Question

You work for the Council of Economic Advisers, providing economic advice to the White House. The president wants to overhaul the income tax system and asks your advice. Suppose that the current income tax system consists of a proportional tax of \(10 \%\) on all income and that there is one person in the country who earns \(\$ 110\) million; everyone else earns less than \(\$ 100\) million. The president proposes a tax cut targeted at the very rich so that the new tax system would consist of a proportional tax of \(10 \%\) on all income up to \(\$ 100\) million and a marginal tax rate of \(0 \%\) (no tax) on income above \(\$ 100\) million. You are asked to evaluate this tax proposal. a. For incomes of \(\$ 100\) million or less, is this proposed tax system progressive, regressive, or proportional? For incomes of more than \(\$ 100\) million? Explain. b. Would this tax system create more or less tax revenue, other things equal? Is this tax system more or less efficient than the current tax system? Explain.

Short answer

#Answer# Based on the steps in the analysis, for incomes of 100 million or less, the tax system is proportional. For incomes above 100 million, the tax system is regressive. The new tax system generates less revenue than the current tax system. In terms of efficiency, the new tax system can be considered less efficient, as it generates lower revenue and may promote income inequality.

Step-by-step solution

Understand the terms progressive, regressive, and proportional tax systems

Progressive tax system: A system where the tax rate increases as the taxable income increases. Regressive tax system: A system where the tax rate decreases as the taxable income increases. Proportional tax system: A system where the tax rate remains constant regardless of the taxable income.

Determine the tax system for incomes of \(100\) million or less and for incomes above \(100\) million

For incomes of \(100\) million or less, the proposed tax system remains unchanged, with a proportional tax of \(10\%\) on all income. So, for this income range, the tax system is proportional. For incomes above \(100\) million, the marginal tax rate is \(0 \%\) on the income exceeding \(100\) million. This introduces a regressive aspect, as the effective average tax rate decreases for individuals with higher incomes.

Evaluate the tax revenue generated by the proposed tax system compared to the current tax system

Under the current tax system, the person with an income of \(110\) million pays \(10\%\) tax on the whole amount, which is \(11\) million in taxes. With the new tax system, the person with an income of \(110\) million pays \(10\%\) tax on the first \(100\) million, yielding \(10\) million in taxes, and no tax on the income above \(100\) million. All other individuals earning less than \(100\) million are not affected by the tax change. So, the tax revenue generated by the proposed tax system is \(1\) million less than the revenue generated under the current tax system.

Analyze the efficiency of the proposed tax system compared to the current tax system

Efficiency, in this context, refers to the tax system's ability to generate revenue and minimize distortions in the economy. By reducing the tax revenue, the new system is less efficient in generating revenue than the current tax system. Regarding economic distortions, the proposed tax system can encourage individuals to increase their income above the \(100\) million threshold, which may stimulate economic growth. However, it also can lead to income inequality as wealthy individuals accumulate more wealth due to lower tax rates, which can undermine the society's overall well-being. Thus, the efficiency of the new tax system compared to the current one is debatable, depending on other factors in the economy. Overall, it can be considered less efficient since it generates less revenue and introduces income inequality.

Key concepts

Progressive Tax

A progressive tax system is where the tax rate increases as the taxable income rises. This means that higher earners pay a larger percentage of their income in taxes compared to lower earners. It is designed to redistribute wealth more effectively and ensure that those with a greater ability to pay contribute more.
In practice, progressive taxes are often structured in brackets, where different portions of an individual's income are taxed at varying rates. Higher income brackets face higher tax rates, making the structure progressively steeper.

• Fairness: Based on the ability-to-pay principle, it aims to reduce income inequality.
• Impact: Typically results in a more equitable distribution of the tax burden across society.

While the proposed system in the exercise could have progressive elements, for incomes above a certain threshold, it is more complex as it introduces regressive features for the very high earners.

Regressive Tax

A regressive tax system is where the effective tax rate decreases as the individual's income increases. This means that lower-income individuals bear a heavier burden of the tax relative to their earnings than higher-income individuals do.
An example of a regressive tax is a fixed overall tax amount or rate regardless of income, where poorer individuals pay a larger proportion of their income compared to wealthier individuals.

• Fairness: Seen as less fair, as it can widen income inequality.
• Impact: Often places a disproportionate burden on the lower-income earners in the society.

In the context of the exercise, the proposed tax system is regressive for income above $100 million, because the marginal tax rate drops to 0% for income above this level, meaning that wealthier individuals pay a smaller percentage of their income in taxes.

Proportional Tax

A proportional tax, also known as a flat tax, applies the same tax rate to every taxpayer regardless of their income. This means everyone pays the same percentage of their income in taxes, whether they earn less or more.
While simple in structure, it does not consider differences in ability to pay, as wealthier individuals do not contribute a larger portion of their income compared to others.

• Fairness: Perceived as fairer by those who argue that everyone contributes equally based on income proportion.
• Impact: Does not directly address income inequality.

In the exercise, for incomes up to $100 million, the tax system remains a 10% proportional tax, unaffected by the proposed changes and thus remains constant across this income bracket.

Tax Revenue

Tax revenue is the total amount of money collected by the government through taxation. It is crucial for financing government services and infrastructure, such as education, defense, and public healthcare. Tax revenue can be influenced by the structure of taxation. Progressive taxes, for example, may generate more revenue from high earners, while regressive taxes might reduce the overall tax revenue because they could suppress spending by lower-income groups.

• Influence of Tax System: The design and implementation of a tax system can significantly impact the overall revenue generated.
• Impact of Changes: Altering the tax code can either increase or decrease tax revenue, affecting government budgets.

In the exercise, the proposed tax changes reduce revenue by $1 million compared to the current system because they decrease the overall tax burden on the wealthy, reducing the contributions from higher income earners.

Economic Efficiency

Economic efficiency in a tax system refers to the ability to collect taxes without distorting resource allocation and minimizing economic harm. This means maximizing tax revenue with minimal adverse effects on investment, labor supply, and consumption decisions. A more efficient tax system should ideally encourage growth while maintaining revenue.

• Distortions: Inefficient taxes can lead to poor economic decisions, such as reduced investment or labor participation.
• Incentives: Efficient tax systems balance revenue generation against economic growth incentives.

In the specific exercise, while the proposed tax structure might incentivize more income generation above the $100 million threshold, it may also lead to income inequality, which poses a long-term challenge to efficiency as wealth concentration can reduce overall economic demand.