Page 663 - Economics

CONFIRMING PAGES

PART EIGHT
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Microeconomics of Government
• A tax is progressive if its average rate increases as in- has an income of $15,000 and spends it all. “High-income”
come increases. Such a tax claims not only a larger Jones has an income of $300,000 but spends only $200,000
absolute (dollar) amount but also a larger percentage and saves the rest. Assuming a 5 percent sales tax applies
of income as income increases. to all expenditures of each individual, we find that Smith
• A tax is regressive if its average rate declines as in- pays $750 (5 percent of $15,000) in sales taxes and Jones
come increases. Such a tax takes a smaller proportion pays $10,000 (5 percent of $200,000). But Smith pays
of income as income increases. A regressive tax may $750 $15,000, or 5 percent of income, as sales taxes, while
or may not take a larger absolute amount of income Jones pays $10,000 $300,000, or 3.3 percent of income.
as income increases. (You may want to derive an ex- The general sales tax therefore is regressive.
ample to substantiate this conclusion.)
• A tax is proportional if its average rate remains the Corporate Income Tax The Federal corporate income
same regardless of the size of income. tax is essentially a proportional tax with a flat 35 percent
We can illustrate these ideas with the personal income tax rate. But this assumes that corporation owners (share-
tax. Suppose tax rates are such that a household pays holders) bear the tax. Some tax experts argue that at least
10 percent of its income in taxes regardless of the size of part of the tax is passed through to consumers in the form
its income. This is a proportional income tax. Now suppose of higher product prices. To the extent that this occurs, the
the rate structure is such that a household with an annual tax is like a sales tax and is thus regressive.
taxable income of less than $10,000 pays 5 percent in
income taxes; a household with an income of $10,000 to Payroll Taxes Taxes levied on payrolls (Social Security
$20,000 pays 10 percent; one with a $20,000 to $30,000 and Medicare) are regressive because the Social Security
income pays 15 percent; and so forth. This is a progressive tax applies to only a fixed amount of income. For exam-
income tax. Finally, suppose the rate declines as taxable in- ple, in 2006 the Social Security tax rate was 6.2 percent,
come rises: You pay 15 percent if you earn less than but only of the first $94,200 of a person’s wage income.
$10,000; 10 percent if you earn $10,000 to $20,000; 5 per- The Medicare tax was 1.45 percent of all wage income.
cent if you earn $20,000 to $30,000; and so forth. This is a Someone earning exactly $94,200 would pay $7206, or
regressive income tax. 7.65 percent ( 6.2 percent 1.45 percent) of his or her
In general, progressive taxes are those that fall rela- income. Someone with twice that wage income,
tively more heavily on people with high incomes; regres- or $188,400, would pay $8572 ( $7206 on the first
sive taxes are those that fall relatively more heavily on the $94,200 $1366 on the second $94,200), which is only
poor. (Key Question 7) 4.55 percent of his or her wage income. So the average
payroll tax falls as income rises, confirming that the pay-
Applications Let’s examine the progressivity, or re- roll tax is regressive.
gressivity, of several taxes. Moreover, government does not collect payroll taxes
on nonwage income (such as interest, dividends, or rents).
Personal Income Tax We noted in Chapter 4 that the High-income persons tend to derive a higher percentage
Federal personal income tax is progressive, with marginal of total income from nonwage sources than do people who
tax rates (those assessed on additional income) ranging have incomes below the $94,200 maximum on which social
from 10 to 35 percent in 2006. Rules that allow individuals security taxes are paid. This makes payroll taxes even
to deduct from income interest on home mortgages and more regressive. If our individual with the $188,400 of
property taxes and that exempt interest on state and local wage income also received $188,400 of nonwage income,
bonds from taxation tend to make the tax less progressive the $8572 of payroll tax would be only 2.23 percent of his
than these marginal rates suggest. Nevertheless, average or her total income.
tax rates rise with income.
Property Taxes Most economists conclude that prop-
Sales Taxes At first thought, a general sales tax with, for erty taxes on buildings are regressive for the same reasons
example, a 5 percent rate would seem to be proportional. as are sales taxes. First, property owners add the tax to the
But in fact it is regressive with respect to income. A larger rents that tenants are charged. Second, property taxes, as a
portion of a low-income person’s income is exposed to the percentage of income, are higher for low-income families
tax than is the case for a high-income person; the rich pay than for high-income families because the poor must
no tax on the part of income that is saved, whereas the spend a larger proportion of their incomes for housing.
poor are unable to save. Example: “Low-income” Smith This alleged regressivity of property taxes may be increased

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