Principles of Taxation

1
Principles of Taxation

• Chapter 2
• Tax Policy Issues Standards for a Good Tax

2
Tax Policy Issues

• The Standards for a Good Tax
• Income and Substitution Effects
• Equity Issues
• Tax Rate Structure

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The art of taxation consists in so plucking the
goose as to obtain the largest possible amount of
feathers with the least possible amount of
hissing.Jean Baptiste Colbert
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Tax Policy Issues

• Standards for a Good Tax
• In theory every tax can and should be evaluated
  on a set of basic standards. In general a tax
  should meet what four objectives?

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Tax Policy Issues - Sufficiency

• A Sufficient Tax
• When is a tax sufficient?
• Forecasting revenue
• ______forecast - assume base stays the same.
• _________forecast - estimate change in base due
  to change in rate. Income versus substitution
  effects help predict change in base.

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Tax Policy Issues - Sufficiency

• Income versus Substitution Effects
• Taxpayers often modify their behavior in reaction
  to increased tax rates. These behavioral changes
  result in either an income effect or substitution
  effect. They are summarized below
• Remember tax _____ ______
• What effect on behavior does a change in either
  rate or base have? (See IR 1)

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Tax Policy Issues - Sufficiency

• Income Effect Taxpayers react to rate increases
  by _________ their income-producing activities to
  maintain the same disposable income experienced
  before the tax rate increase. In other words,
  taxpayers work harder to maintain the same
  economic status.
• See Q5

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Tax Policy Issues - Sufficiency

• Substitution Effect Taxpayers react to rate
  increases by ____________the amount of income
  producing activities. In other words, an hour of
  leisure is worth more than an additional hour of
  labor.
• Theoretically, the income effect is more powerful
  for __________-income taxpayers and the
  substitution effect is more compelling to
  __________-income taxpayers.
• Other examples married women?
• See Q6

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Tax Policy Issues - Convenience

• A Convenient Tax
• When is a tax convenient?
• from the Governments Viewpoint? Q10
• from the Taxpayers Viewpoint? Q11

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Tax Policy Issues - Efficiency

• A tax is efficient if
• judged by the classical standard of efficiency,
  it does not distort the market, create suboptimal
  allocation of goods and services, or modify
  taxpayer behavior.
• judged by Keynesian standards it is an effective
  fiscal policy tool for regulating the economy.

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Tax Policy Issues - Equity

• A tax is fair if
• the taxpayer has the Ability to Pay the tax.
• Define Horizontal Equity
• Define Vertical Equity

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Tax Policy Issues - Equity

• Horizontal Equity
• Achieving horizontal equity depends heavily on
  the tax base definition.
• Tax loopholes vary across taxpayers. (IR2)
• A simple but unpopular solution is to eliminate
  all tax preferences. This solution would likely
  increase the current systems horizontal equity
  but at the expense of the economic or social
  benefits derived from income producing activities
  that tax preferences are designed to promote.
  Examples?

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Tax Policy Issues

• Vertical Equity
• What should rate structure look like?
• The ongoing policy issue is usually not whether
  rich should paying more taxes than poor, but how
  much more is appropriate? The definition of how
  much more is, may result in a tax rate
  structure that is regressive, proportional, or
  progressive.

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Tax Policy Issues - Equity

• A regressive tax structure is one for which the
  rate of tax paid ____________with an increase in
  tax base.
• Assume a tax rate structure for which John Smith
  who earns 20,000 pays a tax of 2,000 and John
  Jones earns 40,000 pays a tax of 3,000.
• John Smiths average tax rate is ______
  (____/_______) while John Joness is ___
  (____/_______). The rate structure meets the
  strict standards of vertical equity
  _____gt_____. Is John Jones is paying an amount
  consistent with his ability to pay?

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Tax Policy Issues - Equity

• Proportional Rate Structure levies a tax that is
  the _______ percentage of income regardless of
  tax base amount.
• Assume a rate structure for which John Smith with
  income of 20,000 pays 2,000 in tax and John
  Jones with 40,000 of income pays 4,000.
• John Smiths and John Joness average tax rates
  are both _____. However, based on the theory of
  the declining marginal utility of income John
  Smiths tax burden is a greater hardship than
  John Joness .
• A proportional rate structure is often referred
  to as a flat tax.
• See Q14

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Tax Policy Issues - Equity

• Progressive Rate Structure levies a tax, which as
  a proportion of income, increases as income
  increases.
• Assume a rate structure for which John Smith with
  income of 20,000 pays a tax of 2,000 and John
  Jones with income of 40,000 pays a tax of
  4,400.
• John Smiths average tax rate is ___ and John
  Joness is ___.
• Whether the tax burden is now equitable is a
  question that is still unanswered.

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Tax Policy Issues - Equity

• Vertical Equity
• Examine data from prior class exercise. How much
  did your opinions vary?
• How does the class average tax burden for
  individuals A B C and D compare with current
  income tax rates?

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Tax Policy Issues

• Tax Rate Structure
• Average Tax Rate The tax rate on income
  determined by dividing tax paid by an income
  measure. Income measures selected are usually
  gross income or taxable income.
• Marginal Tax Rate The rate of tax applied to
  the next dollar of taxable income. In a
  progressive rate structure this rate increases as
  income levels increase. In a proportionate rate
  structure average and marginal rates are the
  same.
• Lets look at tax rates at front of the book
• Single person earns 150,000. MTR? ATR?
• Married couple earns 150,000. MTR? ATR?