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Government Finance

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a PROGRESSIVE TAX increases burden as income rises ... behavior in response to tax rather than benefits/costs of relevant economic activity ... – PowerPoint PPT presentation

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Title: Government Finance


1
Government Finance
2
Methods of Financing Government Activity
  • Debt finance
  • Inflation
  • User charges
  • Donations
  • Revenues from public enterprise
  • Taxation

3
Debt Financing
  • Government borrowing to finance projects
  • appropriate for financing capital projects
  • bridges
  • buildings
  • dams
  • ships
  • airplanes

4
  • Consumers give up current consumption for promise
    by government to return principle with interest
  • Taxation or project revenues used to make
    payments
  • Spreads taxation out over lifetime of benefits

5
Inflation
  • Government purchases resources by creating money
  • money creation increases price level
  • increased price level reduces purchasing power of
    consumers
  • less consumption
  • resources shifted from private sector to public
    sector

6
User Charges
  • Based on a benefits-received principle of
    taxation
  • taxation according to benefits received
  • depends on exclusion
  • can not be used where exclusion not possible
  • road tolls
  • park admission fees
  • gas excise tax

7
Donations
  • Voluntary contributions
  • monetary
  • contributions to public universities
  • donations to aid victims of disasters
  • in-kind
  • donation of land by firm to park
  • labor services
  • volunteer firefighters
  • hospital volunteers
  • park volunteers
  • Peace Corps

8
Revenues from State-Owned Enterprises
  • Revenues for public production of private goods
  • major source of government financing in socialist
    economies
  • minor source of financing in capitalist economies
  • electric power charges
  • transportation services

9
Taxation
  • Major source of funding in capitalist economies
  • along with taxation-supported debt financing
  • Based on ability-to-pay principle
  • payment related to individuals ability to pay
    rather than the benefits received

10
Principles of Taxation
  • Tax base
  • what tax associated with
  • income
  • consumption
  • wealth
  • general versus selective
  • general taxes based on all components of base
  • retail sales tax
  • selective tax based on component of base
  • excise tax on gas

11
  • Tax structure
  • relationship between tax and base
  • relationship between tax paid and measure of
    ability to pay
  • income usual measure of ability to pay
  • average tax rate (ATR) ratio of tax paid and
    value of tax base or income
  • marginal tax rate (MTR) change in tax paid over
    change in base or income

12
  • Tax burden and ability to pay
  • tax can be structured to place different burdens
    on different levels of income
  • a PROGRESSIVE TAX increases burden as income
    rises
  • ATR with respect to income rises as income rises
  • a PROPORTIONAL TAX leaves burden the same
  • ATR stays the same as income rises
  • a REGRESSIVE TAX reduces burden as income rises
  • ATR falls as income rises

13
Evaluation of Taxation
  • Taxes evaluated on basis of three social goals
  • minimization of the efficiency costs of taxes
  • maximization of fairness
  • minimization of administrative costs
  • Taxes should also be transparent
  • should be clear who bears the burden

14
  • Taxes virtually always cause inefficient behavior
  • behavior in response to tax rather than
    benefits/costs of relevant economic activity
  • lump-sum tax is only efficient tax
  • not based on economic activity
  • cannot be avoided
  • head tax
  • Exception tax may improve efficiency if there is
    market failure
  • whole point of corrective taxes

15
  • These goals not always compatible
  • making a tax more equitable usually makes it more
    inefficient
  • Taxation often used to influence behavior on
    merit/demerit grounds
  • sin taxes
  • taxes on alcohol and tobacco
  • deductibility of mortgage interest
  • encourages home ownership
  • accelerated deductibility of certain investment
    expenditures
  • oil exploration

16
Impact of Taxes on Efficiency
  • Taxes result in EXCESS BURDEN
  • efficiency loss to society in addition to direct
    burden of tax to taxpayers
  • tax revenue is a loss to taxpayers, but the
    resources are still there
  • transfer from private to public sector
  • excess burden is a loss due to distortionary
    effect of tax

17
Excess Burden of Unit Excise Tax
  • tax of fixed amount on each unit of a good
  • unrelated to the price of the good
  • gasoline tax
  • causes market supply to be less than MSC
  • equilibrium price higher and quantity lower than
    optimal

18
Unit Excise Tax
STMSCT

SMSC
Tax Revenue
PG
T
Peff
Excess Burden
PN
DMSB
0
Qeff
QT
Q
19
  • Excess burden ½T?Q
  • Note that ?Q depends on T
  • Excess burden ½T2Qeff/Peff .
  • EsEd/(Es - Ed)
  • Excess burden increases quadratically with tax
  • double tax, welfare falls fourfold

20
  • Excess burden is greater the more elastic is
    demand
  • if perfectly inelastic, no welfare loss
  • Excess burden is greater the more elastic is
    supply
  • if perfectly inelastic, no welfare loss

21
Ad Valorem Taxes
  • Tax on percentage of price
  • sales tax
  • payroll tax
  • T tPG
  • Excess burden ½t2(PeffQeff) .
  • EsEd/(Es - Ed)

22
  • Welfare loss increases with square of tax rate
  • Excess burden greater the more elastic is demand
  • Excess burden greater the more elastic is supply

23
Impact of Taxes on Distribution of Income
  • Must first determine who bears the burden of a
    tax
  • difference between paying a tax and bearing a tax
  • all taxes are borne by persons
  • businesses are not persons
  • business are legal entities representing
    collections of owners, workers, customers
  • businesses pay the tax but shift the burden
  • borne by owners as lower returns to investment
  • borne by workers as lower wages
  • borne by customers as higher prices

24
Tax Incidence
  • Incidence is the distribution of burden
  • Before we tell the effect of a tax on the
    distribution of income, we have to know its
    incidence

25
  • Seller bears burden to extent that supply is
    inelastic
  • Buyer bears tax to extent that demand is
    inelastic
  • Incidence identical whether tax paid by seller or
    by buyer

26
Incidence of Unit Excise Tax on Sellers
STMSCT

SMSC
PG
Buyers
T
Peff
Sellers
PN
DMSB
0
Qeff
QT
Q
27
Incidence of Unit Excise Tax on Buyers

SMSC
PG
Buyers
T
Peff
Sellers
PN
DMSB
DTMSB-T
0
Qeff
QT
Q
28
Equity
  • Economics tells us what an efficient tax looks
    like
  • Economics does NOT tell us what a fair tax looks
    like
  • Two concepts of fairness MAY go part of the way
  • horizontal equity
  • vertical equity

29
Horizontal and Vertical Equity
  • Horizontal equity requires individuals in
    identical economic circumstances to pay the same
    tax
  • Vertical equity requires individuals in better
    circumstances to pay more

30
  • what does it mean to be in the same
    circumstances?
  • same income?
  • any adjustment for marital status or number of
    dependents?
  • health costs?
  • what period?
  • annual versus lifetime
  • what about work/leisure choices?
  • should productivity and effort be penalized?
  • would consumption be better?
  • income reflects what we contribute to society
  • consumption is what we take out of society
  • what does paying more mean?
  • regressive taxes can result in richer people
    paying more
  • is progressivity required?

31
Taxation in the United States
  • Multi-level political system
  • one Federal government
  • 50 state governments (plus territories)
  • thousands of local governments
  • counties
  • municipalities
  • school districts
  • others

32
Federal Taxes
  • The Federal Personal Income Tax is the major tax
    at the Federal level
  • Contributions for social insurance through
    payroll taxes is the next
  • increased rapidly as percent of total from late
    50s to late 80s
  • Corporate profits tax
  • decreasing in importance since late 50s

33
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34
State and Local Taxes
  • Sales tax is most important at state level
  • Property taxes next
  • steadily declining as percent of total for
    decades
  • Personal income taxes
  • steadily increasing

35
  • Corporate profits taxes not an important source
    of revenue
  • In addition to taxes, state and local governments
    receive grants-in-aid from the federal government
  • about 21 of total state and local revenues

36
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37
Income Taxation in the U.S.
  • Based on annual household income
  • Certain forms of income left out
  • unrealized capital gains
  • imputed value of owner occupied housing
  • income spent on charitable contributions
  • income spent on state and local taxes
  • employer-provided health insurance
  • These exclusions violate horizontal and vertical
    equity

38
  • Income taxes are transparent
  • you know who youre taxing
  • Can be made as progressive as society wants
  • greater progressivity means greater excess burden
  • MTRs in U.S. from 15 for income up to about
    25,000 (41,000 married filing jointly) to 39
    for incomes over about 270,000 after exemptions
    and deductions

39
  • Exemptions are income exclusion for taxpayer and
    dependents
  • extra exemptions for aged (over 65)
  • extra exemptions for blind
  • exemptions just under 3,000 each
  • exemptions phased out for very high incomes

40
  • Deductions
  • exclusions from income for certain expenses
  • mortgage interest
  • state and local income and property taxes
  • unusually large medical expenses
  • charitable contributions
  • moving expenses
  • large employee expenses
  • casualty losses

41
  • most taxpayers take the standard deduction
  • standard deduction more than most taxpayers
    totals for regular deductions
  • exemptions and standard deduction a way to ensure
    that the very poor pay no tax
  • in effect, a zero tax bracket
  • Income taxes potentially easy to administer
  • U.S. Federal Income Tax very costly because of
    all the loopholes (ways to avoid tax)

42
  • Enforcement cost high
  • making sure that tax properly calculated
  • Compliance cost high
  • costly for taxpayers to determine what their
    taxes are

43
Corporation Income Tax
  • Tax on the profits of corporations
  • corporations are firms in which the investors
    liability is limited to the amount of investment
  • Essentially a flat tax of 35 on profits
  • revenues minus wages, materials, interest paid,
    and depreciation
  • dividend payments not deductible

44
  • Corporation taxes suffer from a lack of
    transparency
  • very hard to tell who bears the burden
  • owners of capital in the form of lower returns
  • workers in the form of lower wages
  • consumers in the form of higher prices
  • only thing that is certain is that the firm bears
    none of it
  • only people pay taxes
  • It is unlikely that the tax satisfies horizontal
    and vertical equity

45
Payroll Taxes in the U.S.
  • Employee pays 7.65 on first 70,000 wages
    (approximately)
  • ceiling indexed to inflation
  • set to 65,400 in 1997
  • Employer matches
  • Total of 15.3

46
  • The tax is regressive
  • non-wage income escapes taxation
  • generally it is the rich who have non-wage income
  • after wage rises above ceiling, payroll tax drops
    to 2.9
  • Lacks transparency
  • burden of the tax the same whether paid by
    employee or employer
  • only depends on elasticities of labor supply and
    demand
  • labor supply in U.S. is almost perfectly
    inelastic
  • thus workers bear the whole burden

47
U.S. Payroll Tax
SLSupply of labor DLDemand for labor DNDemand
net of employee tax D Demand net of employer
tax TBTax on employer at equilibrium TETax on
employee at equilibrium

SL
A
W1
TB
W2
B
TE
W3
C
DL
DDL-TB
DN
0
Labor
48
  • The demand for labor without tax is DL.
  • based on labor productivity
  • Employer now pays tax, shifting demand down to D
  • Out of any gross wage along D employee pays tax,
    so DN is the employees wage net of tax

49
Retail Sales Tax
  • Major source of revenue at state level
  • Different for each state
  • leads to distortions that are especially bad near
    borders when sales tax rates are different
  • Flat rate based on final consumer expenditures
  • in practice, not general
  • services usually excluded

50
  • Generally regressive as expenditures as
    proportion of income greater for the poor than
    the rich
  • Regressivity has led some states to exempt food

51
Property Taxes
  • A tax on certain forms of wealth
  • Real property tax a major source of revenue at
    local level
  • Reduces return to capital
  • Rate differentials cause locational distortions
  • Overall incidence more or less proportional
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