7.2 IncomeTax and Social Security Tax

The Personal Income Tax

Theamount of income tax a person pays depends on the person’s taxable income, which is totalincome minus a personal exemption and a standard exemption (or otherallowable deductions).

·        Marginal tax rate isthe percentage of an additional dollar of income that is paid in tax.

·        Averagetax rateis the percentageof income that is paid in tax.

·        A progressive tax is atax whose average tax rate increases as income increases. TheU.S.personalincome tax is a progressive tax.

·        A proportional tax is atax whose average tax rate is constant at all income levels.

·        A regressive tax is atax whose average tax rate decreases as income increases.

The Effects of the IncomeTax

·        Tax on Labor Income

·        An income tax decreases the supply of labor and thesupply of labor curve shifts leftward. The wage received by workers falls andthe wage paid by firms rises. The quantity of employment decreases and adeadweight loss is created.

·        Tax on Capital Income

·        The supply of capital is perfectly elastic. Anincome tax decreases the supply of capital and shifts the supply curve upwardby the amount of the tax. The interest rate paid by firms rises by the fullamount of the tax. Firms pay the entire capital income tax. The quantity of capitaldecreases and a deadweight loss is created.

·        Tax on the Income from Land andOther Unique Resources

·        The supply of land and other unique resources isperfectly inelastic. The suppliers pay the entire income tax and demanders paynone of the tax. The quantity does not change and no deadweight loss iscreated.

The Social Security Tax

Thelaw states that social security taxes fall equally on workers and employers.But in actuality the tax incidence depends on the elasticities of the demandfor labor and the supply of labor.

·        The effect of a tax on workersis identical to that of a similarly sized tax on employers: workers receive thesame take-home wage and firms pay the same total wage.

·        If the government taxed only workers, the supply oflabor decreases. The wage rate employers pay increases and the wage rateworkers receive decreases.

·        If the government taxed only employers, the demandfor labor decreases. The wage rate employers pay increases and the wage rateworkers receive decreases.

qLand Mine: ForSocial Security, remind students that this tax is paid by the demanders as well as by suppliers. In this case,the demanders are the firms (and suppliers are workers. Be careful here becausestudents can get confused because this tax is reflected as a “minus,” that is,the new demand curve is labeled as D – tax (the idea is that the tax“subtracts” from the demand for labor).

n 8.3       Fairness and the Big Tradeoff

Twoprinciples of fairness for a tax system have been proposed.

·        The benefits principle is the proposition that people should pay taxes equal to the benefitsthey receive from public goods and services.

·        The ability-to-payprinciple is the proposition that people should paytaxes according to how easily they can bear the burden. The ability-to-payprinciple compares people along two dimensions: vertically and horizontally.

·        Horizontalequityis the requirement that taxpayers with the same ability to pay should pay thesame taxes.

·        Verticalequityis the requirement that taxpayers with a greater ability to pay bear a greatershare of the taxes.

The Marriage Tax Problem

Themarriage tax problem is the issuethat in theUnited Statesa married couple can pay a greater income tax than they would if they remainedsingle.

The Big Tradeoff

Thefairness of taxes can conflict with efficiency questions. For instance, incometaxes imposed on capital have a large deadweight loss but tax a small number ofgenerally very wealthy people. The tax system faces tradeoffs between fairnessand efficiency. Efforts to increase fairness with the tax system will hinderefficiency, while efforts to increase efficiency can conflict with fairness.

If studentsunderstand the basics of taxes, they will become more informed voters. Raise anumber of provocative issues related to taxation to evoke student interest inunderstanding why some goods are taxed and others are not. For instance, askthem why cigarettes are taxed so heavily? Or, why does gasoline face heavytaxes? Ask them if they think the deadweight loss from the cigarette tax islarge? How about from the gasoline tax—is its deadweight loss large or small?Should the government place a tax on fast food or junk food? Why mightprescription drugs, fruits, and vegetables often be exempt from sales tax

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