Transcription
How's it class? So today we are lecturing on chapter six, which is funding the public sector. So the public sector, it's just generally the government. So you think of public spending, that's government. Public sector, that's the government. How do we fund the government? So there's three sources of government funding: fees or user charges, taxes, or just like us when we don't earn enough. And for them, how they earn money is through taxes. If they don't earn enough, then they have to end up borrowing.
Some definitions: what's tax base? Or the concept of tax base, it's the value of goods, services, wealth, or income subject to taxation. I think you are familiar that when you get taxed, they're taking a piece of your pie. They're taking a slice of pie from you. So the tax base is essentially the entire pie that they can take from.
On the other hand, the tax rate, which is the percentage of a tax base that must be paid to a government as taxes. That percentage represents the percentage of how big that slice of the pie that they're taking from you or the the the private citizens, the households.
Now, this concept, the marginal tax rate. The word "marginal" is a very important word in microeconomics, in economics. But yes, this is where you really see it prevalent is microeconomics. So the words that you can substitute in for marginal: things like "next," things like "change," "additional." These are all words that you can substitute in for marginal. The next, the additional, uh, the change. So the marginal tax rate is the change in taxes due with respect to the change in taxable income. We'll elaborate on marginal. It's kind of what separates economists in terms of how they generally habitually think from non-economists. And marginal thinking, the marginal, uh, method of thinking is very important in economics.
The tax bracket, it's a specified interval of income to which a specific and unique marginal tax rate is applied. So how much are you going to get taxed? Well, it depends what tax bracket you fall into based on your income.
The average tax rate is the total tax payment divided by the total income. Now, the average tax rate, it's interesting for us to know so we can kind of see, well, I make this much, the government's taking this much from me. What is the average tax rate that I pay? This is what we look at. This is simply the total tax payment divided by your total income. But it will usually differ from the discussion in terms of what is your marginal tax rate. It's what is your, your tax rate on the next or your additional dollar earned. There's that word "marginal" and "additional" being combined or are substituted. We'll talk about that in a bit.
The proportional taxation concept, a tax system in which, regardless of an individual's income, the tax bill comprises of exactly the same percentage. Now, some people will argue that the proportional taxation system is the most fair because regardless of if you earn ten thousand dollars a year versus a hundred million dollars a year, you're just going to pay, for example, a 20% tax rate. And so some people say that's fair. But if you consider maybe the concept of diminishing marginal utility of the dollar, or the decreasing usefulness of a dollar as you get more and more of it, then it might be arguable that you might need to tax more because a dollar, an extra dollar to someone who earns ten thousand dollars a year means a lot more than an extra dollar to someone who earns 100 million dollars a year. Therefore, as you get up into the very high tax brackets, it's arguable that you can take a higher percentage because, you know, it means less to someone who already has so much.
Anyway, based on the proportional taxation, we can, uh, equate the marginal tax rate will happen to equal to the average tax rate. Why? Because every additional dollar you get, it's not going to change the tax rate on each additional dollar. It's always going to be 20% in a proportional taxation system. So you look at the income of ten thousand dollars, they're paying 20%. You look at a hundred thousand dollar income, they're paying 20%. A hundred thousand and one dollar, it's also going to be 20% for that marginal dollar, that extra one dollar I just mentioned, that hundred thousand and one. It's still 20%. So your marginal tax rate is not going to change as you make more. Therefore, the average tax rate is going to remain constant.
Progressive taxation, on the other hand, is a tax system in which, as income increases, a higher percentage of the additional, the marginal, additional income is paid as taxes. So taking a look at a progressive taxation system, the marginal tax rate is going to be greater than the average tax rate. So look at the income zero to ten thousand, ten thousand and one to twenty thousand, twenty thousand and one to thirty thousand. Then you can see the rate: five percent, ten percent, and thirty percent. So as you fall into the different brackets, we have three brackets here: zero to ten, ten, ten thousand and one to twenty, and twenty thousand and one. We have three brackets. The different brackets have different tax rates.
So let's just say I made fifteen thousand dollars. If I made fifteen thousand dollars, then my first ten thousand will be taxed at five percent. So the tax liability will be that five hundred dollars that you see there. But the next five thousand falls into the next, my marginal, the next, my change in income, that next five thousand falls into the ten percent tax rate. And so that would be, I guess, five, so that'd be five thousand dollar tax liability instead of the five hundred dollars. Sorry, tax liability instead of the one thousand there. So I have five hundred dollars for that first ten thousand that I earned. Then I would have five hundred dollars based on that ten percent, five thousand that I earn in that next bracket. So I have a total tax liability of one thousand dollars. I'm using different numbers so you can kind of see what happens when it's not just using up every bracket. I'm breaking it up in that sense.
So in this case, because the rate is going up as you move through the brackets, the marginal tax rate is not going to equal to the average tax rate because the first 10 was charged at a less percentage, the next 10 or the next five, whatever we talk about, is charged at a higher rate. And then if you go further into the third bracket, it's going to be charged at a higher rate of 30%. So that's why the marginal tax rate is going to be greater than the average tax rate.
Now, on the other hand, we have a regressive taxation system. That's possible. A tax system in which, as more dollars are earned, the percentage of tax paid on them falls. So taking a look at regressive taxation, social security, for example. Marginal tax rate is less than the average tax rate. So if you're an income of fifty thousand dollars and your rate is ten percent, then your tax liability is five thousand dollars. Now, if your income is a hundred thousand dollars, your tax rate is five percent. That portion is going to be five thousand dollars. So it's going to be, marginal is going to be less than your average.
Now, in the terms of the taxes by federal, state, and local government. The federal government, uh, has individual income taxes, which is the largest portion of revenue to the fed. Then in order comes the corporate income taxes and social security taxes. And then import and excise taxes comprise the rest. Now, for state and local governments, uh, we have sales taxes, which is the largest portion. Property taxes is next. Personal income tax and corporate income tax falls in that order as well. So you can look at the sources of government tax receipts based on these pie charts. You have the federal tax receipts on the left and the state and local tax receipts on the right. Okay, so you can see in terms of on the left side, we have individual income taxes, uh, is the largest, with social insurance taxes and contributions next. On the right side, you can see it's actually kind of, uh, kind of broken up fairly equally, but you can see, um, property taxes and sales excess and gross receipts taxes are the highest amount aside from revenue from federal government. Uh, so property taxes and at 16.6% and sales at excise and gross receipts taxes at 19%.
Okay, so the federal personal income tax is 43.6% of all federal revenue. All U.S. residents, citizens, resident aliens, and most others are required to pay it. It includes income earned abroad, and it is a progressive tax system, the federal personal income tax. And here's is how this federal progressive income tax looks. Uh, this might be a little dated, it might have changed a little bit, but essentially you should be able to get the idea. On the left side, we have the single person. On the right side, we have married couples. And you can see it's simply double for the, uh, married couples. Okay. And then you can see at the highest tax bracket goes up to 35%.
Okay, now, if you're curious, this is what the federal corporate income tax schedule, what corporations pay. Uh, and so you can see the brackets, they start at 15%, they also go up to 35%.
Okay, um, now the thing about, uh, taxes when it comes down to investments, for example, if you, for stocks, you get hit with double taxation. Double taxation, it's a situation where corporations pay taxes on its profits. Suppose you own a stock in Microsoft. And Microsoft, they earn a profit, they're going to pay corporate taxes. That's the first time on its profits. Then you might receive a dividend as an investor in Microsoft. And then you're going to receive, let's just say you receive one thousand dollars in dividends from your stock holdings with Microsoft. Guess what? You also get taxed on that. So your dividend income is taxed. So there's a double taxation situation, for example, on investments.
Social security taxes, those are imposed on earnings of less than or equal to a hundred and eighteen thousand five hundred. Contributions are 6.2% for employers and 6.2% for employees. So the employers are going to match the employees' contribution.
For state and local governments, taxes imposed on goods and services yield more revenues than income taxes, which we, of course, we saw that on the pie charts earlier. Now, an issue that governments face is how to set tax rates to extract the largest possible payments. Now, some people might say, well, that's easy, charge a higher percentage. You take a greater, a larger piece of the pie, a greater percentage of the pie, you're going to earn more as the government. Well, that depends. Let's talk before we get to that analysis a little bit further. We'll get some more ideas out of the way.
Sales taxes, taxes assessed on the prices paid on goods and services. Ad valorem taxation, uh, that concept. Ad valorem means "to the value" taxation. And that's charging a tax rate equal to a percentage of the market price of each unit purchased. So when you go to Food Land or when you go to a clothing store and you purchase, you probably already automatically factor in the ad valorem taxes that you have to pay.
Now, going back to how do we extract more from, uh, the people through taxation? Do we just high, uh, uh, charge a higher tax rate? Well, there's two schools of thought on how to approach this analysis. The first one is static tax analysis. The second one is dynamic tax analysis. Now, you might wanna, you might have an opinion on which one would be the most appropriate method to analyze the situation.
Static tax analysis assumes that changes in the tax rate leave the tax base unaffected. Is that likely? In other words, I can tax the people working out there. If I'm the government and I want to take a piece of their pie, the pie that I can tax is their earnings. Now, if I can charge them 10% taxes, they're going to work a certain amount, let's just say that yields a million dollar piece of the pie that I can take. What happens if I say, you know what, you guys, I'm going to charge you more than 10%, I'm going to charge a 60% tax rate? Then they're going to say, oh, you're taking a really big chunk of pie from from me. That's all right, I'm going to work the same amount. And so they still, the tax base is still one million dollars. Well, that's more likely with small changes.
But on the other hand, there's dynamic tax analysis. That's where higher tax rates may shrink the tax base. And the reason for that is consumers alter their actions, they respond to incentives. So if the government is going to take 50% more taxes from 10% to 60%, that's kind of a disincentive to work. You might say, well, I could work, but the government's going to take such a large piece of the pie. Maybe I need to enjoy life a little bit because now, you know, the opportunity cost of of working just went out, or the opportunity cost of not taking time off just went up. So because of the increased tax rate, so consumers alter their actions and they respond to incentives. And that's supported empirically.
Here's the states with the highest and lowest sales tax rates. I think it's a little bit different. I think Hawaii's a little bit higher than 4% exactly. I don't pay attention to that too much, maybe I should. But anyway, you can see Alabama has a really high tax rate, looks like easily above 14%, close to 15%. And then Hawaii is around 4%.
So this brings in something called the Laffer Curve. The Laffer Curve focuses on this concept in a sense of dynamic tax analysis. And what we can look about, look at it as is looking at the tax revenues that the government receives based on the tax rate, the tax percentage that they can charge people on their earnings, on the tax base. So this concept, they chose a tax rate of 6%. Uh, I think it's arbitrary. I don't think it's necessarily shown with very, uh, impeccable, solid empirical data. But what this hope, the point about this is that if you charge a higher amount, it might shrink the tax base. So people will work less. And you, instead of a piece of the pie where you take this much, you have a higher slice of the pie that you take. But I'm drawing it relative to the other, the piece is larger, the slice of pie is larger, but it's off a smaller piece of the pie, I mean, a smaller pie overall, the tax base. So that's the idea of this. Is that if you charge, instead of 9%, you can reduce the tax rate, the tax base will increase to this larger one above because people now get to keep more. And so the opportunity cost of not working just went up. So they will work more. The tax base gets larger. Even though you're taking a smaller percentage, your tax revenues are higher.
On the other hand, if you charge too low, you can increase the tax rate and you'll be able to get a higher amount of taxes as well. So this is dynamic tax analysis and talking about how people respond to changes and how it can affect tax revenues. Okay, so hopefully that's clear. Again, this is, even though it's not named here, this is the Laffer Curve. Okay, this curve right here. Okay.
So taxation from the point of view of producers and consumers. There's an excise tax. The excise tax is a tax levied on purchases of a particular good or service. And then there's a concept of unit tax. It's a constant tax assessed on each unit of a good that consumers purchase. So let's take a look at this excise tax and unit tax. What we have here are two diagrams on the left and the right. Now, the one on the right is a more complete picture. Why is it a more complete picture? Because the one on the right includes the demand curve, which would be needed for a more complete analysis. On the left side, all we're looking at is how the unit tax, for example, of 40 cents here, affects the situation of those getting taxed and those who have to pay it and so forth. So what we're saying is a unit tax, let's just say it's imposed upon the sellers. And so the supply curve shifts upwards by the amount of the tax of 40 cents. Okay. And then that's the, now that's the change that we need to apply.
But what on the right side does now? It throws in the demand curve to say, well, what happens truly in the marketplace when that 40 cent unit tax is applied to the sellers and it shifts upwards by 40 cents? So we went from S1 to S2. But we have the demand curve in there now. So what we can see is that equilibrium originally at 445. Okay. But now with the supply curve shifting to the left and a total in terms of a raw number amount, as we saw on this side, it went up by 40 cents. But when we take the demand curve and its slope into account, it kind of changes the situation. Not changes it, but it allows us to see a little bit more. And for one thing, now we have two points that I'm that I'm kind of highlighting here. This distance represents that 40 cent shift that we saw on the left side and the right side. Okay. But if you look at the new price, that 475 here, relative to the old equilibrium price of 445, you can see here that that's a 30 cent change. That 30 cent change is telling us that the equilibrium price went up by 30 cents. But if you take a look at the lower point here, add that 10 cents, that makes the complete 40 cent shift.
So to clean it up a little again, we have this total amount, this total distance of 40 cents between this point and this point. But we had an original equilibrium here at 445. What is the consumer paying now? Originally it was at 445. The consumer now, based on equilibrium, pays 4.75. So let's kind of just summarize what we see here in this diagram, and that's what we'll wrap up with for this chapter. So the tax amount that we saw was a total amount of 40 cents. The increase in equilibrium was 30 cents. So the seller bears 10 cents of that 40 cent tax amount. They share the rest with the consumer. The consumer bears 30 cents, which is equivalent to the increase in price that they have to pay. And that difference is based on the slope of the curve. Now, if the slopes of the curves were different, one, if we reversed how extreme one was, or and so forth, then we would be able to see that maybe the burden shifted more to the supplier versus the consumer. But this distance here that now, oops, let me, sorry, turn off the ink. Here we go. This distance right here that I'm drawing with red is borne by the supplier. And this distance going up to this point is borne by the consumer. Okay. And again, it's based on the slope of the curve. Okay. So, uh, the slope of the curves. Anyway, that is this analysis, uh, for taxes using supply and demand. Um, and hopefully that's that's relatively clear.
So I hope this, uh, this is understandable. I hope you guys are doing well. And, uh, that's it for this chapter. And we'll talk to you soon. Aloha. Take care. Stay healthy.