Distribution of Income
Taxes Affect
  1. production
  2. distribution
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 taxes.
    • personal income is not a complete measure of income
  • In-kind income
    • Goods and services received directly, without payment in a market transaction.
  • Wealth
    • 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 group
  • The Lorenz Curve
    • a graphic illustration of the cumulative size distribution of income; contrasts complete equality with the actual distribution of income
    • 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 Lorenz curve
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 efficiency 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 
    • Loopholes 
      • 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 children, old age, home mortgage interest, etc., is to encourage specific economic 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 tax credits create a distinction between gross economic income and taxable income
      • 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 tax rate is a reflection of loopholes in the tax code, it is also the source 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 tax-preferred activities
    • 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 included:
    1. Loophole closing.
    2. Reductions in marginal tax rates.
    3. Fewer tax brackets.
    4. Tax relief for the poor.
    5. A shift from personal to corporate taxes.
  • Base Broadening
    • the elimination or reduction of scores of tax preferences increased the tax base by almost 25 percent.
  • Rate Reductions
    • by broadening the tax base, the TRA made it possible to reduce tax rates.
    • the TRA increased the progressivity of the federal income tax.
What Is “Fair”?
  • To many people, the apparent ineffectiveness of the tax-transfer-system to redistribute income more strikingly is a mark of government failure.
  • The Costs of Greater Equality
    1. the greatest potential cost of a move toward greater equality is the reduce incentives it might leave in its wake.
    2. the essential economic problem that absolute income equality poses is that it breaks the market link between effort and reward.
    3. the argument for preserving income inequalities is thus anchored in a concern for productivity.
  • The Benefits of Greater Equality
    1. although the potential benefits of inequality are impressive, there is a tradeoff between efficiency and equality.
    2. the first economic argument for greater equality is that the present degree of inequality is more than necessary to maintain work incentives.
    3. the second argument is that low-income earners might actually work harder if incomes were distributed more fairly.
    4. 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:
    1. replacing the current system of multiple tax brackets and rates with a single tax rate that would apply to all taxable income.
    2. eliminating all deductions, credits and most exemptions.
  • Simplicity
    • a major attraction of the flat tax is its simplicity.
    • the current 1400-page tax code that details all the provisions of the present system would be scrapped and all 437 IRS tax forms would be replaced by a single postcard-sized form.
  • Fairness
    1. by scrapping all the deductions, the flat tax would treat everyone equally and eliminate horizontal and vertical inequities.
    2. some progressivity could also be preserved with a flat tax by offering personal exemptions.
  • Efficiency
    1. proponents of a flat tax claim it enhances efficiency as well as equity.
    2. with a simplified flat tax, all the labor resources used to prepare tax returns could be put to uses that are more productive.
  • The Critique
    1. as proposed by Dick Armey, the flat tax would not apply to all income.  Income on savings and investments would not be taxed so that saving, investment and economic growth is encouraged.
    2. this proposal creates vertical and horizontal inequities.  Someone receiving $1 million in interest and dividends could escape all income taxes, while a family earning $50,000 would have to pay.
    3. the transition to a flat tax would entail a wholesale reshuffling of wealth and income.

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this page is maintained by Reed Fisher
last updated January 15, 2011