ECON 369

Lecture Nine:  Tax Analysis – General Theory

Tax Classifications and Tax Incidence

Sources:  Various, including but not only,  Public Finance (Ulbrich) and Public Finance and The American Economy (Bruce). 

What is a tax?

Economist’s definition:  an involuntary payment to the government by an individual or firm that does not entitle the payer to a quid pro quo benefit or to an equivalent value of goods and services in exchange.  Example:  income tax.

Why do taxes exist?

1.

2.

(and let's also include)  3. 

Only governments levy taxes.

To levy a tax:

Tax incidence:

Tax shifting:

User Fee:  A tax is different from a user fee per se.   It is:

Taxes and user fees are polar cases; some payments to the government are a mixture of both tax and user fee.  Example:  lottery tickets.  The price of the ticket includes both the cost of a chance to win plus a tax.  The government sets the price above the expected value of the prize (it can do this because it has no competition – legal barrier to entry).

Closely related is a benefit tax:  an involuntary payment to the government that entitles the taxpayer to a benefit.  Example:  social security tax.  The size of the benefit supposedly depends upon the amount paid.

Classifying Taxes

First Classification:  Who Pays Them:  the oldest and most popular way to classify taxes.

As said:  It is always people (individuals) who pay taxes. 

So this classification is between direct taxes and indirect taxes (which we have seen before).

Direct taxes:  levied on persons who pay the tax.  Example:  income tax. 

Characteristics:

·        Are not anonymous, the tax paid depends upon the personal characteristics of the taxpayers (i.e., the income of the person with respect to the income tax).

·        Also, the tax base (the amount subject to the tax) of a direct tax usually includes the amount of the tax (a tax-inclusive base).  Example:  the income tax is determined by a % of gross income then paid out of that amount.

·        People usually know how much they pay (although there can be fiscal illusion depending upon how the tax is paid and the person paying it)

Indirect taxes:  levied on persons who do not pay the tax (tax is shifted) - sometimes also defined as being levied on goods and services - but be careful, again, only people pay taxes.  Example:  sales taxes.

Characteristics:

·        By their nature, are anonymous, so all taxpayers pay the same amount (or tax rate) of tax (given that they buy a good, for example - regardless of income, etc.).

·        The tax base of an indirect tax usually excludes the amount of the tax (a tax-exclusive base).  Example:  a sales tax is determined by a % of a sale price then added to the sale price (it is not paid out of the sale price).

·        Sometimes “hidden” because they are included in the prices of goods, so the taxpayers may be unaware of the amount of tax they are paying. 

        One of the most hidden taxes is inflation.  In this case the tax is levied on anyone holding cash!

Inflation as a hidden tax:

        a.

        b. 

Again, ultimately it is people who pay taxes, whether they are direct or indirect or levied on persons or "businesses".

This is why most economists prefer to classify taxes according to the economic activity on which the tax is levied.

Second Classification:  Economic Activity – preferred by economists.

With few exceptions, taxes are levied on market activities like incomes and sales. 

Income Tax:

Sales Tax:

    Excise Tax:

Typically, economists will compare any tax with a tax that is NOT levied on economic activity - for example, the head tax; also known as the poll tax or lump-sum tax.

A head tax or lump-sum tax is a fixed amount of money (a lump sum) that the taxpayer must pay to the government regardless of circumstances.  Taxpayers can do nothing to change the amount of tax they pay – so they have no incentives to change their economic behavior in order to reduce the amount of tax paid.  This is why the comparison is interesting - (aside from moving out of the area of the tax or dying).

Remember - with public finance we are looking at how taxes, etc. will change people's behavior in their private lives!

Nearly all taxes levied in the U.S. are levied when the taxpayer engages in an economic activity – so how do these taxes change economic outcomes?

Examples are income and payroll taxes.  Taxes on income are also called factor taxes – because the taxes are levied on the incomes earned by the factors of production in the economy (land, labor, capital and entrepreneurship).

Taxes on economic activities can be selective (levied on a narrow range of economic activities, such as an excise tax levied on a single good) or general (a retail sales tax that is levied on most goods and services purchases by consumers).

Income taxes vary in their degree of selectivity.  The personal income tax is the most general because it covers most forms of income. 

A payroll tax is more selective because it is levied on labor’s earnings only. 

Criteria For Tax/Revenue System Design

Sources:  Public Finance, Holley Ulbrich and the Tax Foundation and Americans for Tax Reform

Major Revenue Sources for Federal (F), State (S) and Local (L) Governments:  there are some exceptions to these but these are generally true.

Criteria for judging a tax:

Five basic areas:

• Equity:  The fairness and neutrality of a tax system - Does your tax system treat people at different income levels, and people at the same income level, fairly?

• Adequacy:  Does the tax system raise enough money, in the short run and the long run, to finance public services?  How does it affect the stability or volatility of tax revenues (from the government's perspective).

• Simplicity:  How complex is the system and how costly is it to comply with it?  Does the tax system allow confusing tax loopholes?  Is it easy to understand how your taxes work?

• Exportability:  Individuals and companies based in other states (sometimes countries) benefit from your state’s public services. Do they pay their fair share?

• Neutrality:  Does the tax system interfere with the investment and spending decisions of businesses and workers?  How does the tax system affect economic activity -  competitiveness and economic growth?

Ask these 11 questions:

1)   Does it make taxes less of a factor in decision-making and reduce social engineering? 

Efficiency:  Minimize economic distortions.

How do the taxes distort individual and business decisions; they distort the economy as well. For example, businesses have an incentive to take on more debt than necessary because interest expenses are deductible, whereas equity financing is not. Individuals may choose tax-free health care benefits over taxable wages, thus causing over-consumption of health care.  The mortgage interest deduction diverts billions of dollars to the housing industry and away from more productive uses, such as investment in ideas and entrepreneurs.

2)   Does it reduce special interest provisions or "loopholes," and minimize the ability of special interests to seek favors?

Equity:

One cost of these preferences is that they dramatically narrow the tax base and require higher rates to raise the same amount of revenues that a simpler system could with lower rates. Secondly, they inject a great deal of unfairness into the tax system as two taxpayers with similar incomes may pay vastly different amounts of tax based on how they have arranged their affairs to match the preferences in the tax code. This gives people the impression that the system can be gamed and does not apply equally to everyone.

Lastly, the more tax preferences there are, the greater the incentives to lobby for more incentives. A clean tax code will reduce the incentives to carve out preferences in the same way that people are less likely to litter when the streets are clean. 

3)    Does it tax everyone's income at the same rate or at different rates?

Equity:

Is a single rate tax system is the fairest system of all?  It treats all Americans equally, no matter their age, occupation, income, or station in life.  Or should people who make more pay more?  What are the general arguments?

4)   Think about - does it lead to double and triple taxation of saving and investment?

If saving and investment is the key to long-term economic growth (Say would say so), a tax code's heavy penalties on saving and investing ultimately harm growth.  Or if demand is the key to long-term economic growth (Keynes would say so), then maybe it doesn't matter.

The current system taxes income multiple times, and often at very high rates.  For example, personal income is taxed once by the income tax, and then a second time on the returns of any saved or invested post-tax income. Similarly, corporate profits are taxed first at the firm level (so owners or workers or even consumers pay), and then a second time when they are distributed as dividends to individuals, or when they are realized as capital gains. Finally, a lifetime of the accumulated savings of a business owner or farmer is taxed a second or third time by the estate tax.

5)   Does it tax business income equally, regardless of organizational form?

Remember - differing tax rates reduce the return to all capital -- and change resource allocation.

6)   Does it reduce complexity and make the tax code easier to understand?

Compliance Costs:

Collection (Administrative) Costs:

Visibility:

According to a recent Tax Foundation study, the "deadweight" costs of the current individual income tax is not inconsequential, amounting to roughly 11 to 15 percent of total income tax revenues. This means that in the course of raising roughly $1 trillion in revenue through the individual income tax, an additional burden of $110 to $150 billion is imposed on taxpayers and the economy.   These are clearly resources that could be put to more productive uses in the economy.  Further, this unnecessary complexity and lack of transparency means most taxpayers do not understand how much they are paying in taxes and how that relates to the services that they receive from government.

7)   Does it improve certainty in the tax code?

People and businesses should be able to make long-term plans without having to worry about large fluctuations in the tax system.  Stability is a key element of an economically sound tax system.

8)   Does it make the economy more competitive and attractive for investment?

Over the past two decades or so, the majority of U.S. major trading partners have been moving toward a fundamentally different model of taxing business income. The basic tenets of this new model are lower tax rates and the exemption of foreign earnings.

9)   Does it promote economic growth rather than redistribution?  Or should redistribution trump economic growth?

Standard economic theory and a great body of evidence indicate there is a tradeoff between economic growth and the redistribution of income. This means that the more we try to make an income tax system progressive, the more we undermine the factors that contribute most to economic growth: investment, risk-taking, entrepreneurship, and productivity. This is because high-income earners tend to do much of the saving, investing, risk-taking, and high-productivity labor.  In simple terms, the more you tax something, the less you get of it, so taxing high-income earners reduces all the key factors in job creation and economic growth.

10)  Does it improve the stability of revenues?

Whatever the size of government, the ideal tax system should do one thing only: raise a sufficient amount of revenue to fund government activities with the least amount of harm to the economy. As Jean Baptiste Colbert famously wrote, "The art of taxation consists in so plucking the goose as to obtain the largest amount of feathers with the least amount of hissing." (OK, bad analogy).

Thus, a fiscally sound tax system should have a broad base that is not restricted to volatile sources of income.

Adequacy:

Sensitivity to Growth and Inflation:

    a. Population growth

    b. Income growth

    c. Inflation

And I am going to add 11 (from Buchanan):

Buchanan's Bridge (or GAP)

Institutions matter!  "The fiscal process appears to embody a double choice:  one a choice or decision as to the size of the public spending program and the other a choice or decision on the rates of taxation.  Clearly, the institutional setting that allows this apparent splitting of the fiscal decision into twp parts can influence the outcome of decision."

In other words -- if there is a large "gap" between an individual's decision regarding government's provision of a good or service and the cost of that good or service -- we will get different results than we would if the gap was smaller (or non-existent).  The degree to which an individual senses the underlying real interdependence will depend partially upon the institutions through which fiscal choices are made.

Remember the Violence of Faction:  If the spending decision is completely separated from the tax decision (when, for example, the tax institutions are set up such that one group pays the taxes while another group receives the benefits) - the individual will "vote for" an expansion in outlay to the point at which his own marginal evaluation of the good or service becomes zero (due to diminishing marginal utility).

This will lead to public services provided beyond the level which fully informed consideration of alternatives would produce.  Conversely, in so far as the tax decision fails to incorporate the benefit side, total revenues will fall short of the amount needed to finance that level of public services that an informed consideration of alternatives would provide.

Therefore, might we add to our criteria for a tax -- that the institutions reduce (or eliminate) gap between the tax decision and the spending decision as much as possible.

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Tax Incidence

Tax incidence: 

Very important, but difficult to answer.

As we have discussed, due to tax shifting, the individual who pays the tax to the government does not necessarily bear the burden of the tax.

Examples we have discussed:  The CFO of a corporation may sign the check to the IRS for corporate income taxes, but he or she does not bear the burden of the tax.  Or the property tax on an apartment building may be borne, in the form of higher rents, by the people renting the apartment rather than by the owner who pays the tax to the city.

Different Measures of Tax Incidence

Because of its complexity, and political implications – there’s a lot of disagreement about how to measure tax incidence.

Statutory Versus Economic Incidence

Statutory incidence of a tax describes its incidence solely in terms of the taxes actually paid by different groups.  If no taxes are paid, no tax burden is incurred.

But once the tax is levied, public finance economists are interested in the economic incidence of the tax, which takes into account not only the taxes paid by different groups in the economy, but also the effect on real incomes caused by changes in wages and prices when the tax is levied.  A group’s real income is its money income adjusted for changes in the cost of living (prices).

A tax not only moves income from people to the government, it can change people’s behavior, resulting in resource allocation changes – which in turn can change the economic performance of a country.

Economic incidence is difficult to analyze:  we need an economic theory of how prices and rewards are affected by the tax - and how people will behave due to these changes.  This involves assumptions – and the outcome of the theory will rest upon the assumptions made.  It is often difficult to get empirical data as well.

But we can go back to our old friend:  The Model

Tax Rules                    Incentives                              Actions                               Outcomes

For example: 

Rule:  Progressive tax system (marginal dollars are taxed at higher rates)

Incentive:  Increases the cost of working more - incentive to work decreases

Action:  Work Less

Outcome:  Drop in productivity

But arbitrary assumptions are often made about tax shifting and also about incentives so we have to be careful.

 Absolute and Differential Incidence

To identify the distribution of a tax burden, we need to specify an alternative to the tax.  For example, to conclude that owners of capital bear the burden of the corporate income tax begs the question:  “Compared to what?”  Compared with no tax at all, or compared with some other tax?

Absolute tax incidence determines the incidence of a tax assuming that no other tax would be levied in its absence.  The assumption is that without the tax the government collects less revenue, so various groups in the economy bear smaller tax burdens.

Differential tax incidence determines the incidence of a tax on the assumption that a benchmark alternative tax is levied in its place.  The alternative tax being hypothetical, such as a head tax.  In other words, we compare two different tax rules.

We will be doing differential tax incidence analysis most of the time.

It allows us to analyze the burden of a tax separately from how the revenue is spent (which we take up later).

To determine the absolute incidence on different groups (especially when speaking of "burden"), we would also have to consider how each group is affected by government spending.  When most tax money goes into a general fund, it is difficult to determine this.

    In other words - Bob pays $50 in tax (statutory incidence) - but he then receives $20 of it back in government spending.  So what is his real burden? 

With differential incidence it is usually assumed that the same amount of revenue is collected (although this isn’t always true) regardless of the type of tax – it is just who pays the tax that changes.

The People Who Bear The Tax Burden

Remember:   Only people – not goods or organizations – can bear the burden of a tax.

Typically economists examine tax burdens on identifiable groups of people.  People are grouped according to some relevant characteristic such as their income, where they live, or how old they are.

Tax Incidence by Income Group

Because of what many people believe about “equity” –  they believe people should bear taxes in accordance with their ability to pay.  Since ability to pay is commonly measured by income, most incidence analysis focuses on incidence by income group.

The income incidence of the tax:  the distribution of a tax burden across people grouped according to their incomes.

Progressive:  The statutory incidence of a tax is described as progressive if:

Note:  progressive does not simply mean that people with more income pay more taxes.  It means that people with more income pay a higher percentage of their income in taxes.

Example:  The U.S. Income Tax

http://www.forbes.com/sites/kellyphillipserb/2014/10/30/irs-announces-2015-tax-brackets-standard-deduction-amounts-and-more/#164b59526f71

Regressive:  The incidence is described as regressive if:

Example:  Sales tax

Proportional or Flat: The incidence is described as proportional or flat if:

Example:  Colorado State Income Tax

http://taxfoundation.org/article/state-individual-income-tax-rates-and-brackets-2015

Question:  Taxpayer A makes $25,000 and pays $5,000 in taxes.

Taxpayer B makes $50,000 and pays $10,000 in taxes.  Taxpayer B pays more taxes.  Is this progressive, regressive or proportional with respect to incidence?

A:  5,000/25,000 = .20 = 20%

B:  10,000/50,000 = .20 = 20%

Both pay 20% -- it is proportional even though taxpayer B pays more taxes.

Stats on taxes by income:

Looking at individual income tax, social insurance (FICA) tax, corporate income tax and excise taxes – only excise taxes are regressive with respect to incidence.  This is because the amount of tax paid by a family depends on the amount it spends on the taxed goods. 

High-income families tend to spend a smaller fraction of their pre-tax income than low-income families overall (high income families save a fraction of their income), so the excise tax is regressive.

The income incidence of all federal taxes combined is progressive.

When just looking at the federal income tax:

http://www.ntu.org/tax-basics/who-pays-income-taxes.html

http://www.wsj.com/articles/top-20-of-earners-pay-84-of-income-tax-1428674384

Tax Incidence by Other Household Groupings

Regional Incidence:  when households are grouped according to where they live.

Examples:  People in the West and South bear a larger fraction of the gasoline excise tax because they drive more, and people living in the Northeast would bear a larger fraction of excise taxes on natural gas and fuel oil because their winters are colder.

Generational Incidence:  the incidence of a tax across people of different generations.  A person’s generation is defined by birth date. 

The lifetime burden of a tax on a person or group of people is equal to the present value of taxes paid over the lifetime, which is the sum of the discounted values of the future annual tax burdens. 

Taxes paid later in a person’s life cause a smaller burden per dollar than taxes paid earlier in life – they could have invested taxes paid earlier in life and earned interest on the balance.

Generational incidence measures the distribution of lifetime tax burdens across different generations.  That is, will one generation pay more over their lifetime than another?

This has become more interesting to economists because of the large and persistent federal budget deficits – which many people believe shift the burden of taxes to future generations.

One famous study (Auerbach, Gokhale and Kotlikoff) says that people born after 1995 (the IPOD generation?) will have a net tax rate of 49.2 percent.  This is because the current fiscal policy is “not sustainable” – present taxes are not high enough to fund government spending, interest payments on the debt, social security, Medicare, and other transfer programs at current levels over the long run.

But it depends upon assumptions made.

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