Question

You are advising the government on how to pay for national defense. There are two proposals for a tax system to fund national defense. Under both proposals, the tax base is an individual's income. Under proposal A, all citizens pay exactly the same lump-sum tax, regardless of income. Under proposal B, individuals with higher incomes pay a greater proportion of their income in taxes. a. Is the tax in proposal A progressive, proportional, or regressive? What about the tax in proposal B? b. Is the tax in proposal A based on the ability-to-pay principle or on the benefits principle? What about the tax in proposal \(\mathrm{B}\) ? c. In terms of efficiency, which tax is better? Explain.

Short answer

Answer: Proposal A is a regressive tax, based on the benefits principle, and is more efficient than proposal B. Proposal B is a progressive tax, based on the ability-to-pay principle, and is less efficient than proposal A.

Step-by-step solution

a. Tax Types: Proposal A and Proposal B

For proposal A, everyone pays the same lump-sum tax, regardless of their income. This means that lower-income individuals pay a higher proportion of their income in taxes compared to higher-income individuals. Therefore, the tax in proposal A is regressive. On the other hand, proposal B requires higher-income individuals to pay a higher proportion of their income in taxes. This indicates that the tax in proposal B is progressive.

b. Tax Principles: Proposal A and Proposal B

Proposal A is based on the benefits principle, as the tax is the same for everyone irrespective of their income. Every individual is assumed to receive the same level of benefits from the government's national defense spending, so they pay the same amount in taxes. In contrast, proposal B is based on the ability-to-pay principle. This principle suggests that people with higher incomes should pay higher taxes because they have a greater ability to pay. Therefore, the tax structure in proposal B reflects this principle by having higher-income individuals pay a greater proportion of their income in taxes.

c. Efficiency: Comparing Proposal A vs. Proposal B

In terms of efficiency, we need to consider the impact of the two tax proposals on economic behavior and the overall tax collection process. Proposal A, being a lump-sum tax, does not distort individuals' economic decisions as it does not change with income. Since everyone pays the same amount of tax regardless of income, there is no disincentive to work more or earn additional income. As a result, proposal A can be considered more efficient as it has fewer negative effects on individual incentives and productivity. However, in Proposal B, higher-income individuals face higher tax rates, potentially discouraging them from pursuing additional income. This can lead to a reduction in overall economic activity and may even encourage tax avoidance and evasion. In terms of efficiency, this makes proposal B less efficient than proposal A. In conclusion, while proposal A is regressive and based on the benefits principle, it is generally more efficient compared to the progressive and ability-to-pay based proposal B.

Key concepts

Regressive Tax

A regressive tax is one where low-income earners pay a higher percentage of their income compared to high-income earners. In simple terms, as your income decreases, the rate of tax you pay increases. This can seem counterintuitive to many people, but it is a scenario that occurs when everyone pays the same amount of tax, regardless of their income.
In the context of the exercise, Proposal A describes such a tax system. Here, each citizen pays a fixed lump-sum tax. While the absolute amount is the same for everyone, this lump sum represents a larger share of a low-income individual's total income than that of a high-income individual.
This type of tax is regressive because it places a disproportionate financial burden on lower-income individuals. While they pay the same amount as wealthier individuals, it eats up a larger portion of their available income, leaving them with less disposable income to cover other expenses.

Progressive Tax

Progressive tax systems are based on the principle of taxing individuals based on their ability to pay. In other words, as an individual's income increases, the percentage of income paid in taxes also rises. This ensures that those who earn more, contribute more to the public coffers in percentage terms.
In Proposal B of the exercise, the tax system is structured to be progressive as it levies higher tax rates on individuals with higher incomes. This way, more affluent individuals pay a larger proportion of their incomes, ensuring that their greater financial resources are reflected in their tax contributions.
The progressive tax is seen as fairer by many because it aligns with the concept that those who have the means to pay more should do so. It redistributes the tax burden more equitably among different income groups, which can help in addressing economic inequality.

Ability-to-Pay Principle

The ability-to-pay principle is the idea that taxes should be levied according to an individual's ability to shoulder the financial burden. This means those with higher income and wealth should contribute more, as they are better positioned to afford paying higher taxes without impairing their standard of living.
In the exercise, Proposal B leverages this principle. It dictates that individuals with higher incomes pay a larger share of their income in taxes. Thus, it ensures that higher earners contribute more in proportion to their financial capabilities.
This principle can help to ensure that public services are funded without placing undue strain on those who are less financially established. By following the ability-to-pay principle, governments can create a more balanced approach to taxation that takes into account the economic circumstances of all citizens.