Economics - Taxation Notes
Why Taxes?
- Taxes are fees collected by federal, state, and local governments
from individuals and businesses for the purpose of benefiting the
economy or society.
- In a mixed economy, taxes are used to pay for the goods and
services provided by the government.
- Nothing is free. If you want lower taxes, you have to expect fewer
goods and services from the government. If you want more from
the government, you have to expect higher taxes.
Criteria for Effective Taxes
- Taxes are effective when they are equitable, simple, and efficient.
A. Equity. Fairness is subjective, but taxes are considered fairer if
they have fewer loopholes, which are exceptions in the tax laws
that let some people escape paying taxes.
B. Simplicity. Tax laws should be easy to understand. Sales tax is
simple; it’s a flat percentage. Individual income tax is
complicated and confusing.
C. Efficiency. They should be easy to administer and successful at
generating revenue.
Two Principles of Taxation
- There are two main theories about how taxes should be administered.
- The benefit principle states that those who benefit from government
goods and services should pay in proportion to the amount of
benefits they receive.
- In other words, the more you use government services, the higher the
percentage of taxes you pay.
- The limitations of this principle are that many government services
provide the greatest benefit to those who can least afford them.
- The ability-to-pay principle is the belief that people should be
taxed according to their ability to pay, regardless of the benefits
they receive.
- The principle is based on the idea that people with higher incomes
suffer less discomfort in paying taxes than people with lower
incomes.
- The U.S. federal income tax system is based on this idea.
Example (don’t copy)
If Stephen Curry pays 50% income taxes on a salary of $100 million annually, he is left with $50 million after taxes.
If a father of two pays 50% income taxes on a salary of $40,000 annually, he is left with $20,000 after taxes.
Steph Curry may not be happy about the taxes, but he can still live a comfortable lifestyle with $50 million per year. The same cannot be said for the father of two who has $20,000 per year.
- We tax high income individuals at higher rates in order to provide
basic necessities for low income individuals.
- This redistribution of wealth creates a social safety net that
theoretically creates a minimum standard of living for all citizens.
- The social safety net refers to welfare programs designed to assist
low-income and elderly Americans, which cover areas such as
food, health care, housing, unemployment, and more.
- Advocates of ability-to-pay taxation argue that those who have
benefited most from the nation’s way of life in the form of higher
incomes and greater wealth can afford and should be obligated to
give back more.
- Critics of progressive taxation argue that it is fundamentally unfair
because they feel it penalizes hard work and success, and reduces
the incentive to make more money.
Types of Taxes
- Three types of taxes exist in the U.S. today.
- A proportional tax, or flat tax, that imposes the same percentage
on everyone, regardless of income. Everyone pays the same %.
- Example: Some state income tax (not California)
For instance, if a tax rate is set at 10 percent, an individual who makes $200,000 a year would pay $20,000 a year in taxes, thereby leaving him/her $180,000 of income. In contrast, a taxpayer who makes $10,000 a year pays $1,000 in taxes, which leaves the person with $9,000 a year to meet all his or her bills. Both are paying 10%, regardless of their income.
- A progressive tax is one that imposes a higher percentage of tax
on people with higher incomes. Higher income pays a higher %.
- It's done to help lower-income families pay for basics like shelter,
food, and transportation. A progressive tax allow them to spend a
larger share of their incomes on cost of living expenses.
- Example: Federal income taxes & most state income taxes
A person making between $85,000 - $163,000 per year pays 24% of that to the federal government. A person making above $518,000 per year pays 37% of that to the federal government.
- A regressive tax is one that imposes a higher percentage on low
incomes than on high incomes. Lower income pays a higher %.
- Example: Sales tax
Regressive Example
Suppose two individuals, Pam and Amy, buy the same computer for $1,000. Both pay 5% in sales tax, which amounts to $50.
Pam makes a monthly income of $5,000, while Amy makes a monthly income of $1,000. In this situation, the $50 sales tax only makes up 1% of Pam’s monthly income, while it’s 5% of Amy’s monthly income.
Economic Impact of Taxes
A. Increased taxes lead to lower consumption of goods.
- For example, a tax placed on a resource that a factory uses to
produce goods (like oil) causes the product to be more expensive
to produce.
- The company responds by raising the retail price of the good.
- Consumers react to the higher price by buying less of the good.
- Firms then cut back on production due to lower sales.
B. Taxes affect consumer behavior.
- Taxes are often used to encourage or discourage consumer behavior.
- For example, a sin tax is a tax that raises money and tries to
prevent consumers from buying harmful products such as soda,
liquor, or tobacco.
- Conversely, a state might give tax rebates (money back) to people
who install solar panels, or donate goods or money to charity.
C. The ability to produce and grow.
- Taxes affect people’s desire to save, invest, consume, and work.
- Why, some people argue, should a person try to earn more
money if much of it will be paid to the government in taxes?
- We know that there is some level of taxes at which productivity
and growth would suffer. This is why many people favor lower
taxes.
Tariff Discussion
A tariff is a tax on imported goods, paid by the importer of the good to their own government. That tax is then passed on to the consumer in the form of higher prices. For example, a Mercedes dealership pays a 25% tariff to the U.S. government to import the automobiles from Germany, who can then raise the prices of cars in order to recoup the tariff.
Since taking office, President Trump has increased tariffs on goods from 60 countries, including a 125% tariff on goods made in China. Why would the government want to increase tariffs on goods from most foreign countries? What would be the pros and cons of doing so for U.S. businesses and consumers?