Figure 10.1 a Proportional Tax Rate Structure

Chapter 10

Introduction to Government Finance

ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0-03-033652-X Copyright © 2002 by Thomson Learning, Inc. Federal, State, and Local Revenue ▪$2.5 trillion ▪ Sources: ▪ Taxes: ▪ Payroll ▪ Income (Corporate and Personal) ▪ Property ▪ Sales and Excise ▪ Estate ▪ Tariffs ▪ Fees ▪ Tuition ▪ Licenses

▪ Political Equilibrium ▪ Market Equilibrium and Its Efficiency ▪ The Distribution of Income

▪ Taxes are compulsory payments to government

▪ Tax Base ▪ The item or the activity that is to be taxed. ▪ Tax Rate Structure ▪ The relationship between the amount that is to be paid in tax and the tax base for a given accounting period. ▪ Marginal Tax Rate ▪ The amount by which the tax increases when the tax base increases.

▪ Average Tax Rate ▪ The total amount of tax divided by the total amount of the tax base.

▪ Tax bracket ▪ The range of the tax base in which the marginal rate is constant.

Copyright © 2002 by Thomson Learning, Inc. Descriptors of the Tax Rate Structure ▪ A Progressive Tax has a structure where the marginal tax rate is increasing and greater than the average tax rate. ▪ A Proportional Tax has a structure where the marginal tax rate is constant and equal to the average tax rate. ▪ A Regressive Tax has a structure where the marginal tax rate is decreasing and less than the average tax rate.

ATR = MTR

t Tax Rate (Percent) (Percent) Rate Tax

0 Tax Base (Dollars per Year)

MTR 35 ATR 25

15 Tax Rate (Percent) (Percent) Rate Tax

0 4,000 29,000 70,000 Tax Base (Dollars of Taxable Income per Year)

15.30

12.35

0 ATR

Average Tax Rates

Tax Brackets Marginal Tax Beginning End of (Taxable Income) Rates (MTR) of Bracket Bracket 0-$4,000 0 0 0 $4000-$29,000 15 0 11

$29,000-$70,000 25 13 20 Above $70,000 35 20 34*

10 Tax Revenues as a Percent of GDP GDP of aRevenuesPercent as Tax

Italy Italy

Spain

Japan Japan Korea

Turkey Turkey

Ireland

France Austria Poland

Iceland Mexico

Finland

Greece

Norway Norway

Canada

Belgium Sweden Sweden

Portugal

Hungary *

Australia

Denmark *

Germany Germany

Switzerland

Netherlands

Luxembourg

New New Zealand

UnitedStates

* *

CzechRepublic UnitedKingdom

Copyright © 2002 by Thomson Learning, Inc. How Should the Burden of Government Be Financed ▪ Benefit Principle ▪ Those that benefit the most from a particular program should pay the most for that program (Lindahl Tax principle at work). ▪ Ability-to-Pay Principle ▪ Those who have the greatest ability to pay should be required to pay the most.

Copyright © 2002 by Thomson Learning, Inc. Criteria for Evaluating Alternative Methods of Government Finance ▪ Equity ▪ The distribution of the burden of government finance should coincide with commonly held notions of fairness and ability-to-pay. ▪ Efficiency ▪ The system of government finance should raise revenues with only a minimal loss in efficiency in the private sector. ▪ Administrative ease ▪ A government finance system should be relatively easy to administer in a consistent manner without excessive costs to collect, enforce, and comply with taxes and tax laws. Copyright © 2002 by Thomson Learning, Inc. Tax Compliance and Evasion

▪ Tax Evasion is the term for illegal ways of avoiding paying taxes. It is typically the result of not declaring income or overstating otherwise legal deductions. ▪ Tax Avoidance is the term for the legal ways of avoiding paying taxes, typically the result of avoiding activities that are taxed, delaying the time in which taxes are owed, or taking an action designed to lower a tax burden.

A B

MC MC

E E

E 1 Cost Cost and Benefit Cost Cost and Benefit 2

MB1 = MTR1 MB = MTR MB2 0 D* 0 D* D* 2 1 Unreported Income per Year (Dollars) Unreported Income per Year (Dollars)

C MC2 MC1

E1 Cost Cost and Benefit

MB = MTR

0 D* D* 2 1 Unreported Income per Year (Dollars)

▪ Debt Finance is the means of financing expenditures through the issuing of bonds. ▪ Inflationary Finance is the means of financing expenditures through the printing of money.

T C I G2

G1 Guns per Year Year perGuns

0 B2 B1 T' Butter per Year Copyright © 2002 by Thomson Learning, Inc. More alternatives to Taxation ▪ Donations ▪ Money (but more usually time) is voluntarily given to government. Military service or work in the Peace Corps can be considered a donation when the compensation is less than the market value of the time. ▪ User Charges ▪ Payments by users of the government service can be expected. Examples include tuition, fees paid to enter state parks, greens fees at publicly owned golf courses. ▪ Earmarked Taxes ▪ Taxes can be implemented to fund specific public goods. Examples include gasoline taxes and tolls designed to fund road and bridge repair.

MSC

Z* C* + S*

S* C*

Z MSB = MPB + MEB Charges MPB

D2 = MSB2 MSC D1 = MSB1 E* 20

E1 N* E2 0 80 100 120 150

User Charges (Cents per Mile) User (CentsCharges Vehicles per Mile per Hour

▪ Local Utilities ▪ Lotteries

▪ Roads and Bridges wear out when too much weight is concentrated on too few axles. ▪ Tolls motivate the wrong behavior in that they tax per axle rather than on pounds per axle. ▪ Estimates suggest that taxing pounds per axle and using the revenue to repair roads to a greater strength would pay for itself more than eight-fold.

▪ State Lotteries account for more than 3% of state revenues. ▪ Evidence suggests that the lottery system is a regressive means of creating government revenue.