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18. CHAPTER. Public Choice, Taxes, and the Distribution of Income. When Barack Obama became president in January 2009, he proposed a number of changes to the tax system. Prepared by:. Fernando Quijano. 18. Chapter Outline and Learning Objectives. CHAPTER.

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  1. 18 CHAPTER Public Choice,Taxes, and the Distribution of Income When Barack Obama became president in January 2009, he proposed a number of changes to the tax system. Prepared by: Fernando Quijano

  2. 18 Chapter OutlineandLearning Objectives CHAPTER Public Choice,Taxes, and the Distribution of Income

  3. Public Choice, Taxes, andthe Distribution of Income Public choicemodel A model that applies economic analysis to government decision making.

  4. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice How Do We Know the Public Interest?Models of Voting The Voting Paradox Table 18-1 The Voting Paradox

  5. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice How Do We Know the Public Interest? Models of Voting The Voting Paradox Voting paradox The failure of majority voting to always result in consistent choices. Arrow impossibility theorem A mathematical theorem that holds that no system of voting can be devised that will consistently represent the underlying preferences of voters.

  6. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice How Do We Know the Public Interest? Models of Voting The Median Voter Theorem Median voter theoremThe proposition that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle.

  7. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice How Do We Know the Public Interest? Models of Voting The Median Voter Theorem FIGURE 18-1 The Median Voter Theorem The median voter theorem states that the outcome of a majority vote is likely to represent the preferences of the voter who is in the political middle. In this case, David is in the political middle because two voters want to spend more on breast cancer research than he does and two voters want to spend less. In any vote between a proposal to spend $2 billion and a proposal to spend a different amount, a proposal to spend $2 billion will win.

  8. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice Government Failure? Rent seeking Rent seeking Attempts by individuals and firms to use government action to make themselves better off at the expense of others. Logrolling and Rational Ignorance Logrolling refers to the situation where a member of Congress votes to approve a bill in exchange for favorable votes from other members on other bills. Because becoming informed on an issue may require time and effort and the economic payoff is often low, some economists argue that many voters are rationally ignorant of the effect of rent-seeking legislation.

  9. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice Government Failure? Regulatory Capture One way in which the government intervenes in the economy is by establishing a regulatory agency or commission that is given authority over a particular industry or type of product. However, because the firms being regulated are significantly affected by the regulatory agency’s actions, the firms have an incentive to try to influence those actions. In extreme cases, this influence may lead the agency to make decisions that are in the best interests of the firms being regulated, even if these actions are not in the public interest.

  10. 18.1 LEARNING OBJECTIVE Define the public choice model and explain how it is used to analyze government decision making. Public Choice Is Government Regulation Necessary? Although government regulation can clearly provide important benefits to consumers, we need to take into account the costs of regulations. Economics can help policymakers devise regulations that provide benefits to consumers that exceed their costs.

  11. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. However the size of government and the types of activities it engages in are determined, government spending has to be financed. The government primarily relies on taxes to raise the revenue it needs. These are the most widely used taxes: • Individual income taxes. • Social insurance taxes. • Sales taxes. • Property taxes. • Excise taxes.

  12. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. An Overview of the U.S. Tax System FIGURE 18-2 Federal, State, and Local Sources of Revenue, 2008 Individual income taxes are the most important source of revenue for the federal government, and social insurance taxes are the second most important source. State and local governments receive the most revenue from sales taxes. State and local governments also receive large transfers from the federal government, in part to help pay for federally mandated programs. Many local governments depend on property taxes to raise most of their tax revenue.

  13. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Progressive and Regressive Taxes Regressive tax A tax for which people with lower incomes pay a higher percentage of their income in tax than do people with higher incomes. Progressive tax A tax for which people with lower incomes pay a lower percentage of their income in tax than do people with higher incomes.

  14. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Progressive and Regressive Taxes Table 18-2 Federal Income Tax Brackets and Tax Rates for Single Taxpayers, 2009 Table 18-3 Federal Income Tax Paid on Taxable Income of $100,000

  15. 18.2 LEARNING OBJECTIVE MakingtheConnection Understand the tax system in the United States, including the principles that governments use to create tax policy. • Which Groups Pay the Most in Federal Taxes? • YOUR TURN:Test your understanding by doing related problem 2.9 at the end of this chapter.

  16. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Marginal and Average Income Tax Rates Marginal tax rate The fraction of each additional dollar of income that must be paid in taxes. Average tax rate Total tax paid divided by total income. For example, in Table 18-3, Matt had a marginal tax rate of 28 percent because that is the rate he paid on the last dollar of his income. But his average tax rate was:

  17. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. The Corporate Income Tax The federal government taxes the profits earned by corporations under the corporate income tax. Some economists argue that if the purpose of the corporate income tax is to tax the owners of corporations, it would be better to do so directly by taxing the owners’ incomes rather than by taxing the owners indirectly through the corporate income tax.

  18. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. International Comparison of Corporate Income Taxes Table 18-4 Corporate Income Tax Rates around the World

  19. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Evaluating Taxes In selecting which taxes to use, governments take into account the following goals and principles: • The goal of economic efficiency • The ability-to-pay principle • The horizontal-equity principle • The benefits-received principle • The goal of attaining social objectives

  20. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Evaluating Taxes The Goal of Economic Efficiency FIGURE 18-3 The Efficiency Loss from a Sales Tax A sales tax increases the cost of supplying a good, which causes the supply curve to shift up from S1 to S2. Without the tax, the equilibrium price of the good is P1, and the equilibrium quantity is Q1. After the tax is imposed, the equilibrium price rises to P2, and the equilibrium quantity falls to Q2. After paying the tax, producers receive P3. The government receives tax revenue equal to the green-shaded rectangle. Some consumer surplus and some producer surplus become tax revenue for the government, and some become deadweight loss, shown by the yellow-shaded triangle. The deadweight loss is the excess burden of the tax.

  21. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Evaluating Taxes The Goal of Economic Efficiency Excess burden A measure of the efficiency loss to the economy that results from a tax having reduced the quantity of a good produced; also known as the deadweight loss.

  22. 18.2 LEARNING OBJECTIVE MakingtheConnection Understand the tax system in the United States, including the principles that governments use to create tax policy. • Should the United StatesShift from an Income Taxto a Consumption Tax? Under the income tax, households pay taxes on all income earned. Under a consumption tax, households pay taxes only on the part of income they spend. Would a consumption tax be more efficient than an income tax? • YOUR TURN:Test your understanding by doing related problem 2.11 at the end of this chapter.

  23. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Evaluating Taxes The Ability-to-Pay Principle The ability-to-pay principle holds that when the government raises revenue through taxes, it is fair to expect a greater share of the tax burden to be borne by people who have a greater ability to pay. The Horizontal-Equity Principle The horizontal-equity principle states that people in the same economic situation should be treated equally.

  24. The Tax System 18.2 LEARNING OBJECTIVE Understand the tax system in the United States, including the principles that governments use to create tax policy. Evaluating Taxes The Benefits-Received Principle According to the benefits-received principle, people who receive the benefits from a government program should pay the taxes that support the program. The Goal of Attaining Social Objectives Taxes intended to discourage certain activities are sometimes referred to as “sin taxes.”

  25. Tax Incidence Revisited: The Effect of Price Elasticity 18.3 LEARNING OBJECTIVE Understand the effect of price elasticity on tax incidence. Tax incidence The actual division of the burden of a tax between buyers and sellers in a market. Don’t Let This Happen to YOU!Remember Not to Confuse Who Pays the Tax with Who Bears the Burden of the Tax • YOUR TURN:Test your understanding by doing related problem 3.9 at the end of this chapter.

  26. Tax Incidence Revisited: The Effect of Price Elasticity 18.3 LEARNING OBJECTIVE Understand the effect of price elasticity on tax incidence. FIGURE 18-4 The Effect of Elasticity on Tax Incidence When demand is more elastic than supply, consumers bear less of the burden of a tax. When supply is more elastic than demand, firms bear less of the burden of a tax. D1 is inelastic between point A and point B, and D2 is elastic between point A and point C. With demand curve D1, a 10-cents-per-gallon tax raises the equilibrium price from $3.00 (point A) to $3.08 (point B), so consumers pay 8 cents of the tax, and firms pay 2 cents. With D2, a 10-cents-per-gallon tax on gasoline raises the equilibrium price only from $3.00 (point A) to $3.02 (point C), so consumers pay 2 cents of the tax. Because in this case producers receive $2.92 per gallon after paying the tax, their share of the tax is 8 cents per gallon.

  27. 18.3 LEARNING OBJECTIVE MakingtheConnection Understand the effect of price elasticity on tax incidence. • Do Corporations Really Bear theBurden of the Federal CorporateIncome Tax? Most economists agree that some of the burden of the corporate income tax is passed on to consumers in the form of higher prices. Will she be paying part of Apple’s corporate income tax when she buys an iPhone? • YOUR TURN:Test your understanding by doing related problem 3.7 at the end of this chapter.

  28. 18.3 LEARNING OBJECTIVE 18-3 Solved Problem • YOUR TURN:For more practice, do related problems 3.5 and 3.6 at the end of the chapter. Understand the effect of price elasticity on tax incidence. The Effect of Price Elasticity on the Excess Burden of a Tax When demand is less elastic, the excess burden of a tax is smaller than when demand is more elastic.

  29. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Measuring the Income Distribution and Poverty Table 18-5 The Distribution of Household Income in the United States, 2007

  30. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Measuring the Income Distribution and Poverty Table 18-6 How Has the Distribution of Income Changed over Time?

  31. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Measuring the Income Distribution and Poverty The Poverty Rate in the United States Poverty line A level of annual income equal to three times the amount of money necessary to purchase the minimum quantity of food required for adequate nutrition. Poverty rate The percentage of the population that is poor according to the federal government’s definition.

  32. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Measuring the Income Distribution and Poverty The Poverty Rate in the United States FIGURE 18-5 Poverty in the United States, 1960–2007 The poverty rate in the United States declined from 22 percent of the population in 1960 to 11 percent in 1973. Over the past 30 years, the poverty rate has fluctuated between 11 percent and 15 percent of the population.

  33. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Measuring the Income Distribution and Poverty The Poverty Rate in the United States Table 18-7 Poverty Rates Vary across Groups, 2007

  34. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Explaining Income Inequality For most people, the most important factor of production they own is their labor. Therefore, the income they earn depends on how productive they are and on the prices of the goods and services their labor helps produce. Many people own other factors of production, such as capital in the form of stock in corporations. Ownership of capital is not equally distributed. The tax system does not seem to have played a major role in recent changes in income inequality. Earning an income is also subject to good and bad fortune.

  35. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Showing the Income Distribution with a Lorenz Curve Lorenz curve A curve that shows the distribution of income by arraying incomes from lowest to highest on the horizontal axis and indicating the cumulative fraction of income earned by each fraction of households on the vertical axis.

  36. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Showing the Income Distribution with a Lorenz Curve FIGURE 18-6 The Lorenz Curve and Gini Coefficient Because the Lorenz curve for 1980 is closer to the line of perfect equality than the Lorenz curve for 2007, we know that income was more equally distributed in 1980 than in 2007. In panel (b), we show the Gini coefficient. The closer the Gini coefficient is to 1, the more unequal the income distribution.

  37. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Problems in Measuring Poverty and the Distribution of Income Income Mobility in the United States FIGURE 18-7 Income Mobility in the United States, 1996–1999 Each column represents one quintile—or 20 percent—of households, arranged by their incomes in 1996. Reading up the column, we can see where the households that started in that quintile in 1996 ended up in 1999. Only 62 percent of the households that were in the bottom quintile of income in 1996 were still in the bottom quintile in 1999. Only 66 percent of the households that were in the top quintile of income in 1996 were still in the top quintile in 1999.Note: Incomes are in 1999 dollars to correct for the effects of inflation.

  38. 18.4 LEARNING OBJECTIVE • YOUR TURN:For more practice, do related problem 4.7 at the end of the chapter. 18-4 Discuss the distribution of income in the United States and understand the extent of income mobility. Solved Problem Are Many Individuals Stuck in Poverty? Evaluate the following statement: Government statistics indicate that 12 percent of the population is below the poverty line. The fraction of the population in poverty has never dropped below 10 percent. Therefore, more than 10 percent of the population must cope with very low incomes year after year.

  39. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Problems in Measuring Poverty and the Distribution of Income The Effect of Taxes and Transfers Because individuals with low incomes are more likely to receive transfer payments and other benefits from the government than are individuals with high incomes, the distribution of income is more equal if we take these benefits into account.

  40. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Income Distribution and Poverty around the World Table 18-8 Income Inequality around the World

  41. 18.4 LEARNING OBJECTIVE Income Distribution and Poverty Discuss the distribution of income in the United States and understand the extent of income mobility. Income Distribution and Poverty around the World Table 18-9 Poverty in Sub-Saharan Africa Is Much Greater Than Elsewhere in the World

  42. AN INSIDE LOOKat Policy AN INSIDELOOKat Policy >> Should the Government Use a Tax on Soda to Pay For an Overhaul of Health Care? A tax decreases the supply of sugary soft drinks. The amount of revenue raised by the tax depends on the elasticity of the demand and the elasticity of supply of the drinks.

  43. KEY TERMS K e y T e r m Arrow impossibility theorem Average tax rate Excess burden Lorenz curve Marginal tax rate Median voter theorem Poverty line Poverty rate Progressive tax Public choice model Regressive tax Rent seeking Tax incidence Voting paradox

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