Design of the Tax System

A1 Scar face Capone the notorious 1920s gangster and crime boss, was never convicted for his many violent crimes. Yet eventually he did go to jail – for tax evasion. He had neglected to heed Ben Franklin’s observation that in this world nothing is certain but death and taxes.

When Franklin made this claim in 1789, the average American paid less than 5 per cent of his income in taxes, and that remained true for the next hundred years. Over the course of the 20th century however taxes became ever more important in the life of the typical US citizen. Today all taxes taken together — including personal income taxes, corporate income taxes, payroll taxes, sales taxes and property taxes – use up about a third of the average American’s income. In many European countries, the tax bite is even larger.

Taxes are inevitable because we as citizens expect the government to provide us with various services. The previous two chapters shed light on one of the Ten Principles of Economics. The government can sometimes improve market outcomes. Whether government remedies and externality (such as air pollution) provides a public good (such as national defense) or regulates the use of a common resource (such as fish in a public lake) can raise economic well being. Yet the benefits of government come with costs. For the government to perform these and its many other functions, it needs to raise revenues through taxation.

We began our study of taxation. Where we saw how a tax on a good effects supply and demand for that good. We saw that a tax reduces the quantity sold in a market and we examined how the burden of a tax is shared by buyers and sellers depending on the elasticities of supply and demand. We examined how taxes affect economic well being. We shared taxes cause deadweight losses: The reduction in consumers and producer surplus resulting from a tax, exceeds the revenue raised by the government.

We build on these lessons to discuss the design of a tax system. We begin with a financial overview of the US government. When thinking abut the tax systems, it is good to know some basic facts about how the US government raises and spends money. We then consider the fundamental principles of taxation. Most people agree that taxes should impose as small a cost on society as possible and that the burden of taxes should be distributed fairly. That is to say that the tax systems should be both efficient and equitable. As we will see however, stating these goals is easier than achieving them.

A financial overview of the US government:

How much of the nation’s income does the government take as taxes? Figures show that government revenues including federal state, and local government as a percentage of total income for the US economy. It shows that the role of the government has grown substantially over the past century. In 1902 the government collected 7 per cent of total income, in recent years government has collected about 30 per cent. In other words as the economy‘s income has grown the government’s revenue from taxation has grown even more.

Table compares the tax burden for several major countries as measured by the central government’s tax revenue as a percentage of the nation’s total income. The US is in the middle of the pack. The US tax burden is low compared to many European countries but it is high compared to many other nations around the world. Poor countries such as India and Pakistan usually have relatively low tax burdens. This fact is inconsistent with the evidence in Figure of a growing Tax burden over time. As nation gets richer, the government typically takes a larger share of income in taxes.

The overall size of government tells part of the story. Behind the total dollar figures lie thousands of individual decisions about taxes and spending. To understand the government finances more fully let’s look at how the total breaks down into some broad categories.
Excerpts from Principles of Economics