The Design of the Tax System

Surface Capone, the notorious 1920s gangster and crime boss, was never convicted for his many violent crimes. Yet eventually, he did go to jail-for tax evasion. He had neglected to heed Ben Franklin’s observation that “in this world nothing is certain but death and taxes.When Franklin made this claim in 1789, the average American paid less than 5 percent of his income in taxes, and that remained true for the next hundred years. Over the course of the 20th century, however, taxes .became ever more important in the life of the typical US. citizen. Today, all taxes taken together including personal income taxes, corporate income taxes, payroll taxes, sales taxes, and property taxes use up about a third of the average American’s income. In many European countries, the tax bite is even larger.

Taxes are inevitable because we as citizens expect the government to provide us with various goods and . services. The previous two chapters shed light on one of the Ten Principles of Economics from Chapter 1: The government can sometimes improve market outcomes. When the government remedies an externalize (such as air pollution), provides a public good (such as national defense), or regulates the use of a common resource (such as fish in a public lake), it can raise economic well-being. Yet the benefits of government come with costs. For the government to perform these and its many other functions, it needs to raise revenue through taxation.

We began our study of taxation in earlier chapters, where we saw how a tax on a good affects supply and demand for that good. In Chapter 6, we saw that a tax reduces the quantity sold in a market, and we examined how the burden of a tax is shared by buyers and sellers depending on the elasticizes of supply and demand. In Chapter 8, we examined how taxes affect economic well-being. We learned that taxes cause dead weight losses: The reduction in consumer and producer surplus resulting from a tax exceeds the revenue raised by the government.

In this chapter, we build on these lessons to discuss the design of a tax system. We begin with a financial overview of the US. government. When thinking about the tax system, it is useful to know some basic facts about how the US. government raises and spends money. We then consider the fundamental principles of taxation. Most people agree that taxes should impose as small a cost on society and that the burden of taxes should be distributed fairly. That is, the tax system should be both efficient and equitable. As we will see, however, stating these goals is easier than achieving them.

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