Lecture 23: Taxation and Public Expenditure

Outline:

1. Some facts about taxation in the U.S.

2. Taxes and the distribution of income

i. Progressive taxes

ii. Proportional taxes

iii. Regressive taxes

3. The U.S. tax system

i. Federal personal income tax

ii. Payroll taxes

iii. corporate income tax

iv. excise and sales taxes

v. Property taxes

4. Evaluating the tax system

i. Equity

ii. Efficiency

5. Major categories of government spending

i. Transfer payments

ii. Purchases of goods and services

iii. Grants-in-aid

6. Dollars and Sense Article 4

1. Some facts about the U.S. Tax System:

* Value of taxes collected in the U.S. by all levels of govt equals approximately 1/3 of the country's GDP.

* This is a small proportion compared with Western Europe and Canada.

* Table 20-1 Lipsey and Courant

* Significant reforms of the US tax system occurred in 1981 and in 1986 - they involved lowering the tax burdens of the wealthiest citizens.

2. Taxes and the distribution of income:

How a tax affects the distribution of income is described by classifying taxes as progressive, proportional, or regressive.

Progressive tax: Takes an increasing proportion of income as income rises

* The wealthy pay a larger proportion of their income in these taxes than the poor.

Proportional tax: Takes a constant proportion of income at all income levels

* The wealthy pay the same proportion of their income in taxes as the poor.

Regressive tax: Takes a decreasing proportion of income as income rises

* The wealthy pay a smaller proportion of their income in these taxes than the poor.

Note: Progressive taxes make the distribution of income in the country more equal whereas regressive taxes make the distribution of income less equal.

3. The U.S. tax system and the different levels of government:

* The federal govt collects about 1 ½ times more revenue than all other levels of govt combined

* Main sources of revenue for the federal govt are the personal income tax and payroll taxes

* Main sources of revenue for the state govt are sales taxes and state income taxes

* Main source of income for local govts is property taxes

Federal personal income tax:

* Accounts for 44% of federal tax revenues

* The tax is paid on all forms of income: wages, salaries, interest, rent, dividends.

* Wage and salary income provides the most revenue

* Higher marginal tax rates apply as income rises: 15%, 28%, 31%, 36%, 39.6%

Question: How do these marginal tax rates work?

* The majority of taxpayers face the 15% rate

* the tax reforms of 1986 lowered the highest marginal rate from 50% to 36.9% and raised the lowest rate from 11% to 15%

* Prior to 1981 the highest marginal tax rate was 70%

Question: Is the federal income tax a progressive, regressive, or proportional tax?

* Exemptions and deductions - make the personal income tax less progressive - the wealthy are more likely to be able to take advantage of them and since they are in higher tax brackets they are worth more

Exemptions: specific categories of income that are not taxed e.g. first $2450 of income per household member is considered a personal exemption that is not taxed

Deductions: specific categories of expenditures that are not taxed e.g. mortgage interest can be deducted from taxable income.

Payroll taxes:

* Have grown in importance over the last 20 years

* The bulk of payroll taxes are social security taxes

* Taxes levied on wages and salaries

* They are proportional up to a ceiling - in 1994 Social security taxes were approximately 12.4% of wages and salaries below $53,400 and above $60,600 the marginal tax rate was zero - making the overall tax slightly regressive.

Corporate income tax:

* Taxes levied on the accounting profits of corporations

* Flat tax of 34% after a small exemption

* Tax reforms of 1986 reduced the corporate tax rate from 46% to 34%

* The corporate tax has decreased in importance as a source of tax revenue over the last 20 years

* It accounts for only about 16% of federal revenue currently

* There is some controversy over the way the corporate tax rate affects the distribution of income - to what extent is it passed on to consumer? To the extent that it is passed on, the tax is regressive

Question: Why tax corporate income twice? Why not abolish the corporate income tax and increase the marginal tax rates on personal income at the higher income levels where most people who earn dividends income can be found?

Excise and sales taxes:

* An excise tax: is a tax levied on a particular commodity e.g. liquor

* A sales tax: is a tax levied on most sales of goods.

* On average the poor spend proportionately more of their income than the wealthy

Question: Are excise and sales taxes progressive, regressive, or proportional?

Question: What would happen to the progressivity of the US tax system if we replaced the federal personal income tax with a Value-added tax or general sales tax?

Property taxes:

* Property taxes are based on the value of taxable property including residential housing - owner-occupied and rental - farms, factories and business equipment.

* At any time there is an assessed value of properties and the tax rate - often called a millage which is expressed as the tax per $1000 worth of property - is multiplied by the value of the properties.

* This is the only important tax in the U.S. based on wealth.

* The tax is considered proportional although it is difficult to determine its effect on the income distribution since wealth and income are not perfectly correlated.

4. Evaluating the tax system:

* People seem to be dissatisfied with the current tax system - why?

* What makes a "good" tax system?

* Economists evaluate the tax system by asking the question - holding the amount of revenue to be raised constant, what makes one tax system better than others?

* In evaluating the tax system economists consider two factors - equity and efficiency

Equity: An equitable tax system is generally considered one that depends on people's ability to pay.

Ability to pay: In considering households' abilities-to-pay there are two issues that arise: (1) vertical equity which concerns equity across income groups and (2) horizontal equity which concerns equity within income groups

Proponents of progressive taxes argue that these are equitable in the sense that the greater one's income the greater their ability to meet their consumption needs with resource left over and hence the greater is their ability to pay taxes.

Benefit principle: Some argue that taxation should be paid in proportion to the benefits received from public expenditures. The ideal tax based on this principle would be "user fees". While this may make sense for some categories of spending it would clearly be problematic for many others.

Question: Can you think of any examples of when this principle would be appropriate and when not?

Efficiency: An efficient tax system is generally considered one that minimizes the distortions to economic activity and collects tax revenues in the least cost way. An ideal tax system based on efficiency would be one of lump sum taxes. In practice it would be difficult to levy such taxes in a way that would generate sufficient revenue.

Question: Since equity and efficiency are often competing goals, what is the "right" mix of equity and efficiency in a tax system?

5. Public expenditure:

* Without tax revenues the government would not be able to undertake any spending - no purchases of goods and services, no provision of public goods, no subsidies for positive externalities, no social spending.

* the government's ability to spend, and hence what we can expect the government to provide for us, is constrained by its revenues.

* In 1994 spending by all levels of govt accounted for approximately 33.5 percent of GDP - this has not been very different from the share in 1980 and 1970 and is somewhat higher than in 1960 when it was 26.6%

* The federal govt accounts for 68% of all govt spending

* For the federal govt, defense and social security are the largest categories of spending - totaling almost half of all federal spending

* At the state and local levels the major categories of spending are education and public welfare

* Table 20-3 Major categories of public expenditure

Categories of public expenditure:

Transfer payments: payments made to individuals without expecting anything in return

e.g. welfare payments, social security payments, pensions, veterans benefits, unemployment insurance, fellowships

* Main source of growth in this area has been social security and medicare - in 1994 these accounted for 36% of all federal spending.

Purchases of goods and services: payments by the government for resources and final products and services.

e.g. salaries paid to police officers, spending on highways

* The majority of govt purchases are made by state and local govts

* Education and highways account for half of these purchases

* Other spending includes police protection, fire trash collection, hospitals, prisons, libraries, etc.

* Nearly 2/3 of federal purchases were for defense related goods and services.

Grants-in-aid: These are transfer payments from the federal govt to the state and local govts.

It is considered more efficient to collect revenues at the federal level and then allow spending decisions to be made at the state and local levels.