Tax code is full of special interest legislation, value judgments, incentives and disincentives. Declining to levy a tax is a judgment too and is effectively the government spending money by not taking any in.
Efficiency and Fairness –who should pay?
Neutrality – the more a tax changes behavior, the less efficient it is. No effect on behavior means it’s neutral. A head-tax would be neutral.
Income taxes affect leisure time.
Consumption taxes affect spending.
Elasticity determines the degree to which tax affects behavior. High response/high elasticity.
Income effect – when people work more to have same amount of money as if there were no tax.
Substitution effect – substitute leisure time for work so as to pay less tax. The two effects offset each other, which predominates depends on elasticity, income and tax level (from Econ 1).
Incidence – who bears burden of the tax? Important for determining fairness.
Example, government could levy consumption tax on consumers or on retailers, who would pass tax on in form of higher prices.
Often hard to determine who is bearing what share of burden. Corporate income tax – do shareholders, employees or consumers bear burden?
Capitalization – market can shift burden of tax by affecting price.
If annual real property tax introduced, current owner will pay tax but also bear burden of subsequent purchases (reflected in purchase price). Taxes get built into price of an item and changing rules can adversely affect owners.
If value falls by present value of all future liability, tax is fully capitalized into the purchase price and current owner bears whole burden.
Mechanism by which market responds to different tax treatments of identical transactions.
Tax free bond will be bid up in price until after-tax returns are equal on taxed and tax-free equivalent bonds.
Tax and tax-free bond, each paying 10% interest. At 40% tax rate, price of tax-free bond will rise until return is 6%.
Repealing tax preferences that have been capitalized will penalize purchases who were relying on tax favorable treatment. If Congress repealed mortgage deduction, value of owner-occupied housing would plummet b/c prices reflect tax-favorability.
Tax often reduces individual welfare more than it increases public welfare, creating deadweight losses.
Hidden cost in any tax of changes in behavior of people avoiding the tax. People who choose not to buy oranges because of price + tax lose out on enjoying the orange without paying anything to public coffers.
At extreme, tax can create only deadweight loss by making everyone choose a non-taxable activity over the taxed one.
Sometimes, government taxes things specifically to discourage purchase (cigarettes).
Theories of Distributive Justice – should system be based on ability to pay (income)? Standard of living (consumption)?
Utilitarianism – dominant, perhaps still. Maximizes “utility” – happiness, preference satisfaction, what have you. “Greatest good for the greatest number.”
Declining marginal utility of income – people derive less utility from each dollar as they have more dollars. Theoretical justification for progressivity.
Progressivity – taxpayers pay a greater proportion in tax as the tax base increases. Proportionate tax – same rate even as base varies. Regressive tax – percentage of base paid in tax decreases as base increases.
Graduated rates in §1 of tax code is one way of achieving progressivity.
Can also be achieved through flat tax + exemption or demogrant (uniform payment from government).
Critics question any one of the above premises. see pp13-14.
Vertical Equity – differences in tax burdens on people in different economic situations.
Horizontal Equity – subset of vertical. People who are the “same” according to whatever theory of distributive justice should pay the same amount of tax.