|Distribution of Income
this creates a potential tradeoff between the goal of equity and the
goal of efficiency
|What Is “Income”?
- Personal Income
- income received by households before payment of personal
- personal income is not a complete measure of income
- In-kind income
- Goods and services received directly, without payment in
a market transaction.
- the market value of assets.
- wealth represents a stock of potential purchasing power
|The Size Distribution of Income
- Size distribution of income
- the way total personal income is divided up among
households or income classes.
- Income share
- the proportion of total income received by a particular
- The Lorenz Curve
- a graphic illustration of the cumulative size
of income; contrasts complete equality with the actual distribution of
- the greater the area between the Lorenz curve and the
diagonal, the more inequality exists.
- Gini Coefficient
- the ratio of the shaded area of the Lorenz curve compared
to the area of the triangle formed by the diagonal
- a mathematical summary of inequality based on the
|The Federal Income Tax
- The federal income tax is designed to be progressive
- progressivity is achieved by imposing increasing marginal
tax rates on higher incomes
- Efficiency Concerns
- although the redistributive intent of a progressive tax
system is evident, it raises concerns about efficiency.
- the incentive to work more, produce more, or invest more
is reduced by high marginal tax rates.
- Tax Elasticity
- How great the conflict is between the equity and
depends on how responsive market participants are to higher tax rates
- the percentage change in quantity supplied divided by the
percentage change in tax rates
- if the tax elasticity of supply were zero, there would be
no conflict between equity and efficiency
- Equity Concerns
- how well does the federal income tax promote equity
- what appears to be a progressive tax structure in theory
turns out to be a lot less progressive in practice
- the progressive tax rates described in the tax code
apply to “taxable” income, not to all income
- the purpose of itemized deductions, such as dependent
old age, home mortgage interest, etc., is to encourage specific
activities and reduce potential hardships
- these exemptions create potential inequities
- Vertical Equity – principle that people with higher
incomes should pay more taxes
- Horizontal Equity – principle that people with equal
incomes should pay equal taxes
- Nominal vs. Effective Tax Rates
- the loopholes created by exemptions, deductions, and
credits create a distinction between gross economic income and taxable
- This distinction, in turn, requires us to distinguish
between nominal tax rates and effective tax rates
- Nominal tax rate = taxes paid divided by taxable income
- Effective tax rate = taxes paid divided by total income
- the gap between the nominal tax rate and the effective
rate is a reflection of loopholes in the tax code, it is also the
of vertical and horizontal inequities
- Tax-Induced Misallocations
- tax loopholes not only foster inequity but encourage
inefficiency as well
- tax preferences induce resource shifts into
- A Shrinking Tax Base
- as deductions, exemptions, and credits accumulate, the
tax base shrinks
|The 1986 Tax Reform Act
- The basic features of the Tax Reform Act (TRA) of 1986
- Loophole closing.
- Reductions in marginal tax rates.
- Fewer tax brackets.
- Tax relief for the poor.
- A shift from personal to corporate taxes.
- the elimination or reduction of scores of tax preferences
increased the tax base by almost 25 percent.
- by broadening the tax base, the TRA made it possible to
reduce tax rates.
- the TRA increased the progressivity of the federal income
|What Is “Fair”?
- To many people, the apparent ineffectiveness of the
to redistribute income more strikingly is a mark of government failure.
- The Costs of Greater Equality
The Benefits of Greater Equality
- the greatest potential cost of a move toward greater
equality is the reduce incentives it might leave in its wake.
- the essential economic problem that absolute income
equality poses is that it breaks the market link between effort and
- the argument for preserving income inequalities is thus
anchored in a concern for productivity.
- although the potential benefits of inequality are
impressive, there is a tradeoff between efficiency and equality.
- the first economic argument for greater equality is that
present degree of inequality is more than necessary to maintain work
- the second argument is that low-income earners might
actually work harder if incomes were distributed more fairly.
- finally, if greater equality was achieved via tax
simplification, a more efficient allocation of resources might result.
|A Flat Tax?
- The key features of a flat tax include:
- replacing the current system of multiple tax brackets and
rates with a single tax rate that would apply to all taxable income.
- eliminating all deductions, credits and most exemptions.
- a major attraction of the flat tax is its simplicity.
- the current 1400-page tax code that details all the
of the present system would be scrapped and all 437 IRS tax forms would
replaced by a single postcard-sized form.
- by scrapping all the deductions, the flat tax would treat
everyone equally and eliminate horizontal and vertical inequities.
- some progressivity could also be preserved with a flat
tax by offering personal exemptions.
- proponents of a flat tax claim it enhances efficiency as
well as equity.
- with a simplified flat tax, all the labor resources used
to prepare tax returns could be put to uses that are more productive.
- as proposed by Dick Armey, the flat tax would not apply
all income. Income on savings and investments would not be taxed
that saving, investment and economic growth is encouraged.
- this proposal creates vertical and horizontal
Someone receiving $1 million in interest and dividends could escape all
taxes, while a family earning $50,000 would have to pay.
- the transition to a flat tax would entail a wholesale
reshuffling of wealth and income.