Chapter 33:Taxes: Equity versus Efficiency

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Distribution• Once goods are produced, the FOR WHOM

question must be answered.– Should the market decide?– Should government intervene?

• The market would strive for efficiency and reward producers according to their value in production.

• The government would strive for greater equity – that is, a more equal distribution.

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Distribution

• Some participants in the market are wildly successful and earn millions. Others are unsuccessful and must go without many amenities.– The market generates inequalities in income

distribution.– Should the government intervene to

redistribute some income?– If so, how should it do that?

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Distribution

• The tax system is the government’s main lever to redistribute income.

• Taxes affect both production and distribution.

• There is a potential trade-off between equity and efficiency.

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Learning Objectives

• 33-01. Know how the U.S. tax system is structured.

• 33-02. Know what makes taxes more or less progressive.

• 33-03. Know the nature of the equity-efficiency trade-off.

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What Is Income?

• Personal income is the amount earned and received by households before taxes are paid.

• Some households get in-kind income: goods and services received directly (not via a market transaction).

• Measuring income by different means causes some distortions in year-to-year comparisons.

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What Is Income?

• A family is declared to be “poor” if their money income is below a certain threshold. – Counting this way, there has been no progress in

the War on Poverty since it started in 1965.– There are more “poor” today than in 1965.

• If we add in-kind income, there are fewer “poor” today than in 1965, indicating modest progress.

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What Is Income?

• We also must consider the distribution of wealth (the market value of assets owned).– Wealth is a stock of potential purchasing power.– Wealth tends to be distributed less equally than

income.

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The Distribution of Income• We divide households

into quintiles (fifths or 20% of households) according to their income.

• The bowed Lorenz curve shows that the income share of the lowest fifth is 3.4% and the top fifth has half of the total income.

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The Distribution of Income• The diagonal line

shows what the distribution would be if there were complete equality.– 20% of households

would receive 20% of income.

• The greater the area between the Lorenz curve and the diagonal, the more inequality exists.

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The Distribution of Income• The area under the diagonal of the Lorenz

curve is represented by the Gini coefficient.– The higher the Gini coefficient, the greater the

inequality of income.

• Large inequality, to some, represents market failure.– Income distribution is “unfair.”– The government should intervene by levying taxes

on the “rich” and making transfer payments to the “poor.”

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The Federal Income Tax

• Efficiency concerns.• The federal income tax is progressive.– It imposes higher tax rates on high incomes than on

low incomes.– The marginal tax rate increases as incomes rise.

• Marginal tax rate: the tax rate imposed on the last (marginal) dollar of income.

–Higher-income earners find themselves in higher tax brackets.

• The goal of progressive tax rates is to reduce inequality.

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The Federal Income Tax

• Efficiency concerns.– Progressive taxes reduce inequality but also

affect efficiency.– Since marginal tax rates increase as income

increases, the progressive tax system punishes success.• It is a disincentive to work more, produce more, or

invest more.

– The implication is that rising marginal tax rates can contribute to a decrease in total output.

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The Federal Income Tax• Equity concerns.– In theory, a progressive tax system taxes the

“rich” heavily and distributes the proceeds to the “poor.”

– In reality, the system is not so progressive.– The tax code applies only to “taxable” income,

not all income. To arrive at taxable income, deduct all• Exemptions.• Itemized deductions.• Other tax breaks in the tax code (“loopholes”).

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The Federal Income Tax• Equity concerns.– As a result, many high-income earners can

reduce their taxable income greatly and pay little tax.• Some pay less tax than people with lower incomes.• The bulk of taxes are paid by the “middle class,” not

the “rich.”– There are two equity considerations:• Vertical equity: people with higher incomes should

pay more taxes than people with lower incomes.• Horizontal equity: people with equal incomes should

pay equal taxes.

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The Federal Income Tax

• Equity concerns.– As a result of loopholes, there is a distinction

between nominal tax rates and effective tax rates.• Nominal tax rate: taxes paid divided by taxable

income.• Effective tax rate: taxes paid divided by total income.

– The gap between nominal and effective tax rates reflects the loopholes in the tax code.

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The Federal Income Tax

• Resource misallocations.– Tax loopholes alter the mix of outputs.– Tax-preferred activities receive more resources,

and heavily taxed activities receive fewer resources.

– The resulting mix of output could be inferior to the mix that a pure market outcome would generate, and therefore could be characterized as government failure.

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The Federal Income Tax

• A shrinking tax base.– Loopholes shrink the tax base. – As the base of taxable income shrinks, the

average tax rate must increase to maintain the same tax revenue.

Tax revenue = Average tax rate X Tax base

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Payroll, State, and Local Taxes

• Sales and property taxes.– These are major sources of revenue for state

and local government.– Both taxes are regressive because the tax rate

falls as income rises.– This imposes a proportionally larger burden of

the tax on lower-income earners.

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Payroll, State, and Local Taxes

• Sales and property taxes.– Tax incidence: where the real burden of a tax

falls.– Sales tax incidence: • At lower incomes, earners spend all of their

income, which is subject to sales tax.• At higher incomes, earners do not pay sales

tax on income not spent, but saved.

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Payroll, State, and Local Taxes

• Sales and property taxes.– Property tax incidence:• Income going to housing is higher for low-

income earners, who primarily rent rather than own.• Property tax is reflected in higher rents.

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Payroll, State, and Local Taxes

• Payroll taxes.– Social Security payroll tax is the second-largest

source of federal tax revenue.– Workers pay this tax on earnings up to

$106,800.– Thus the tax is regressive. Higher-income

earners pay no tax on income above that level.– Half of the tax is paid by employers. This is an

added business cost, which is a disincentive to hire.

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Taxes and Inequality• Despite rampant

loopholes, the income tax system ends up being progressive.

• Note that the top 50% earn 88% of income and pay 97% of taxes, while the bottom 50% earn 12% of income and pay 3% of taxes.

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Taxes and Inequality• When state and local taxes are taken into

account, however, the tax system as a whole ends up being nearly proportional.– Proportional tax system: the percentage of income

going to taxes is the same no matter what the income.

• The redistribution process is completed by the government transferring income to favored segments of society. We will look at this in the next chapter.

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What Is Fair?• Everyone has an opinion about how to answer

this question.• Costs of greater equality.– Incentives to work hard are reduced.– The willingness to produce is reduced.– The link between effort and reward is weakened.

• The argument for preserving some inequity is to maintain productivity.

• There is a trade-off between efficiency and equality.

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What Is Fair?• There is a trade-off between efficiency and

equality.• The benefits of greater equality.– Low-income earners might work harder if incomes

were more fairly distributed.– Low incomes subject their earners to poor health,

malnutrition, and inadequate educational opportunities.

– Loopholes distort economic incentives. Simplify the tax code and resources would be more efficiently allocated.