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Public Finance: The Economics of Taxation
(Part A)
by
Charles Lamson
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The previous posts have analyzed the potential role of government in the economy. Together, those posts discuss much of the field of public economics. In the next several posts we make the transition to public finance. No matter what functions we end up assigning to government, to do anything at all government must first raise revenues. The primary vehicle that the government uses to finance itself is taxation.
Taxes may be imposed on transactions, institutions, property, meals, and other things, but in the final analysis they are paid by individuals or households. The Economics of Taxation Taxes: Basic Concepts To begin our analysis of the U.S. tax system, we need to clarify some terms. There are many kinds of taxes, and tax analysts use a specific language to describe them. Every tax has two parts: a base and a rate structure. The tax base is the measure or value upon which the tax is levied. In the United States, taxes are levied on a variety of bases, including income, sales, property, and corporate profits. The tax rate structure determines the portion of the tax base that must be paid in taxes. A tax rate of 25 percent on income, for example, means that I pay a tax equal to 25 percent of my income. Taxes on Stocks versus Taxes on Flows Tax bases may be either stock measures or flow measures. The local property tax is a tax on the value of residential, commercial, or industrial property. A homeowner, for instance, is taxed on the current assessed value of his or her home. Current value is stock variable---that is, it is measured or estimated at a point in time.  Other taxes are levied on flows. Income is a flow. Most people are paid on a monthly basis, and they have taxes taken out every month. Retail sales take place continuously, and a retail sales tax takes a portion of that flow. Figure 1 diagrams in simple form the important continuous payment flows between households and firms and the points at which the government levies 6 different taxes.  Proportional, Progressive, and Regressive Taxes All taxes are ultimately paid out of income. A tax whose burden is a constant proportion of income for all households is a proportional tax. A tax of 20 percent on all forms of income, with no deductions or exclusions, is a proportional tax. A tax that exacts a higher proportion of income from higher-income households than from lower-income households is a progressive tax. Because its rate structure increases with income, the U.S. individual income tax is a progressive tax. Under current law, a family with a taxable income of under $14,101 would pay a tax of 10 percent, while a family with an income of $100,000 would pay about 24 percent (https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets).  A tax that exacts a lower proportion of income from higher-income families than from lower-income families is a regressive tax. Excise taxes (taxes on specific commodities such as gasoline or telephone calls) are regressive. The retail sales tax is also a regressive tax. Suppose the retail sales tax in your state is 5 percent. You might assume it is a proportional tax because everyone pays 5 percent. But all people do not spend the same fraction of their income on taxable goods and services. In fact, higher income households save a larger fraction of their incomes. Even though they spend more on expensive things and may pay more taxes in dollars than lower-income families, they end up paying a smaller proportion of their incomes in sales tax. Table 2 shows this principle at work in three families. The lowest-income family saves 20 percent of its $10,000 income, leaving $8,000 for consumption. With a hypothetical 5 percent sales tax, the household pays $400, or 4 percent of total income, in tax. The $50,000 family saves 50 percent of its income, or $25,000, leaving $25,000 for consumption. With the 5 percent sales tax, the household pays $1,250, only 2.5 percent of its total income, in tax.  Marginal versus Average Tax Rates When discussing specific tax or taxes in general, we should distinguish between average tax rate and marginal tax rates. Your average tax rate is the total amount of tax you pay divided by your total income. If you earned a total income of $15,000 and paid income taxes of $1,500, your average income tax rate would be 10 percent ($1,500 / $15,000). If you pay $3,000 in taxes, your average rate would be 20 percent ($3,000 / $15,000). Your marginal tax rate is the tax rate you pay on any additional income you earn. If you take a part-time job and pay an additional $280 in tax on the extra $1,000 you've earned, your marginal tax rate is 28 percent ($280 / $1,000). Marginal and average tax rates are usually different. The U.S. individual income tax shows how and why marginal tax rates can differ. Each year, you must file a tax return with the Internal Revenue Service on or before April 15th. On that form you first figure out the total tax you are responsible for paying. Next, you determine how much was withheld from your income and sent to the IRS by your employer. If too much was withheld, you get a refund; If not enough; you have to write a check to the government for the difference.  In figuring out the total amount of tax you must pay, you first add up all your income. You are then allowed to subtract certain items from it. Among the things that virtually all taxpayers can subtract are the personal exemption and the standard deduction. However, the personal exemption remains at 0, as it was for 2020: This elimination of the personal exemption was a provision in the Tax Cuts and Jobs Act (irs.gov). After everything is subtracted, you are left with taxable income. Taxable income is then subject to a set of marginal rates that rise with income. Table 3 presents the marginal individual income tax rates for 2021. TABLE 3 Individual Income Tax Rates, 2021  Suppose you are a single taxpayer who earned $80,000 in 2021. During 2021 you had tax withheld by your employer. By April 15th, 2022, you must file a return to see if your employer withheld too much or too little. Rushing to meet the deadline, you must do the following calculations, which are summarized in Table 4.  First, you take your total income, $80,000, and subtract the personal exemption and the standard deduction [$12,500 (wsj.com)], leaving "taxable income" of $67,450. To figure the tax, three separate calculations are involved. The first $9,875 is taxed at 10 percent (see Table 3). The tax on this amount is simply .10 * $9,875, or $987.50. The second "slice" of income, between $9,875 and $40,125, is taxed at 12 percent. The difference between $40,125 and $9,875 is $30,250. The tax on this amount of .12 * $30,250, or $3,630. Finally, the last "slice" of income, from $40,125 up to $67,450 or $27,325, is taxed at 22 percent. The tax on this amount is .22 * $27,325, or $6,011.55. Thus, the total tax due is $987.50 + $3,630 + $6,011.55 = $10,629.05. You now check to see if the amount withheld by your employer was too little or too much. If you paid too much, you get a refund; if you did not pay enough, you must send Uncle Sam a check for the shortfall by April 15th!  You can now see the difference between average and marginal tax rates. Your average rate in 2021 is $10,629.05 as a percentage of $80,000 or 13.3%. But note that any additional income that you might have earned up to $85,525 would be taxed at 22% because it is simply more income over $67,450. Marginal tax rates influence behavior. Decisions about how much to work depend on how much of the added income you get to take home. Similarly, a firm's decision about how much to invest depends in part on the additional, or marginal profits that the investment project would yield after tax. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 353-356* end |
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