Tax Fairness and Tax Efficiency

We’ve just seen how economic analysis can be used to determine the inefficiency caused by a tax. It’s clear that, other things equal, policy makers should choose a tax that creates less inefficiency over a tax that creates more. But that guideline still leaves policy makers with wide discretion in choosing what to tax and, consequently, who bears the burden of the tax. How should they exercise this discretion?

One answer is that policy makers should make the tax system fair. But what exactly does fairness mean? Moreover, however you define fairness, how should policy makers balance considerations of fairness versus considerations of efficiency?

Two Principles of Tax Fairness

Fairness, like beauty, is often in the eyes of the beholder. When it comes to taxes, however, most debates about fairness rely on one of two principles of tax fairness: the benefits principle and the ability-to-pay principle.

According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending.

According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending. For example, those who benefit from a road should pay for that road’s upkeep, those who fly on airplanes should pay for air traffic control, and so on. The benefits principle is the basis for some parts of the U.S. tax system. For example, revenue from the federal tax on gasoline is specifically reserved for the maintenance and improvement of federal roads, including the Interstate Highway System. In this way motorists who benefit from the highway system also pay for it.

The benefits principle is attractive from an economic point of view because it matches well with one of the major justifications for public spending—the theory of public goods, which will be covered in Chapter 17. This theory explains why government action is sometimes needed to provide people with goods that markets alone would not provide, goods like national defense. If that’s the role of government, it seems natural to charge each person in proportion to the benefits he or she gets from those goods.

According to the ability-to-pay principle of tax fairness, those with greater ability to pay a tax should pay more tax.

Practical considerations, however, make it impossible to base the entire tax system on the benefits principle. It would be too cumbersome to have a specific tax for each of the many distinct programs that the government offers. Also, attempts to base taxes on the benefits principle often conflict with the other major principle of tax fairness: the ability-to-pay principle, according to which those with greater ability to pay a tax should pay more.

The ability-to-pay principle is usually interpreted to mean that high-income individuals should pay more in taxes than low-income individuals. Often the ability-to-pay principle is used to argue not only that high-income individuals should pay more taxes but also that they should pay a higher percentage of their income in taxes. We’ll consider the issue of how taxes vary as a percentage of income later.

The Whiskey Rebellion described at the beginning of this chapter was basically a protest against the failure of the whiskey tax to take the ability-to-pay principle into account. In fact, the tax made small distillers—farmers of modest means—pay a higher proportion of their income than large, relatively well-off distillers. It’s not surprising that farmers were upset that the new tax completely disregarded the ability-to-pay principle.

Equity versus Efficiency

A lump-sum tax is the same for everyone, regardless of any actions people take.

Under the whiskey tax, the flat amount of tax paid by large distillers (in contrast to the per-gallon tax paid by small distillers) was an example of a lump-sum tax, a tax that is the same regardless of any actions people take. In this case, the large distillers paid the same amount of tax regardless of how many gallons they produced. Lump-sum taxes are widely perceived to be much less fair than a tax that is proportional to the amount of the transaction. And this was true in the Whiskey Rebellion: although the small farmers were unhappy to pay a proportional tax, it was still less than they would have owed with the lump-sum tax, which would have imposed an even more unfair burden on them.

But the per-gallon whiskey tax definitely distorted incentives to engage in mutually beneficial transactions and created deadweight loss. Because of the tax, some farmers would have reduced how much whiskey they distilled, with some forgoing distilling altogether. The result, surely, was a lower production of whiskey and less income earned by farmers because of the tax.

In contrast, a lump-sum tax does not distort incentives. Because under a lump-sum tax people have to pay the same amount of tax regardless of their actions, it does not lead them to change their actions and therefore causes no deadweight loss. So lump-sum taxes, although unfair, are better than other taxes at promoting economic efficiency.

In a well-designed tax system, there is a trade-off between equity and efficiency: the system can be made more efficient only by making it less fair, and vice versa.

A tax system can be made fairer by moving it in the direction of the benefits principle or the ability-to-pay principle. But this will come at a cost because the tax system will now tax people more heavily based on their actions, increasing the amount of deadweight loss. This observation reflects a general principle that we learned in Chapter 1: there is often a trade-off between equity and efficiency. Here, unless a tax system is badly designed, it can be made fairer only by sacrificing efficiency. Conversely, it can be made more efficient only by making it less fair. This means that there is normally a trade-off between equity and efficiency in the design of a tax system.

It’s important to understand that economic analysis cannot say how much weight a tax system should give to equity and how much to efficiency. That choice is a value judgment, one we make through the political process.

ECONOMICS in Action: Federal Tax Philosophy

Federal Tax Philosophy

Every year, Americans use the 1040 form to calculate the amount of federal taxes that they owe …
Robyn Mackenzie/Shutterstock

What is the principle underlying the federal tax system? (By federal, we mean taxes collected by the federal government, as opposed to the taxes collected by state and local governments.) The answer is that it depends on the tax.

The best-known federal tax, accounting for about half of all federal revenue, is the income tax. The structure of the income tax reflects the ability-to-pay principle: families with low incomes pay little or no income tax. In fact, some families pay negative income tax: a program known as the Earned Income Tax Credit “tops up,” or adds to, the earnings of low-wage workers. Meanwhile, those with high incomes not only pay a lot of income tax but also must pay a larger share of their income in income taxes than the average family.

… and the vast majority of Americans submit those forms online.
Thomas J. Peterson/Getty Images

The second most important federal tax, FICA, also known as the payroll tax, is set up very differently. It was originally introduced in 1935 to pay for Social Security, a program that guarantees retirement income to qualifying older Americans and also provides benefits to workers who become disabled and to family members of workers who die. (Part of the payroll tax is now also used to pay for Medicare, a program that pays most medical bills of older Americans.) The Social Security system was set up to resemble a private insurance program: people pay into the system during their working years, then receive benefits based on their payments. And the tax more or less reflects the benefits principle: because the benefits of Social Security are mainly intended to assist lower-and middle-income people, and don’t increase substantially for the rich, the Social Security tax is levied only on incomes up to a maximum level—$117,000 in 2014. (The Medicare portion of the payroll tax has no upper limit.) As a result, a high-income family doesn’t pay much more in payroll taxes than a middle-income family.

Income group

Percent of total pre-tax income received

Percent of total federal income tax paid

Percent of total payroll tax paid

Bottom quintile

     5.1%

    –6.2%

     5.6%

Second quintile

  9.6

 –2.9

  9.8

Third quintile

14.2

  2.9

15.4

Fourth quintile

20.4

13.3

23.9

Top quintile

51.9

92.9

45.1

Source: Congressional Budget Office.
Table :

TABLE 7-2 Share of Pre-Tax Income, Federal Income Tax, and Payroll Tax, by Quintile in 2010

Table 7-2 illustrates the difference in the two taxes, using data from a Congressional Budget Office study. The study divided American families into quintiles: the bottom quintile is the poorest 20% of families, the second quintile is the next poorest 20%, and so on. The second column shows the share of total U.S. pre-tax income received by each quintile. The third column shows the share of total federal income tax collected that is paid by each quintile.

As you can see, low-income families actually paid negative income tax through the Earned Income Tax Credit program. Even middle-income families paid a substantially smaller share of total income tax collected than their share of total income. In contrast, the fifth or top quintile, the richest 20% of families, paid a much higher share of total federal income tax collected compared with their share of total income. The fourth column shows the share of total payroll tax collected that is paid by each quintile, and the results are very different: the share of total payroll tax paid by the top quintile is substantially less than their share of total income.

Quick Review

  • Other things equal, government tax policy aims for tax efficiency. But it also tries to achieve tax fairness, or tax equity.

  • There are two important principles of tax fairness: the benefits principle and the ability-to-pay principle.

  • A lump-sum tax is efficient because it does not distort incentives, but it is generally considered unfair. In any well-designed tax system, there is a trade-off between equity and efficiency. How the tax system should weight equity and efficiency is a value judgment to be decided by the political process.

7-3

  1. Question 7.8

    Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax.

    1. A federal tax of $500 for each new car purchased that finances highway safety programs

    2. A local tax of 20% on hotel rooms that finances local government expenditures

    3. A local tax of 1% on the assessed value of homes that finances local schools

    4. A 1% sales tax on food that pays for government food safety regulation and inspection programs

Solutions appear at back of book.