May 18 2010

The role of taxes in income re-distribution – another preview of my textbook

Inequality in the distribution of income is an inevitable result of an economic system that rewards the households with the highest skills, best education and most access to capital with higher wages and incomes in the marketplace.

The existence of poverty, both relative and absolute, poses several obstacles to the improvement of well-being for a nation’s people. Social unrest among the poorest members of society can lead to political and economic instability for a nation as a whole. The hardships experienced by society’s poorest members are ultimately felt by the rest of society as the needs of the poor must be met in one way or another, and in extreme circumstances may lead to a violent struggle between economic classes.

The existence of absolute poverty poses the greatest obstacle to national economies and society as those who experience it are unlikely to contribute whatsoever to national output and economic growth given the desperate state of their health and education. Without promoting some degree of equality in the distribution of income, governments run the risk of undermining their accomplishment of other social and economic objectives. So how do governments achieve more equal income distribution? Before we look at the modern mechanisms by which this objective is achieved, it is important to examine the historical ideology that frames modern economic policy.

For centuries the role of government has been debated among economists. The extent to which it is the government’s job to assure equality in the distribution of income has never been fully agreed upon by policymakers, whose opinions differ depending on the school of economic ideology to which they prescribe. On the far left of the economic spectrum is Marxist/socialist ideology, which believes that households’ money incomes should be made obsolete and each household’s level of consumption should instead be based on the “use-value” of the output which it produces. In a pure Marxist or socialist economy, money incomes do not matter since the output of the nation will be shared equally among all those who contribute to its production. Private ownership of resources and the output those resources produce is wholly abolished in a socialist economy and the ownership and allocation of resources, goods and services is in the hands of the state and production and consumption is undertaken based on the principle of equality.

The slogan “from each according to his ability, to each according to his need”, made populate by Karl Marx, summarized the view that a household’s consumption should be based on its level of need. To take this idea to its logical conclusion, all households in a nation have essentially the same basic needs therefore household incomes should be equal across the nation.

On the other extreme of the economic spectrum is the laissez faire, free market model which argues that the only role the government should play in the market economy is in the protection of private property rights, which assures that the private owners of resources, including land, labor and capital, are able to pursue their own self-interest in an unregulated marketplace where their money incomes are determined by the “exchange-value” of the resources they control. In a laissez-faire market economy, the level of income and consumption of households varies greatly across society as the exchange-value of the resources owned by households determines income, rather than the principle of equality underlying socialism. Each individual in society is free to pursue his monetary objectives through the improvement of his human capital and the subsequent increase in its exchange-value in the labor market.

In today’s world, there exists neither a purely socialist economy nor a purely laissez fair free market economy. In reality, all modern national economies are mixed economies in which governments do much more than simply protect property rights, but do not go so far as to own and allocate all factors of production. The role of government in the distribution of income in today’s economies is relegated to the collection of taxes and the provision of public goods and services and transfer payments.

A tax is simply a fee charged by a government on a person’s income, property, or consumption of goods and services. Taxes can be broken into two main categories: direct and indirect.
  • Direct taxes: These are taxes paid directly to the government by those on whom they are imposed. An income tax is a direct tax because it is taken directly out of a worker’s earned income. Corporate and business taxes are also direct taxes based on the revenues or profits of firms. Direct taxes cannot be legally avoided since they are based on the earned income of each individual. The burden of direct taxes is born entirely by the households or firms paying them.
  • Indirect taxes: These are the taxes paid by households through an intermediary such as a retail store. The consumer pays the tax at the time of his purchase of a good or service and the amount of the tax is usually calculated by adding a percentage rate to the price of the item being purchased. Indirect taxes include sales taxes, value added taxes (VAT), goods and services tax (GST) as well as ad valorem taxes (or excise taxes) which are placed on specific goods such as cigarettes, alcohol or petrol. Indirect taxes can be avoided simply by not consuming certain products or by consuming less of all products. The burden of indirect taxes is born by both households and firms, the proportion born by each is determined by the price elasticities of demand and supply (as demonstrated in chapter 4).

Taxes can be either progressive, regressive or proportional in nature, meaning that different taxes place different burdens on the rich and the poor.

Proportional tax: A tax for which the percentage of income taxed remains constant as income increases is a proportional tax. The rich will pay more tax than the poor in absolute terms, but the burden of the tax will be no greater on the rich than it is on the poor. A household earning 20,000 euros may pay 10% tax to the government, totaling 2,000 euros. A rich household in the same country pays 10% on its income of 200,000 euros, totaling 20,000 euros in taxes, but the burden is the same on the rich household as it is on the poor household. Proportional taxes are uncommon in advanced economies, although some “payroll taxes”, which are those collected to support social security or welfare programs, are payed by employers based on a percentage of employees’ incomes up to a certain level. For instance, the US social security tax is 6.2% of gross income up to $108,000. Regardless of a person’s income below $108,000, he or she will pay 6.2% to the government to support the country’s social security program.

Regressive taxA tax that decreases in percentage as income increases is said to be regressive. Such a tax places a larger burden on lower income households than it does higher income earners since a greater percentage of a poor household’s income is used to pay the tax than a rich household’s. You may be wondering what kind of government would levy a tax that harms the poor more than it does the rich, but in fact almost every national government uses regressive taxes to raise a significant portion of its tax revenues. Most indirect taxes are actually regressive, which may not make sense at first, since a sales tax is a percentage of the price of products consumed consumed. The regressiveness is apparent when the amount of the tax is compared to the income of the consumer, however.

To demonstrate how a sales tax is regressive, imagine three different consumers who purchase an identical laptop computer for 1,000€ in a country with a value added tax of 10% added to the price of the computer.
Income of buyer Amount of tax paid % of income taxed
10,000€ 100€ 1%
50,000€ 100€ 0.2%
100,000€ 100€ 0.1%

The higher income consumer pays the same amount of tax as the lower income consumer, but the the tax makes up a lower percentage of her income than it did the lower income consumer’s. Although they appear to be fair since everyone pays the same percentage of the price of the the goods they consume, indirect taxes such as VAT, GST and sales taxes are in fact regressive taxes, placing a larger burden on those whose ability to pay is lower and a smaller burden on the higher income earners whose ability to pay is greater.


Progressive tax: This is a tax for which the percentage of income taxed increases as income increases. The principle underlying a progressive tax is that those with the ability to pay the most tax (the rich) should bear a larger burden of the nation’s total tax receipts than those whose ability to pay is less. Lower income households not only pay less tax, but they pay a smaller percentage of their income in tax as well. Most nation’s income tax systems are progressive, the most progressive being those in the Northern European countries which, not surprisingly, also demonstrate the most equal distributions of income. Of the various types of taxes, a progressive income tax aligns most with the macroeconomic objective of increased income equality.

A progressive income tax typically consists of a marginal tax bracket in which the increasing tax rates apply to marginal income, rather than to total income. In such a system, the average tax a household pays increases less rapidly than the marginal tax, since the higher marginal rate only applies to additional income beyond the upper range of the previous bracket.

Income range Marginal tax rate
Tax paid by someone
at top of bracket
Average tax rate
$0-$8,375 10%
$837.5
10.00%
$8,375-$34,000 15%
$4,681.25
13.77%
$34,000-$82,400 25%
$16,781.25
20.37%
$82,400-$171,850 28%
$41,827.25
24.34%
$171,850-$373,650 33%
$108421.25
29.02%
$373,850 -$500,000
(and above)
35%
$152,643.75
(on $500,000)
30.53%

Notice in the table above that the total tax paid by Americans at the top of each income bracket is NOT the simply the tax rate times income. Rather, the tax rate for each income bracket only applies to income earned above and beyond the upper boundary of the previous bracket. An American worker earning $8,000, for instance, will pay $800 in income tax. But if his income increases to $10,000 he will NOT pay 15% of the full $10,000, or $1,500. Rather, he will pay 15% on the income earned above $8,375. Such a worker would therefore pay 10% of his first $8,375 ($837.50) plus 15% on the additional $1,625 he earned, which is another $243.75. The marginal rate of taxation (MRT) is the change in tax (t) divided by the change in gross income (yg). His total tax would therefore equal $1,081.25.

The marginal rate of taxation between the first and second income brackets above is found using the equation:

The average rate of taxation (ART) is equal to the tax paid (t) divided by the gross income (yg):

The average rate for workers who fall in the second income bracket above can be found using the equation:

For workers in each of the income brackets above, the average rate of taxation is always lower than the marginal rate of taxation, since tax increases only apply to additional income earned beyond the previous bracket. The graph below shows the marginal (in blue) and the average (in red) rates of taxation for individuals earning between $0 and $500,000 in the United States in 2010.

Marginal and average tax rates in the US

The main argument against progressive income taxes is that taxing higher incomes at higher rates creates a disincentive to work, in effect punishing any increase in productivity or effort among the nation’s workers. However, the fact that higher rates only apply to marginal income, rather than total income, assures that a worker’s after tax income will always be an increasing function of gross income; therefore there will always be an incentive to increase income by working harder, longer, or more efficiently since the increase in taxes will always be less than the increase income.

A progressive income tax system provides governments with an effective means of re-distributing the nation’s income since those with the greatest ability to pay (the rich) provide the nation with far more of its tax revenue than those with the least ability to pay (the poor). The graph below shows the total amount of tax revenue generated by each of the five quintiles of income earners in the United States in 2006. While the lowest 20% of income earners accounted for around 1% of total tax receipts, the top quintile contributed nearly 70% to America’s tax revenues.

Progressive income tax burden:data source:http://www.taxpolicycenter.org/taxfacts/displayafact.cfm?DocID=558&Topic2id=20&Topic3id=22

In other Western economies, progressive income taxes typically account for the largest proportion of total tax receipts by the government. America’s neighbor to the north, Canada, has an even higher top marginal tax rate than the US, and rather than applying to people earning above $370,000, as it does in the US, Canada’s top tax rate kicks in for workers earning just $100,000 per year. In Canada, personal income taxes account account for around 50% of total federal tax revenues, while the corporate tax and the national goods and services tax make up the next largest portions.

As mentioned, the highest marginal tax rates tend to exist in the social democratic nations of Northern and Western Europe. Denmark, a country with a Gini index of 29, has the highest tax rate on top income earners. More significant than the high rate, however, is the fact that it kicks in at such a low income level, around $50,000 per year. This means that a large number of Danish workers are paying a high marginal and average tax rate. The burden of the income tax in Denmark is born not by only the rich, but by the middle class as well. In contrast, Germany’s top marginal tax rate of 47% is only reached when a worker’s gross income exceeds $300,000 per year, meaning the income tax burden in Germany will be born more by the rich than those earning lower incomes, as is the case in the United States.

Marginal tax rates in OECD countrieshttp://www.oecd.org/document/60/0,3343,en_2649_34533_1942460_1_1_1_1,00.html#pir


Arguments against progressive income taxes – the Laffer Curve:

The primary argument against the use of progressive income taxes as a means to redistribute national income comes from the “supply-side” school of macroeconomic thought. Supply-siders, whose views are formed by the classical theory of macroeconomics based on the belief that a free market economy left entirely to its own devices will always gravitate towards a level of production corresponding with full employment of the nation’s resources, believe there is a certain level of taxation at which a nation’s total tax receipts will be maximized. Beyond this point, further increases in the tax rat actually lead to a decline in the amount of taxable income due to the disincentive created by the higher tax rate. The Laffer Curve demonstrates the relationship between tax rate and tax revenue graphically:




At a tax rate of 0% households and firms will keep 100% of their gross income and there will be no tax revenue for the government. At a tax rate of 100%, however, there will also be no tax revenue since no rational individual will choose to work if the government takes everything he or she earns. The supply of labor falls as the tax rate increases since fewer individuals will be willing to work as the government collects higher percentages of their earned income. Therefore there will be no income for the government to tax when the tax rate is 100%.

Since both 0% tax and 100% create zero tax revenue, the Laffer Curve theory holds that at some tax rate (m) in between 0% and 100% the government’s total tax receipts will be maximized.The Laffer Curve is often cited by supply-side advocates as an argument for reducing marginal income tax rates on the top income earners. If, for instance, the tax rate is at y, it is possible that a lower tax rate could lead to higher tax revenue if the falling taxes incentivize individuals to join the labor force and existing workers to work harder and longer hours, creating more taxable income. In addition, entrepreneurs may be more inclined to start businesses and firms to increase their investments in physical and human capital, both activities contributing further to increases in national output and taxable income. At lower tax rates, argue the supply-siders, the level of taxable income may increase leading to higher tax revenues for the government.

It is not clear from the Laffer Curve at what precise level of taxation tax revenues are maximized. The model is most commonly employed by supply-siders to justify their desire for lower income and corporate taxes and a general reduction in the interference of the government in the functioning of the free market. The supply-side argument holds that lower taxes lead to an increase in the supply of labor and capital as households and firms are incentivized to become more economically active, leading to increases in the nation’s aggregate supply and thereby promoting the accomplishment of the macroeconomic goals of full employment and economic growth.

Practice calculating marginal and average rates of taxation in France (2010)http://www.french-property.com/guides/france/finance-taxation/taxation/calculation-tax-liability/rates/:

Marginal Income Brackets Marginal rate of taxation Worker’s gross income Tax paid Average rate of taxation
0-€5,875 0% €5,000
€0
0%
€5,876 – €11,720 5.5% €10,000 - -
€11,721 – €26,030 14% €20,000 €1,480.675 7.4%
€26,031 – €69,783 - €50,000 - 19%
€69,783 and above 40% €100,000 €27,537.575 -
  1. Calculate the total amount of tax paid by a French worker earning €10,000 per year.
  2. Calculate the average rate of taxation the same worker pays. Which is greater, the marginal rate of taxation or the average rate of taxation? Explain.
  3. What will a French worker earning €50,000 pay in taxes?
  4. Calculate the marginal rate of taxation for for a worker whose income increases from €20,000 to €50,000.
  5. What is the average rate of taxation for a French worker earning €100,000 per year?
  6. Evaluate the claim that a progressive income tax decreases the incentive among workers to work harder improve their productivity.

3 responses so far

3 Responses to “The role of taxes in income re-distribution – another preview of my textbook”

  1. Spenceron 19 May 2010 at 10:11 pm

    I'm looking forward to seeing the book Jason! I know this is not a tax preparation lesson but it would probably be a good idea to cite the year and filing status of the tax tables you use. For example the US Tax Table above is 2010 for single people and the French table seems to be the same. After all they change so much from year to year.

    It was particularly interesting to look at the link you provided to the French tax tables, if I read it correctly there is no marriage penalty at all and I now have a much better understanding of the size of the tax break given for having children in France. In France I might have decided to have children…

    Thanks for all the work you post.

  2. alanon 27 May 2010 at 2:57 pm

    i'm sorry but i can't see some of the diagrams!

    thanks

  3. […] are available on his blog as samples. The book will be available in Spring 2011. Samples – Income Redistribution | Unemployment, Inflation and the Philips Curve | Price Control in European Agricultural […]

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