Taxes: Equity vs. Efficiency

1. Taxes: Equity vs. Efficiency Chapter15 Prepared by Angela Chow Centennial College

2. Learning Objectives • Define personal income, in-kind income, and wealth • Explain the economic importance of distribution of income and wealth • Explain how the Lorenz curve and Gini coefficient capture income inequality • Define a progressive tax, a regressive tax, and marginal tax rates

3. Learning Objectives • Explain how a progressive tax system reduces income inequality • Define vertical and horizontal equity, nominal tax rates, and effective tax rates • Explain how tax deductions, exemptions, and credits create equity concerns • Define tax incidence and understand its application to payroll taxes

4. Learning Objectives • Explain the trade-off between efficiency and equity associated with income redistribution • Discuss the arguments for and against the implementation of a flat tax system

5. What Is Income? • There are several ways to measure income.

6. Personal Income • Personal income(PI) is income received by households before payment of personal taxes. • Personal income is not a complete measure of income.

7. Personal Income • Many goods and services are distributed directly as in-kind income. • In-kind income - Goods and services received directly, without payment in a market transaction.

8. Personal Income • The distribution of money income is not synonymous with the distribution of goods and services. • Political factors (such as eligibility criteria for transfer payments) play an important role in identifying the difference.

9. Wealth • The distribution of wealth is also important in determining access to goods and services. • Wealth - the market value of assets.

10. Wealth • Wealth represents a stock of potential purchasing power. • Income statistics tell us how this year’s flow of purchasing power (income) is being distributed.

11. Wealth • In general, wealth tends to be distributed much less equally than income. • Recent data shows that the richest 20% of Canadians account for 44% of after-tax income but almost 70% of the total wealth in the economy.

12. International Wealth Inequality The top 10% of the wealthiest Canadians account for 53% of Canada’s total wealth.

13. The Size Distribution of Income • Size distribution of income is the way total personal income is divided up among households or income classes. • Income share is the proportion of total income received by a particular group.

14. 1/5 of the population, rank-ordered by income The Distribution of Income in Canada (2004)

15. The Lorenz Curve • TheLorenz curve is a graphic illustration of the cumulative size distribution of income. • It contrasts complete equality with the actual distribution of income.

16. The Lorenz Curve • The greater the area between the Lorenz curve and the diagonal, the more inequality exists.

17. The Lorenz Curve • The ratio of the shaded area in the Lorenz curve to the area of the triangle formed by the diagonal is called the Gini coefficient. • TheGini coefficient is a mathematical summary of inequality based on the Lorenz curve.

18. 100 90 80 Inequality gap 70 Absolute equality 60 Cumulative Percentage of Income 50 40 Actual distribution B 31.9 30 C 20 10 A 4.8 0 10 20 30 40 50 60 70 80 90 100 Cumulative Percentage of People The Lorenz Curve The higher the Gini coefficient, the greater the degree of inequality. Between 1981 and 2004, the Gini coefficient rose form 0.348 to 0.393, indicating increased inequality.

19. The Call for Intervention • To many people, large and increasing inequality represents a form of market failure. • Market failure – An imperfection in the market mechanism that prevent optimal outcomes.

20. The Call for Intervention • The government could promote greater equality by levying higher taxes on the rich and providing more generous transfer payments to the poor.

21. The Federal Income Tax • The federal income tax is designed to be progressive. • Progressive tax - A tax system in which tax rates rise as incomes rise.

22. The Federal Income Tax • Progressivity is achieved by imposing increasing marginal tax rates on higher incomes. • Marginal tax rate - The tax rate imposed on the last (marginal) dollar of income.

23. Progressive Taxes

24. Average Tax Rate Average tax rate = 23%

25. Efficiency Concerns • A progressive tax system raises concerns about efficiency. • High marginal tax rates may reduce the incentive to work, produce, or invest.

26. Tax Elasticity • The degree of conflict between equity and efficiency depends on how responsive market participants are to higher tax rates. • This response is summarized using the tax elasticity of supply.

27. % change in quantity of labour supplied Tax elasticity of supply = % change in tax rate Tax Elasticity • The tax elasticity of supply is the percentage change in quantity supplied divided by the percentage change in tax rates.

28. Tax Elasticity • In today’s range of taxes, the average household’s tax elasticity of labour supply is between -0.15 and -0.30.

29. Equity Concerns • Critics raise questions about how well the federal income tax promotes equity. • What appears to be a progressive tax structure in theory turns out to be a lot less progressive in practice.

30. Loopholes • The progressive tax rates described in the tax code apply to “taxable” income, not to all income.

31. Using tax brackets and tax rates Taxable Income Gross Income Non-taxable Income = - - Deductions Deduct non-refundable tax credits Tax payable before credits Actual tax payable Loopholes RRSPs, child care expenses, union and professional dues…. Gifts and inheritances, lottery winnings, strike pay, capital gains on sale of principal residence…..

32. Loopholes • The purpose of itemized deductions is to encourage specific economic activities and reduce potential hardships.

33. Loopholes • These deductions may violate the principles of vertical or horizontal equity. • Vertical equity – Principle that people with higher incomes should pay more taxes. • Horizontal equity – Principle that people with equal incomes should pay equal taxes.

34. Nominal vs. Effective Tax Rates • Exemptions, deductions, and tax credits create a distinction between gross economic income and taxable income.

35. Vertical Inequity

36. Nominal tax rate tax paid = taxable income Effective tax rate tax paid = total economic income Nominal vs. Effective Tax Rates • Thenominal tax rate is calculated by dividing taxes paid by taxable income. • Theeffective tax rate is calculated by dividing taxes paid by total income.

37. Nominal vs. Effective Tax Rates • 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.

38. Tax-Induced Misallocations • Tax loopholes not only foster inequity but encourage inefficiency as well. • Tax preferences induce resource shifts into tax-preferred activities.

39. A Shrinking Tax Base • As deductions, exemptions, and credits accumulate, the tax base shrinks. • Thetax base is the amount of income or property directly subject to nominal tax rates. Tax revenue = average tax rate X tax base

40. Tax Reform in Canada Over the past 30 years, the problems of a shrinking tax base, horizontal and vertical inequities, and tax-distorted resource allocations have been partially addressed through a reduction in marginal tax rates and fewer tax brackets.

41. Provincial, Municipal, and Payroll Taxes • In addition to federal income taxes, Canadians taxpayers must also pay provincial/territorial income taxes.

42. Provincial, Municipal, and Payroll Taxes • With the exception of Alberta, sales taxes are a major source of revenue for provincial governments. • Municipal governments rely on property taxes for the bulk of their tax receipts.

43. Combined Federal, Provincial /Territorial Marginal Tax Rates

44. Sales and Property Taxes • We gauge tax burdens in relation to people’s incomes. • Sales taxes and property taxes are both regressive. • A regressive tax is a tax system in which tax rates fall as incomes rise.

45. Sales and Property Taxes • Sales taxes and property taxes are regressive because poor people pay a larger percentage of their income on these taxes than do the rich people.

46. The Regressivity of Sales Taxes

47. Tax Incidence • Tax incidence is the distribution of the real burden of a tax. • The burden of property taxes is reflected in higher rents. • Landlords tend to pass along to tenants any property taxes they must pay. • People who rent apartments pay higher rents because of property taxes.

48. Payroll Taxes • Canada’s Employment Insurance (EI) program is a payroll tax. • For every $100 earned below the legislated taxable ceiling ($39,000 in 2006), a worker contributes $1.87 and the employer contributes $2.62. • Workers pay $1.87 out of $4.49 ($1.87+2.62) or 42% of the EI tax.

49. Payroll Taxes • The same maximum EI tax of $729.30 will apply to earnings above $39,000. • This is a regressive tax.

50. Payroll Taxes • Labour demand reflects the marginal revenue product (MRP) of labour. • Marginal revenue product (MRP) – The change in total revenue associated with one additional unit of input.