Taxation

Objectives of This Lecture

Discuss the economics and nature of taxes.
An unbiased approach.
Assist students to see that:
Taxation is a complicated issue.
There is no such thing as a best tax.

Question: How do we pay for public goods?

Taxation: A Brief History

Matthew, the tax collector.
Tax farming.
Tax collectors = sinners.

The French:
An important cause of the French revolution.
Contributed to the downfall of Napoleon.

The English:
After the Glorious Revolution, Parliament stripped the King of the
right to tax.
The wig and powder tax.

The United States:

The Boston tea party make is a coffee drinking nation.
Our constitution specifically states who has the right to tax.
The Whiskey Rebellion.

Adam Smiths Maxims of

Taxation
Source: Smith, Adam, The Wealth of Nations, The Modern
Library, 2000, pp 888-890

Smiths Maxims of Taxation (No.1)

The subjects of every state ought to contribute
towards the support of the government, as nearly as
possible, in proportion to their respective abilities;
that is, in proportion to the revenue which they
respectively enjoy under the protection of the state.
The expense of government to the individuals of a
great nation, is like the expense of management to
the joint tenants of a great estate, who are all
obliged to contribute in proportion to their respective
interests in the estate.

Smiths Maxim of Taxation (No. 2)

The tax which each individual is bound to pay
ought to be certain, and not arbitrary. The time
of payment, the manner of payment, the quantity
to be paid, ought to be clear and plain to the
contributor, and to every other person.
Where it is otherwise, every person subject to the
tax is put more or less in the power of the taxgatherer, who can either aggravate the tax upon
any obnoxious contributor, or extort, by the terror
of such aggravation, some present or perquisitie
to himself.

Smiths Maxim of Taxation (No. 3)

Every tax ought to be levied at the time, or in the
manner, in which it is most likely to be convenient
for the contributor to pay it.
A tax upon the rent of land or of houses, payable at
the same term at which such rents are usually paid,
is levied at the time when it is most for the likely to
be convenient for the contributor to pay; or when he
is most likely to have the wherewithal to pay. Taxes
upon such consumable goods as are articles of
luxury, are all finally paid by the consumer, and
generally in a manner that is very convenient for
him.

Smith Maxims of Taxation ( No. 4)

Every tax ought to be so contrived as both
to take out and to keep out of the pockets
of the people as little as possible, over and
above what is brings into the public
treasury of the state.

Smiths Additional Comment

An injudicious tax offers a great temptation to
smuggling. But the penalties of smuggling must
rise in proportion to the temptation.
The law, contrary to all the principles of justice, first
creates the temptation, and then punishes those
who yield to it; and it commonly enhances the
punishment too in proportion to the very
circumstances which ought certainly to alleviate
it, the temptation to commit the crime.

Tax Features
Smiths Tax Philosophy:
Equality.
Certainty.
Convenience of
payment.
Economy of collection.

Modern Tax Philosophy:

Is distribution of the tax
burden fair?
Are taxes designed to
minimize frictions or
distortions?
Is the system
understandable to the
payers?
Is the tax system
operated at as low a
cost as possible?

What Do We Tax
Income.
Wages.
Interest and dividends.

Consumption.
Sales tax.
Excise tax.

Wealth.
Property (Personal and real).
Capital gains.
Inheritance.

What Do We Tax - Continued

Tax base: The measure of value on which a
tax is levied. (Page 377 in text.)
Examples:
All income after deductions above X amount.
Federal income tax.

The value of your home.

County real estate tax.

The value of your automobile.

Personal property tax.

Principles of Taxation

The goal of economic efficiency.

The benefits received principle.
The ability to pay principle.
The horizontal and vertical equity
principles.
The progressive and regressive tax
concepts.
The goal of attaining social objectives.

Taxes and Economic Efficiency

A tax is efficient if it imposes a small excess burden
relative to the tax revenue it raises.
Excess burden is the efficiency loss to the economy
that results from a tax causing a reduction in the
quantity of a good produced.
Do high taxes discourage the start of new businesses?
Do high taxes encourage people to leave the formal labor
force?
Do high taxes alter incentives to work, save, or invest?

A tax that is neutral with respect to economic

decisions is preferable to one that distorts economic
dedcisions.

Tax Efficiency & Tax Burden

We begin
with a
common
supply
and
demand
diagram.

Tax Efficiency and Tax Burden, Cont.

When we
include the
tax on the
item the
supply curve
shifts left and
the price
increases.

Tax Efficiency and Tax Burden, Cont.

Tax Efficiency and Tax Burden, Cont.

Tax Efficiency and Tax Burden, Cont.

With the new
higher price and
the lower quantity
demanded, we
see that producers
are producing less
and receiving a
lower price.
Therefore, high
taxes lead to
lower production.

Benefits Received Principle

A theory of fairness holding that taxpayers
should contribute to government (in the form
of taxes) in proportion to the benefits that they
receive from public expenditures. (Page 381)
Examples;
Toll roads and bridges.
Federal highway trust fund.
Landing fees at an airport.
The tax side and the expenditure side are connected.
Problem: How does society pay for public goods?

Ability to Pay Principle

A theory of taxation that holds that citizens
should bear tax burdens in line with their
ability to pay.

The tax side and the expenditure side are

viewed separately.

Ability To Pay Principle - Continued

Regressive tax (Page 379 in text.):
A tax whose burden, expressed as a percentage of
income, falls as income increases.
Example: A retail sales tax.

Progressive tax (Page

378 in text.):

A tax whose burdens, expressed as a percentage of

income, increases as income increases.
Example: Individual income tax.

Proportional tax (Page 378 in text.)

A tax whose burden is the same proportion of income for
all households.
Example: A flat tax.

Ability To Pay Principal - Continued

Horizontal equity (Page 387 in text.):
The principle of horizontal equity holds that
those with equal ability to pay should bear
equal tax burden.
Vertical equity (Page 387 in text.)
The principle of vertical equity holds that
those with greater ability to pay should pay
more.

Social Goals and Taxation

There are citizens who believe that one of the
legitimate purposes of a tax system is to promote
social goals.
Redistribution of income.
John Maynard Keynes.
Franco Modigliani.

Promote economic growth.

Deduction of mortgage interest on income taxes.
Deductions for number of children on income taxes.

Sin taxes.
Liquor taxes.
Tobacco taxes.

Features of an Income Tax

A tax on income.
A tax on flow.
Generally considered progressive.
Contains both horizontal and vertical equity.
An ability to pay tax.
Generally considered to be anti-growth since tax
payers are taxed twice.
Types:
Federal tax: A marginal tax above a certain level.
Missouri Tax: Marginal to a point and then proportional.
City of St. Louis: A proportional tax.

Marginal Tax Rates

Single Tax Payer 2005 Rates

Average Tax Rate

Features of Real Estate Taxes

A tax on stock.
A tax on wealth.
There is vertical equity:
Those who have the most pay the most.
There is no horizontal equity:
The tax is not uniform city to city.
It is an ability-to-pay tax.
Is it regressive?
Lower income households pay a larger percentage of their income.
However, studies show that upper income people pay a higher
percentage of their income on housing that do lower income people.

Keynesian Rate/Receipts Curve

Laffer Rate/Receipts Curve

Supply Side
Tenets of Taxation
Beyond some point, high marginal tax rates on
personal income can reduce peoples
willingness to work.
High marginal tax rates discourage people from
investing in education and improving their work
related skills.
High marginal tax rates encourage people to
work in the underground economy.
(Source: Page 331, McKenzie, Richard B., Macroeconomics, Houghton
Mifflin Co, 1986)

When Do Tax Cuts Matter

(Chapter 14 in the Readings Book)

When Do Tax Cuts Matter

The concept of marginal utility:
As a general rule, people maximize their own
utility:
They make choices that maximize their
satisfaction.
They look at the marginal cost and marginal
benefit.
They consider what is happening today as well as
what they believe will happen in the future.

When Do Tax Cuts Matter

Therefore:
Temporary tax cuts have temporary benefits.
Any change in behavior will be short lived.
If the income tax is cut for next year but not the
year after:
> People will work hard next year, but not the
next year after that.

Permanent tax cuts affect peoples futures,

and they pick up on that.
=> Permanent tax cuts affect peoples
utility, and , therefore, their behavior.

Cairo Egypt, picture taken 1-6-10

Hausers Law
In 1993, William Kurt Hauser, a San Francisco
economist, said, No matter what the tax rates
have been, in post war America tax revenues have
remained at about 19.5% of GDP.
The data show that the tax yield has been
independent of marginal tax rates over this period,
but tax revenue is directly proportional to GDP.
The implication, based on actual data, is that if the
government wants to increase tax revenue, we
need to increase GDP.
Note the difference between tax avoidance and tax
delinquency.

Hausers Law, Cont.

Hausers Law, Cont.