ECON 510Tax Policy

PowerPoint Material2015

J. Fred GiertzInstitute of Government and Public Affairs and

Department of EconomicsUniversity of Illinois at Urbana

Circular Flow (Khan Academy):https://www.khanacademy.org/economics-finance-domain/macroeconomics/gdp-topic/circular-econ-gdp-tutorial/v/circular-flow-of-income-and-expenditures

 Supply and Demand (Khan Academy): https://www.khanacademy.org/economics-finance-domain/microeconomics/supply-demand-equilibrium

 Consumer and Producer Surplus (Khan Academy)https://www.khanacademy.org/economics-finance-domain/microeconomics/consumer-producer-surplus/consumer-producer-surplus-tut

Short On-Line Lectures

Role of the Market

• Decentralized system can lead to desirable results

• Economic efficiency– Maximizing net benefits– Consumer and producer surpluses

• Economic equilibrium• Coincidence of equilibrium and efficiency• Examples of inefficiency• Equity

Evaluation of Market

• Efficiency• Equity (fairness)

Review of Economic Efficiencyand Market Equilibrium

REVIEW

Marginal Cost

Marginal

Marginal Benefit

Examples of Inefficiency

http://www.economicshelp.org/microessays/markets/monopoly-diagram/

Price Ceiling

Possible Problems with Market(What is the role government in a private

enterprise economy?)• Philosophical issues• Technical issues

– Public goods– Externalities– Incomplete Markets– Imperfect information–Asymmetric information– Distribution– Monopoly– Macro issues—stability and growth

Public Goods in More Detail

• Definition—contrast with private goods– Non-exclusion– Non-rivalry

• Public goods vs. public production vs. public provision

• Why does the market fail?• Free riding problems

– Non-exclusion – Insignificance

Efficiency with public goods

Externalities in More Detail

• Externalities defined– Negative such as pollution– Positive such as education

• Why do they create problems for the market?

• Social costs vs. private costs• Corrective actions

– Are they needed?– What form should they take?

Externalities in More Detail

• Externalities defined– Negative such as pollution– Positive such as education

• Why do they create problems for the market?• Social costs vs. private costs

– Private costs + external costs= social costs– Private benefits + external benefits= social benefits

• Example of inefficiencies

Externalities (continued)

• Corrective actions– Are they needed?

(Pigou vs. Coase)– What form should they

take?• Regulations• Taxes and subsidies

• A market for externalities

Firm A Firm BLevel MB for A Level MB for B

0 01 60 1 222 50 2 183 40 3 144 30 4 105 20 5 66 10 6 27 0 7 0

Reduce total from 12 to 6

Introduction to Taxation

• Taxes are one way of financing government along with borrowing, fees & charges, etc.

• Basic criteria for evaluating taxation– Efficiency

• Neutrality as a goal• Do as little harm to the functioning of the private

market

– Equity or fairness

Equity

• Equity is basically a normative or ethical concept

• Equity like beauty is in the eye of the beholder

• Components of equity– Horizontal equity—equal treatment of equals– Vertical equity—the appropriate differential

treatment of unequal

Taxes vs. Fees

Fees are related to prices for public services where exclusion is possible. Generally, the revenue generated by a fee is used to finance the activity.

Fees are applications of the benefits-received theory

In practice, the distinction is often not well defined.

Benefits-received vs. Ability-to-pay

• Benefits-received– Advantages

• Mirrors private market?• Provides incentives for citizens

– Disadvantages• Difficult to apply in some cases• Not useful for redistribution

• Ability-to-pay—advantages and disadvantages

Letter to Editor

ChampaignNews-GazetteMay 17, 2010

Inclusive vs. Exclusive RateExclusive vs. Inclusive RatesRates with equal revenue

Inclusive ExclusiveTax Tax Ratio

Rate Rate

0.0% 0.0%5.0% 5.3% 1.05

10.0% 11.1% 1.1115.0% 17.6% 1.1820.0% 25.0% 1.2525.0% 33.3% 1.3330.0% 42.9% 1.4335.0% 53.8% 1.5440.0% 66.7% 1.6745.0% 81.8% 1.8250.0% 100.0% 2.0055.0% 122.2% 2.2260.0% 150.0% 2.5065.0% 185.7% 2.8670.0% 233.3% 3.3375.0% 300.0% 4.0080.0% 400.0% 5.0085.0% 566.7% 6.6790.0% 900.0% 10.0095.0% 1900.0% 20.0099.0% 9900.0% 100.00

0 0.1 0.2 0.3 0.4 0.5 0.6

Inclusive Rate

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Exc

lusi

ve R

ate

Equal Yield: Inclusive and Exclusive rates

Ti = (Te)/(1+Te)

Rationales for ProgressivityExample

• What are the problems with this approach?– Is utility measurable?– Does MU decline?– Can you compare utility among

persons?

Total MarginalIncome Utility Utility

010 100 10020 195 9530 285 9040 370 8550 450 8060 525 7570 595 7080 660 6590 720 60

100 775 55110 825 50120 870 45130 910 40140 945 35150 975 30160 1000 25170 1020 20180 1035 15190 1045 10200 1050 5

ResultsTaxes Tax Rates Utility

Compare $50 person$200 person $50 person$200 person $50 person$200 person

Taxes needed = $40

Equal $ $20 $20 40.0% 10.0% 165 U 15 UProportional $ 16% $8 $32 16.0% 16.0% 64 U 34 U 5+10+15+.1*20

Minimum sacrifice $0 $40 0.0% 20.0% 0 U 50 UEqual Sacrifice $5 $35 10.0% 17.5% 40U 40UProportional Sacrifice $2.41 $37.575 4.8% 18.8% 45.15U 19.35U

Measuring ProgressivityLump Sum

AverageIncome Tax Rate Income

0 100010000 1000 10.00%20000 1000 5.00%30000 1000 3.33%40000 1000 2.50%50000 1000 2.00%60000 1000 1.67%70000 1000 1.43%80000 1000 1.25%90000 1000 1.11%

100000 1000 1.00%

Flat RateAverage

Income Tax Rate0 0 ERR

10000 1000 10.00%20000 2000 10.00%30000 3000 10.00%40000 4000 10.00%50000 5000 10.00%60000 6000 10.00%70000 7000 10.00%80000 8000 10.00%90000 9000 10.00%

100000 10000 10.00%10% Tax

Income Consump. Tax AR Income0 3000 300 ERR

10000 11000 1100 11.00%20000 19000 1900 9.50%30000 27000 2700 9.00%40000 35000 3500 8.75%50000 43000 4300 8.60%60000 51000 5100 8.50%70000 59000 5900 8.43%80000 67000 6700 8.38%90000 75000 7500 8.33%

100000 83000 8300 8.30%

Tax = 10% of consumptionConsumption= 3000+.8*Income 0-10,000

10-20,000

Flat Rate with 10,000 Exempt Average

Income Tax Rate Income0 0 ERR

10000 0 0.00%20000 1000 5.00%30000 2000 6.67%40000 3000 7.50%50000 4000 8.00%60000 5000 8.33%70000 6000 8.57%80000 7000 8.75%90000 8000 8.89%

100000 9000 9.00%10% Tax

Income Tax AR0 0

10000 1000 10.00%20000 2500 12.50%30000 4500 15.00%40000 6500 16.25%50000 9000 18.00%60000 11500 19.17%70000 14000 20.00%80000 16500 20.63%90000 19000 21.11%

100000 21500 21.50%

Tax Brackets0-10,000 10%

10-20,000 1,000+15%20-40,000 2,500+20%

> 40,000 6,500+25%--------------------------------------

Gini Coefficient = A/(A+B)G=0; Complete EqualityG=1; Complete Inequality

Tax Avoidance, Evasion and Deliquency

• Economics of crime– Benefits– Costs

• Direct costs• Probability of arrest

and conviction• Severity of punishment

• Economics of evasion– Benefits—taxes saved– Costs

• Direct costs• Psychic costs• Probability of detection• Severity of punishment

Visualizing the Laffer Curve

Laffer Curve—Tax rates and Tax RevenuesAre tax revenues proportional to tax rates?The example of a tariff?Elasticity issues

Cigarettes?A tax on Cokes vs. a tax on soft drinks?The Laffer curve“Dynamic scoring”Short runLong runAdjustments—example of income tax

Tax Rates and Tax Revenues

Tax Expenditures

Tax expenditures are revenue losses attributable to tax provisions that often result from the use of the tax system to promote social goals without incurring direct expenditures. How tax expenditures are structured affects both who will benefit from them and how much they will reduce federal revenues.

Partial equilibrium approach

• The excise tax example– Selective excise– Specific (unit) vs. ad valorem

• Is the tax applied on the consumer or the producer?– Different approaches– Same results

Excise tax incidence--examples

• Basic example—sharing the price burden– Consumer and producer price burden– Equivalence of consumer and producer

imposition– Short run and long run

• Special cases – Inelastic supply– Inelastic demand– Elastic supply

Tax Legal Responsibility of Seller

Tax Legal Responsibility of Buyer

Taxation and efficiency

• Review of efficiency concept• Welfare cost and excess burden• The excise example once again—Basic

case– Tax revenues– Welfare cost s

• Special cases– Inelastic supply– Inelastic demand

Tax rates and tax revenues

• Are tax revenues proportional to tax rates?• The example of a tariff?• Elasticity issues

– Cigarettes?– A tax on Cokes vs. a tax on soft drinks?

• The Laffer curve• “Dynamic scoring”

– Short run– Long run– Adjustments—example of income tax

Individual Income Taxation• Definition of income

– Measure of ability-to-pay– Haig-Simons, Accretion concept,

Comprehensive Income, Economic income– “Income may be defined as the algebraic sum

of the market value of rights exercised in consumption plus the change in value of the store of property rights between the beginning and end of the period in question.” Simons

– Income = Consumption + Change in Wealth

Calculation of Income

I C NW0 NW1

100 100 50 50110 100 40 50 90 100 60 50

Individual Income Taxation (continued)

• Other definitions– Legal (AGI)– Income as production

• Income vs. consumption (a first look)– Income = Consumption + Saving– Income – Consumption = Saving– The issue is the tax treatment of savings

Applications of the Haig-Simons Definition

Wages H-S income The corporate income (Disc. Later)

Retained earnings (Discussed later) Employee-paid safety equipmentExcludable H-S income

Social Security payments H-S income Death transfers H-S income

Gifts H-S income Employer-paid education (Depends on purpose)

Unemployment Compensation H-S income

Housing—owning vs. rentingNet imputed rent H-S income

Bequests H-S income to heirs Employer-paid vacation H-S income

Interest H-S income (real return only) Owning vs. leasing a car

Employer-paid insurance H-S income Travel expenses for sales personExcludable H-S income

Dividends H-S income (real return only)

Inflationary wage increasesH-S income (with indexation)

Capital gains H-S income (real return only)

Employer-paid pension contributionsH-S income (real return only)

Education expenses—not employer paid (Depends on purpose)

Child care ????

Business class air travel for business purposes (Depends on purpose)

Free checking accounts (tax Interest, charge for checking)