 trillion demand for current goods and services o No Excess demand nor Excess supply for total goods and services Auction prices: Price s that adjust on a nearly daily basis, fresh fish, fruit, vegetables, other food products

Custom prices: Prices that adjust slowly, industrial commodities e.g. steel rods or machine tools wage-long term contract, union workers, university professor, government workers, high school teachers, minimum wage workers o Sticky Prices & Sticky Wages  Buyer and seller agree on a price for a fixed period: the seller changes price infrequently  Prices adjust slowly and not quickly enough to avoid shortages and surpluses Keynesian theory and policy o Analyzes on the idea that DEMAND DETERMINED OUTPUT in the SR, not the P, Increase AD o Short-Run in Macroeconomics: The study of how the economy operates away from full employment; Prices do not fully adjust to changes in demand o Sticky Prices and Sticky Wages o Analyzes on the idea that DEMAND DETERMINED OUTPUT in the SR, not the price  Increase Aggregate Demand the Golden Age: 1960s: demand-management policy o 1960 s demand-management policy o Increase or decreases Aggregate Demand Kennedy Tax Cut o Lowered marginal rates from 91% to70% at the top and from 20% to 14% at the bottom o Rates in between were cut by about 30% o Discussed in 1961; Proposed in 1962 Results o Had little effect on the economy until 1965- 1967 o Long-term effect on economic growth was significant

PRO AND CONS OF BUDGET DEFICIT CONS: 1. Decrease in National saving, Crowding out of Investment 2. Slowing down LR growth 3. Burden to future generation PROS: 1. AS AUTOMATIC STABILIZERS: y Stimulate AD (recessions) & Dampen AD (expansions) y Gov t Spending & taxes that automatically increase and decrease along w/ the business cycle y Government spending and taxes that automatically increase and decrease along with the business cycle

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During the expansion: Employment Increases o Tax Revenue increases, unemployment insurance payments decrease During recession: Employment Decreases o Tax Revenue: Decreases, Unemployment insurance payments increase The Federal Budget deficit is counter cyclical o Induced Tax: Taxes that vary with real GDP; e.g. Federal income tax, Progressive income tax o Needs- Tested Spending : Government expenditure on programs that pay benefits to people and businesses depending on their economic status; e.g. Unemployment insurance, Welfare payments

2. TAX SMOOTHING y Alternative a sharp tax hike to finance war 3. FINANCING WAR: y Automatic Stabilizers: changes in fiscal policy that stimulate Aggregate demand in a recession without explicit action by policy makers Smooth out fluctuations o Welfare and transfer programs y Recession: more people apply for welfare assistance and unemployment benefits: Increase income increase Consumption Stimulate AD o Consumption smoothing y People drawing on savings during an economic downturn y Credit cards can help consumption smoothing o Progressive Federal income tax OPEN ECONOMY MACROECONOMICS: TRADE y Closed vs. Open Economy o Closed No Exports & Imports Net Exports = 0 o Balance of Trade: the value of a nation s exports minus the value of its imports; also called the trade balance. Trade Surplus: an excess of exports over imports; net exports are positive; a country sells more goods and services abroad than it buys. Trade Deficit: an excess of imports over exports; net exports are negative; sells fewer goods/services abroad than it buys. Balanced Trade: exports equal imports; net exports = 0 o Net capital Outflow: the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

Inflow: the purchase of domestic assets by foreigners the purchase of foreign assets by domestic assets what happen to domestic Investment (I)? y Trade surplus exports > imports Net Exports > 0 Income > Domestic spending Saving > Investing sending more saving abroad Net Capital Outflow > 0 Foreign investment > Domestic y Trade Deficit exports < imports Net Exports < 0 Income < Domestic Spending Savings < Investment Financing domestic investment by selling assets abroad Net capital outflow < 0 Foreign Investment < Domestic Investment o Brain Drain: the emigration of many of the most highly educated workers to rich countries, where these workers can enjoy a higher standard of living. o Offshoring: relocation of a business or an element of the business process (i.e. the production process) almost always because of a lower cost of operations in another country. o Outsourcing: contracting a third-party (labor, research & development, etc.) mainly to reduce costs. (other reasons include: improve quality, knowledge (i.e. research and development), operational expertise, access to talent, reduce time to market, tax benefit (i.e. lower corporate tax in other country), etc.) o Rent seeking: occurs when an individual, organization or firm seeks to earn income by capturing economic rent through manipulation or exploitation of the economic or political environment, rather than by earning profits through economic transactions and the production of added wealth; Rent seeking generally implies the extraction of uncompensated value from others without making any contribution to productivity, such as by gaining control of land and other pre-existing natural resources, or by imposing burdensome regulations or other government decisions that may affect consumers or businesses. o Quota: a limit on the quantity of a good produced abroad that can be sold domestically; a type of protectionist trade restriction that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time. Quotas, like other trade restrictions, are used to benefit the producers of a good in a domestic economy at the expense of all consumers of the good in that economy. o Tariff: a tax on imported goods. o Subsidy: tax credits (reduces tax) Nominal Exchange Rates: rate at which a person can trade the currency of one country for the currency of another country; e.g. you go to a bank and see a posted exchange of 80 yen per dollar. o Nominal exchange rate (per dollar) = amount of foreign currency o Amount of U.S. currency $ o You would flip the equation if it was expressed as dollars ($) per foreign currency. o Appreciation (strengthens): the dollar buys more foreign currency.

o Depreciation (weakens): dollar buys less foreign currency Real Exchange Rates: expressed as units of foreign item per unit of the domestic item o Real exchange rate = (nominal exchange rate(e) x price index for a U.S. basket(P)) Price index for a foreign basket(P*) o Appreciation(rise): U.S. goods become more expensive relative to foreign goods; discourages consumers both at home and abroad from buying U.S. goods and encourages consumers to buy goods from other countries U.S. exports fall U.S. imports rise U.S. net exports fall o Depreciation (fall): U.S. goods become cheaper relative to foreign goods; encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries U.S. exports rise U.S. imports fall raises U.S. net exports Why is International Trade Restricted? Arguments for Protectionism o Dumping: exporting a product to another country at a price which is either below the price it charges in its home market or is below its costs of production; governments take action against dumping in order to defend their domestic industries. o Infant industry argument: an economic rationale for protectionism. The core of the argument is that emerging industries often do not have the economies of scale that their older competitors from other countries may have, and thus need to be protected until they can attain similar economies of scale (tariff barriers to restrict imports are often used). Worldwide movement toward free trade over the post-WWII era o Economic Integration: trade unification between different states by the partial or full abolishing of customs tariffs on trade taking place within the borders of each state. This is meant in turn to lead to lower prices for distributors and consumers (as no customs duties are paid within the integrated area) and the goal is to increase trade. o Multilateral vs. bilateral trade agreement Multilateral: negotiations between General Agreement on Tariffs and Trade. Bilateral: a trade agreement between any two countries, usually in order to reduce tariffs and quotas on items traded between themselves. The Sources of CA: The Hecksher-Ohlin Theorem o "A capital-abundant country will export the capital-intensive good, while the laborabundant country will export the labor-intensive good." Law of one price: Purchasing Power Parity theory: a theory of exchange rates whereby a unit of any given currency should be able to the same quantity of goods in all countries. o The Impact of the opening of trade Purchasing power of the dollar is the same at home and abroad The real exchange rate at home and abroad cannot change. o Arbitrage: the process of taking advantage of price differences for the same item in different markets. o Limitation of Purchasing Power Parity

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Many goods are not easily traded between markets; arbitrage is too limited in some cases to eliminate difference in prices, especially when the price difference is minimal (e.g. a haircut in Paris vs. New York) Even tradable goods are not always perfect substitutes when they are produced in different countries; e.g. some consumers prefer German cars, and others prefer American cars. Due to these limitations, real exchange rates fluctuate over time. Even though there are fluctuations in real exchange rates, the theory provides reason to believe that changes in the real exchange rate are most often small or temporary. Large and persistent movements in nominal exchange rates typically reflect changes in price levels at home & abroad.