ECONOMICS TOPIC 8 LESSON 1

ECONOMICS TOPIC 8 LESSON 1

UNDERSTANDING TAXES

ESSENTIAL QUESTION

Can and should the government be fair to everyone?

OBJECTIVES

Identify the sources of the government’s authority to tax in the U.S. Constitution.

Describe types of tax bases and tax structures.

Identify who bears the burden of a tax.

Describe the key characteristics of a tax.

The Importance of National Taxes

A tax is a required payment to a local, state, or national government. The federal government and most state governments levy taxes on personal income. 

The Importance of National Taxes

The Impact of Taxation

Looking at all of the taxes taken from your paycheck can be discouraging. You worked hard for that money, and now it is being taken away. Similar feelings of frustration over taxes helped persuade American colonists to declare their independence from Britain.

The Importance of National Taxes

taxation is the primary way that the government collects money. Taxes give the government the money it needs to operate. The income received by a government from taxes and other nontax sources is called revenue.

The Power to Tax

Taxation is a powerful tool. The founders of the United States thought long and hard before giving this tool to their new national government. The Constitution they created assigned each branch of the government certain powers and responsibilities. The powers of the legislative branch—Congress—appear in Article I, Section 8. The very first clause in this section grants Congress the power to tax.

Limits on the Power to Tax

The Constitution also spells out specific limits on the government’s power to tax. Two of those limits are in the taxation clause. First, the purpose of a tax must be “to pay the debts and provide for the common defense and general welfare of the United States.” 

Limits on the Power to Tax

Second, federal taxes must be the same in every state. 

Open Ended

Analyze Political Cartoons What does this cartoon’s caption suggest about the effect of taxes on a million-dollar windfall?

Limits on the Power to Tax

Another clause of the Constitution prohibits taxing exports—goods sent out of the United States to foreign customers. The government can collect taxes only on imports—goods brought into the United States.

Limits on the Power to Tax

Yet another clause of the Constitution (Article 1, Section 9, Clause 4) prohibits Congress from levying a capitation, or “head,” tax, which is a tax to be paid by every single person. This same clause also prohibited direct taxes unless they were divided among the states according to population.

Limits on the Power to Tax

A direct tax is one paid directly by a taxpayer to the government rather than indirectly—say, to a shopkeeper who later sends the money to the government. But, the Sixteenth Amendment legalized a direct tax on citizens’ personal income. This income-tax amendment was ratified in 1913.

Multiple Choice

Identify Main Ideas According to the Constitution, for what purpose can government collect taxes?

• to pay the nation’s debts and provide for its defense and welfare

• to discourage exports and promote imports

• to ensure religious freedom for all citizens

• to establish the nation’s gross domestic product

Tax Structures and Tax Bases

Progressive Taxes

A progressive tax is a tax for which the percentage of income paid in taxes increases as income increases. 

Open Ended

The progressive structure shown here is similar—but not identical—to the federal income tax. Analyze Graphs What percentage of total income does each earner shown on this graph pay?

Proportional Taxes

A proportional tax is a tax for which the percentage of income paid in taxes remains the same at all income levels.. 

Regressive Taxes

A regressive tax is a tax for which the percentage of income paid in taxes decreases as income increases. The sales tax levied on the sale of goods and services in many states is generally regressive—even though the sales tax rate remains constant. This is because higher-income households typically spend a lower proportion of their incomes on the goods and services that are taxable under a sales tax.

Tax Bases

A tax base is the income, property, good, or service that is subject to a tax. Different taxes have different bases. The individual income tax is based on a person’s earnings. The corporate income tax uses a company’s profits as its base. The property tax is based on real estate and other property. 

Multiple Choice

Recall What is the tax structure of the federal individual income tax?

• regressive

• proportional

• flat

• progressive

The Tax Burden

It is important to think about who actually bears the burden of a tax. This is not necessarily the person who sends in the money to pay the tax bill. How can we know who is actually bearing the burden of a tax? The answer lies in supply-and-demand analysis.

The Tax Burden

For the purpose of this analysis, consider this example: Suppose the government imposes a gasoline tax of $.50 per gallon and collects the tax from service stations. You may think the burden of the tax falls only on the service stations, because they send the tax money to the government. But you will see that this is not always the case.

The Tax Burden

the original supply curve (in green) and a supply curve after the $.50 tax is imposed (in blue). You see that before the tax, the market was at equilibrium, and gas cost $1.00 per gallon. The new supply curve reflects the fact that when a tax is imposed on a good, the cost of supplying the good increases. Quantity supplied will decrease at every price level.

The Tax Burden

Notice the steep demand curve . This is what you would see if demand for gas were inelastic—that is, if consumers bought about the same amount no matter what the price. 

The Tax Burden

In contrast, if demand is relatively elastic, the demand curve will be relatively flat, Consumers will pay a relatively small part of the tax. In this case, a $.50 tax increases the equilibrium price by only $.10 (from $1.00 to $1.10). Consumers pay only one fifth of the tax. Businesses pay the other four fifths.

The Tax Burden

This example shows the incidence of a tax—that is, the final burden of a tax. When policymakers consider a new tax, they examine who will actually bear the burden.

Open Ended

Elasticity of demand for a product affects whether consumers or businesses bear the burden of a tax on it. Apply Concepts Why does the burden shift to businesses if demand is elastic?

Multiple Choice

Recall Who bears the greater burden of a tax on a good or service when demand is inelastic?

• manufacturers

• consumers

• sellers

• the government

Key Characteristics of a Tax

Simplicity. Tax laws should be simple and easily understood. Taxpayers and businesses should be able to keep the necessary records and pay the taxes on a predictable schedule.

Key Characteristics of a Tax

Efficiency. Government administrators should be able to assess and collect taxes without spending too much time or money. Similarly, taxpayers should be able to pay taxes without giving up too much time or paying too much money in fees.

Key Characteristics of a Tax

Certainty. Certainty is also a characteristic of a good tax. It should be clear to the taxpayer when a tax is due, how much money is due, and how the tax should be paid.

Equity. The tax system should be fair, so that no one bears too much or too little of the tax burden.

Determining Equity

Although everyone agrees that a tax system should be equitable and fair to taxpayers, people often disagree on what equity really means. Does it require equal distribution of wealth, or does it simply demand equal opportunity and treatment for all? Over time, this debate has led economists to propose two different ideas about how to measure the fairness of a tax.

Determining Equity

The first idea is called the benefits-received principle. According to this principle, a person should pay taxes based on the level of benefits he or she expects to receive from the government.

Determining Equity

The second idea about fairness is called the ability-to-pay principle. According to this principle, people should pay taxes according to their ability to pay. 

Multiple Choice

Check Understanding Economists generally agree that taxes ought to be

• simple, efficient, certain, and fair.

• universal, progressive, fair, and low.

• simple, proportional, low, and infrequent.

• high, regressive, simple, and universal.

Open Ended

Can and should the government be fair to everyone?