Chapter 12: The Design of the Tax System

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Welcome, deep divers.

Today we're plunging into a topic that, well, much like death is absolutely certain in life, taxes.

And our journey starts, interestingly,

not with dusty forms, but notorious figure Al Scarface Capone, this legendary 1920s gangster, you know, responsible for countless violent crimes, was famously brought down not for the violence, but actually for tax evasion.

Seems he didn't quite listen to Ben Franklin's timeless observation back in 1789.

In this world, nothing is certain but death and taxes.

And wow, what a journey taxes have been since Franklin's era.

Back then, the average American paid like less than 5 % of their income taxes.

Fast forward to today, and that number, it's ballooned to over a quarter of the average Americans income, even more in lots of European countries.

It's a huge economic and social shift.

Okay, so let's unpack this.

Our mission today is to take a deep dive into how governments actually design their tax systems.

We're looking at both the why they tax and how they structure it all.

We'll focus on the core goals of efficiency and equity, which you'll see often pull in opposite directions.

By the end of this deep dive, you should have a much clearer picture of what makes a tax system tick and where the real challenge is.

That's absolutely right.

The inevitability of taxes, it isn't just some historical footnote.

It's fundamental to how modern societies function.

Governments are there to provide essential goods and services that markets, well, they often can't deliver efficiently on their own.

Think back to our earlier talks on market failures.

Governments provide the foundation, things like police and courts, to make sure property rights are secure.

They step in to fix externalities like, say, air pollution, and they provide crucial public goods, national defense being a big one.

Plus, they regulate common resources, maybe managing fish stocks in a lake.

All these vital things are expensive, really expensive, and that cost inevitably needs revenue, and that revenue comes from taxation.

Right, and this isn't the first time we've bumped into taxes in our discussions.

We've touched on them before, so let's just quickly reconnect with some key ideas.

We know that a tax on a good, it usually affects supply and demand, right?

It tends to reduce the quantity sold.

And crucially, we've explored how elasticities, how responsive buyers and sellers are to price changes, play a huge role in figuring out who, buyers or sellers, actually ends up bearing the tax burden.

We also know taxes generally cause deadweight losses.

That means the drop in overall well -being, consumer and producer surplus, is often bigger than the actual tax money the government collects.

But there's that remember,

when you have externalities like pollution, a well -designed tax can actually boost efficiency by making polluters pay the true social cost.

Exactly.

And what's so interesting here is how this deep dive really builds on those foundational concepts.

We're moving beyond looking at just one specific tax, but thinking about the overall design of the whole tax system.

The goal, as you'll see, is crafting a system that tries to balance those two, often competing objectives, being efficient and being equitable.

And that means understanding the really complex trade -offs involved in pretty much every tax policy decision.

Okay.

So the why is pretty clear.

Governments need money for stuff.

Now, let's quickly get a sense of the sheer scale of US taxation.

If you look at total government revenue, that's federal, state and local all bundled together as a slice of the nation's total income.

Well, it's grown a lot over the last century.

We're talking from around 7 % back in the early 1900s to nearly 30 % in recent years.

That definitely shows a bigger role for government in the economy.

And if we put that 30 % figure into an international perspective, you might be surprised.

The US actually has a relatively low tax burden compared to many other advanced economies.

While the US government collects around, say, 26 % of GDP in taxes,

countries like Denmark, France, Sweden, they collect way more, often over 40%.

And those higher taxes in Europe, they typically pay for a much more extensive social safety net and, you know, more public services generally.

Okay, so the government collects a ton, but maybe less than some others.

But where does all this federal money actually come from?

Let's look specifically at the federal level.

By far the biggest single source of federal revenue is personal income taxes.

This is the one most of us wrestle with every April.

It's a tax on your wages, interest, dividends, business profits, all calculated after you take out various deductions and exemptions.

The federal income tax system here is also progressive.

That means higher income earners face higher marginal tax rates.

Right, the rate on each additional dollar of income.

Exactly.

Those rates climb as your income goes up, starting around 10 % and going up to nearly 40 % for the highest earners.

But importantly, each rate only hits the income within that specific bracket.

Okay, number two source.

That's payroll taxes, sometimes called social insurance taxes.

These are mostly taxes on wages earmarked specifically to fund social security for retirees and Medicare, the health program for seniors.

And for a lot of middle -income families, these payroll taxes, they're actually the single biggest tax they pay each year.

Then we have corporate income taxes.

These are levied on the profits of businesses set up as legal entities corporations.

And this leads to that interesting double taxation issue sometimes.

Right.

The profit gets taxed once when the corporation earns it, and then potentially again when it's paid out to shareholders as dividends, though there are some adjustments for that.

And finally, there's a catch all other taxes category.

This includes things like excise taxes on specific goods, the gasoline, alcohol, cigarettes, plus estate taxes and customs duties.

Now that's the federal picture, but state and local governments, they also collect a pretty significant chunk of change, though their main tools are a bit different.

For states and localities, the really big ones are usually property taxes, which are based on the estimated value of land and buildings.

And sale taxes, that percentage added on to stuff you buy at retail,

though some states exempt necessities like food or clothing.

Yeah, that varies a lot.

It does.

And many states also have their own personal and corporate income taxes, but again, huge variation across the country.

Some don't even have a state income tax.

It's also worth pointing out that a decent slice of state and local money actually comes from the federal government, often for specific programs like Medicaid.

All right.

So we've got a handle on what taxes are collected.

Now let's dive into how we actually judge a tax system, what makes a good one.

Well, most folks agree on two main goals, efficiency and equity.

Sounds simple, but getting both at the same time.

That's the tricky part.

So first, efficiency.

A tax system is considered more efficient if it raises the same amount of money, puts a smaller cost on taxpayers overall.

And beyond the obvious cost, the tax payment itself, there are two other costs taxes impose that we really want to minimize.

Deadweight losses and administrative burdens.

Yeah.

And that first one, deadweight losses is really key to understanding efficiency.

It comes down to how taxes change people's behavior.

People respond to incentives, right?

So when the government taxes something in activity, a good loss, it distorts those incentives.

Tax ice cream, people might eat less ice cream.

Tax work, people might work less.

A deadweight loss is basically the reduction in the wellbeing of everyone in the market buyers and sellers that goes beyond the actual tax revenue the government collects.

It's an inefficiency because resources end up getting allocated based on these tax distorted signals, not necessarily on the true underlying costs and benefits.

Let's use that pizza example from the text.

Imagine a $4 tax put on pizza.

Maybe the price goes up and someone who valued a pizza at $12, but now sees it cost $14, decides not to buy it.

The government doesn't get any tax revenue from that sale that didn't happen.

But that person lost the potential enjoyment, the consumer surplus they would have gotten.

That lost welfare with no offsetting government revenue.

That's the deadweight loss.

It comes from the transactions that don't occur because of the tax.

So it's not just about who pays the tax.

It's also about the economic activity that gets choked off.

Exactly.

But it's also crucial to remember that corrective taxes, the ones designed to deal with negative externalities like pollution, they can actually reduce deadweight loss and increase efficiency by aligning private costs with social costs.

Okay, this whole idea of distorted incentives brings up a really interesting and pretty long running debate.

Should we be taxing income or consumption?

Our current income tax system, well, it can definitely discourage saving.

Think about it.

If you save $1 ,000 for 40 years earning 8 % interest untaxed, it grows quite large.

But if say 25 % of that interest is taxed away each year, your effective return drops significantly, and your savings grow to maybe less than half as much over those 40 years, that's a pretty clear disincentive to save and invest for the long term, which impacts capital formation.

Now, consumption tax would work differently.

It would tax what people spend, not what they earn.

So any income you save wouldn't be taxed until you actually spend it down the road.

That removes or at least reduces the tax disincentive to save.

And we actually have elements of this already in the US, right?

Things like IRAs, 401Ks.

Exactly.

Those retirement accounts let savings grow tax deferred, functioning a bit like a consumption tax for that portion of income.

And you see this more broadly in other cases.

Many European countries rely heavily on a value added tax, a VAT, which is basically a consumption tax collected piece by piece during production.

Yeah, economists like Alan Greenspan have argued that moving more towards a consumption tax could really boost saving and economic growth.

But of course, making that transition would be incredibly complex politically and administratively.

Okay, so besides deadweight losses from changed behavior, the other big efficiency cost is the administrative burden.

This is all the time, effort and money that goes into just dealing with taxes.

For taxpayers, it's filling out forms, keeping records, maybe hiring accountants or lawyers.

And for the government, it's the cost of collecting the taxes and enforcing the rules.

All those hours spent gathering receipts in April.

Exactly.

And higher income folks, especially, often spend significant resources on tax planning, finding legal ways to minimize their tax liability.

This is tax avoidance, which is legal, not tax evasion, which is illegal.

They often use what people call loopholes.

These might be ambiguities in the law, or sometimes they're deliberate policy choices Congress made, maybe to encourage certain activities.

Like deductions for mortgage interest or charitable donations.

Right, and all that time and money spent on compliance and planning.

It's essentially a deadweight loss, too.

It's real cost to society.

But the government doesn't get that money as revenue.

Everyone says they want tax simplification, but simplifying often means getting rid of someone's favorite deduction or loophole, which makes it politically very, very difficult.

Okay, this leads us to a really critical distinction, one that affects both efficiency and how we think about fairness.

It's the difference between your average tax rate and your marginal tax rate.

Your average tax rate is pretty simple.

It's just your total tax bill divided by your total income.

It tells you the overall fraction of your income you paid in taxes kind of gauges the overall sacrifice.

But your marginal tax rate is different.

It's the rate of tax you pay on the next dollar you earn.

So if earning one more dollar means you pay 25 cents more in tax, your marginal rate is 25%.

And here's why it's so important.

Your average rate tells you about the total burden, but it's the marginal tax rate that really influences your decisions at the margin.

Should I work that extra hour?

Should I make that extra investment?

Rational people think about the additional costs and benefits.

So the marginal tax rate is what primarily drives the incentive effects of the income tax, and therefore it's what largely determines the size of the deadweight loss.

Right, and to really drive home this idea of efficiency,

economists often talk about a theoretical concept, the lump sum tax.

This is a tax where everyone pays the exact same fixed amount, say $6 ,000 per person, regardless of their income, their spending, anything they do.

So rich or poor, you pay the same dollar amount.

Exactly.

Now think about the rates.

If you earn $30 ,000, your average rate is 20%.

If you earn $60 ,000, your average rate is 10%.

So it's regressive in average terms.

But what's the marginal rate?

Since nothing you do changes the $6 ,000 you owe, your marginal tax rate is zero.

Ah, because earning an extra dollar doesn't change your tax bill at all.

Precisely.

And because it doesn't change the payoff to working, saving, or doing anything else, it doesn't distort incentives.

Therefore, a lump sum tax causes no deadweight losses.

Yep.

And its administrative burden is tiny.

It's super simple.

So purely from an efficiency standpoint, it's the most efficient tax possible.

But, this is a huge but, if it's so efficient, why don't we see it used?

Why isn't it popular?

Yeah, I can guess why.

It doesn't exactly sound fair, does it?

Exactly.

And that brings us squarely to the other major goal of tax policy.

Equity.

Or fairness.

Right.

Equity.

This is where tax policy often gets really shitted.

It's less about the economic efficiency arguments and much more about what people feel is fair.

How should the tax burden be shared across society?

And there's just no single easy answer that satisfies everyone.

Reminds me of that quote from Senator Russell Long, don't tax you, don't tax me, tax that fella behind the tree.

Yes, that perfectly captures the political reality, doesn't it?

Everyone wants taxes paid, just maybe not buy them.

So,

how do we think about fairness systematically?

One approach is the benefits principle.

This idea says people should pay taxes based on the benefits they receive from government services.

It tries to make paying for public goods feel a bit like buying private goods.

Okay, like the gas tax example.

You use the roads, you buy gas, so you pay the tax that funds the That's a classic example.

You could also argue the wealthy benefit more from things like police protection, they have more property to protect, or a strong legal system, or even national defense.

And maybe you should pay more based on that greater benefit.

You could even apply it to anti -poverty programs, arguing that wealthier people might value living in a society with less poverty, seeing that as a public good, they benefit from and thus should contribute more towards it.

Okay, that's one way.

What's another common approach?

The other major framework is the ability to pay principle.

Ah, this sounds more familiar.

It probably is.

This principle states that taxes should be levied based on how well someone can shoulder the burden.

The underlying idea is often about equal sacrifice.

Meaning, a thousand dollar tax hits a low -income person much harder than a ten thousand dollar tax hits a very wealthy person, even though the dollar Exactly.

And this principle leads to two related concepts of equity.

First, there's vertical equity.

This says taxpayers with a greater ability to pay, usually meaning higher income or wealth, should contribute larger amounts in taxes.

But this immediately raises the question, how much larger?

Should they pay proportionally more or even progressively more?

That's where the big debates often happen.

And second, there's horizontal equity.

This suggests that taxpayers with similar abilities to pay should contribute same amount.

Sounds simple on the surface.

Right.

But defining similar ability to pay in the real world, with all its complexities, that's incredibly difficult.

We can illustrate these ideas by looking at different tax structures.

A proportional tax takes the same fraction of income from everyone's say 20%, whether you're in 50k or 200k.

A regressive tax takes a smaller fraction from high -income earners than low -income earners.

Maybe 30 % from 50k, but only 20 % from 200k.

And a progressive tax like the US federal income tax takes a larger fraction from high -income earners.

So maybe 20 % from 50k, but 30 % from 200k.

And it's really important to stress,

economics can describe these systems, but it can't tell us which one is inherently the fairest.

That's a judgment based on philosophy and values.

So how does this actually shake out in the US?

Let's look at how the federal tax burden is distributed.

If you rank households by their income, from lowest to highest, and look at the federal taxes they pay as a share of that income, the system is clearly progressive.

The data shows the poorest fifth of households put a relatively small percentage of their income in federal taxes, maybe around 2 -3%.

The richest fifth pay a much larger share, maybe 25 -30%, and the top 1 % pay an even higher percentage, perhaps over 33%.

But here's where it gets even more interesting.

That's just looking at taxes paid to the government.

Money also flows the other way, right?

You mean transfer payments, like social security, unemployment benefits, food stamps.

Exactly.

These are like negative taxes.

And when you factor those in, when you look at taxes minus transfers,

the picture changes dramatically, especially at the bottom.

For the lowest income groups, their average tax rate actually becomes negative.

They receive more back in transfers than they pay in taxes.

Wow.

So the system as a whole, including transfers, is significantly redistributive.

Very much so.

That lowest quintile earning maybe $15 ,000 in the market might end up with over $30 ,000 after taxes and transfers are accounted for.

This reflects that ability to pay principal in action through both taxes and spending.

Okay.

Let's circle back quickly to horizontal equity, that idea of similar people paying similar taxes.

You said it's complex.

Why?

Well, think about two families, both earning exactly $100 ,000 a year.

Sounds similar, right?

On the surface, yes.

But what one family has, say, $30 ,000 in unavoidable medical expenses for a chronically ill child, and the other family is perfectly healthy, but chooses to spend $60 ,000 on college tuition for their kids.

Do they still have the similar ability to pay?

Should they pay the exact same amount of tax?

It's a tough question.

And that's precisely why the tax code ends up being filled with all sorts of deductions, credits, and special provisions for medical expenses, for dependents, for education costs, for mortgage interest, for state and local taxes.

They're all attempts, often imperfect, to achieve some measure of horizontal equity by adjusting for specific circumstances that affect a taxpayer's true ability to pay.

But they also make the system incredibly complex.

And this leads us to another crucial concept for evaluating equity, maybe the most important one, tax incidence.

Tax incidence.

Okay.

What's that about?

Tax incidence is the who ultimately bears the economic burden of a tax.

And the key insight is that the burden often doesn't fall on the person or company that actually sends the check to the government.

Oh, so it's not necessarily who the tax is levied on.

Exactly.

Economists kind of mock the simplistic flypaper theory, the idea that the tax burden just sticks wherever Congress initially places it.

It rarely works that way because taxes change prices and behavior, shifting the real burden around.

Let's take that example of a tax on expensive fur coats.

It seems targeted at the wealthy, right?

So it looks vertically equitable on the surface.

Makes sense.

Only rich people buy fur coats, mostly.

But what if those wealthy buyers have lots of other luxury options?

If the tax makes furs more expensive, maybe they just easily switch to buying, I don't know, designer handbags or fancy watches instead.

Demand for furs drops.

Well, who gets hurt then?

It might not be the wealthy buyers as much as the workers who manufacture the furs or the retailers who sell them.

And those workers might not be wealthy at all.

So the burden shifts away from the buyer and onto the supplier or the workers.

It can, yes.

The actual incidence who really bears the cost depends heavily on the elasticities of supply and demand, how easily buyers can substitute away and how easily suppliers can shift resources.

So the true equity impact can be very different from how it first appears.

That's a fantastic illustration.

And it ties directly into that perennial debate.

Who actually pays the corporate income tax?

Politically, taxing corporations is often popular.

People think, great, tax the big company, not me, because, you know, corporations aren't people, right?

Well, that's the common sentiment.

But economically speaking, people always pay taxes.

A corporation, in this sense, is more like a tax collector than a taxpayer itself.

The burden of that corporate tax has to fall on some group of actual people.

It could be the owners of the corporation, the shareholders, through lower profits and dividends.

It could be the corporation's customers, through higher prices.

Or it could be the corporation's workers, through lower wages or fewer jobs.

Think about a tax imposed on, say, car companies' profits.

Initially, yeah, the owners see lower returns.

But over time, what happens?

Maybe less capital flows into building car factories in that country.

Maybe investment elsewhere.

That could lead to fewer cars being produced domestically, pushing prices up for consumers.

And it could reduce the demand for auto workers, potentially pushing their wages down.

So the burden gets shared, potentially, among owners, customers, and workers.

Exactly.

How much falls on each group is a complex empirical question, debated fiercely by economists.

But the core point is, when you tax a corporation, you're ultimately taxing some combination of these people.

This was absolutely central to arguments around the 2017 tax bill that cut the U .S.

corporate rate significantly.

Supporters argued it would boost investment and wages for workers.

Critics argued most benefits would flow to wealthy owners.

Both sides, importantly, agreed that you had to look at tax incidents to evaluate the fairness.

Okay, so wrapping this all together, we've explored these two big goals for a tax system, efficiency and equity.

But as we've seen over and over, they often seem to stand in direct conflict, especially when we define equity in terms of progressivity, asking higher earners to pay a larger share.

Policies aimed at increasing progressivity can sometimes blunt incentives and reduce efficiency.

That trade -off is really the crux of the matter.

Yeah.

And this fundamental tension is usually right at the heart of political fights over tax policy.

You can almost see it as a pendulum swinging back and forth over time.

Think back to the 1980s.

President Reagan argued that very high marginal tax rates, sometimes over 50 or even 70 percent, were crippling efficiency, discouraging work, and saving.

So he pushed for major cuts, bringing the top rate way down.

Then, maybe a decade later, President Clinton argued the wealthy weren't paying their fair share, emphasizing vertical equity.

Top rates went back up.

Then President Bush reduced them again in the 2000s.

President Obama raised them again, again citing vertical equity.

And then President Trump oversaw cuts in 2017, bringing the top rate down slightly again.

A constant back and forth.

It really highlights that there's no single right answer that lasts forever.

It reflects shifting political winds, changing economic conditions, and different philosophical views on that core trade -off.

Absolutely.

And economics alone can't definitively tell us where that pendulum should rest.

That involves value judgments about fairness versus efficiency.

But what economics can do, and what it strives to do, is to clearly eliminate those trade -offs by understanding concepts like deadweight loss, administrative burden, marginal rates, and tax incidences.

We can better analyze the likely consequences of different tax policies.

We can try to understand who benefits, who pays, and what the impact on overall economic activity might be.

The hope is to help policymakers,

and really all of us as citizens, make more informed choices and maybe avoid policies that sacrifice a lot of efficiency without actually achieving much greater equity, or vice versa.

Okay, so let's quickly recap the key takeaways from our deep dive into tax system design for you.

We started with the why government's tax and got a sense the sheer scale of U .S.

taxation, also comparing it internationally.

We then briefly touched on the major types of taxes used by federal, state, and local governments, income taxes, payroll taxes, corporate taxes, sales taxes, property taxes, and others.

Then we really dove into the two main pillars for evaluating a tax system.

First, efficiency.

Minimizing those deadweight losses caused by distorted incentives, cutting down on administrative burdens, and understanding that difference between average and marginal tax rates.

We even looked at the theoretical efficiency of a lump sum tax.

And second, equity or fairness.

We looked at it through the lens of the benefits principle versus the ability to pay principle, which involves ideas like vertical equity, richer pay more, and horizontal equity is similar.

And critically, we discussed tax incidents figuring out who really bears the burden, which often isn't who the tax is levied on, debunking that simple flypaper theory.

And all this leads to a really fundamental question for you, the listener, to think about.

Given that persistent, often unavoidable tradeoff between efficiency and equity, what balance do you think is most important for a society to strike in its tax system?

And maybe more importantly, why?

What principles guide your view on that?

That's it for this Deep Dive.

We really hope you've gained a clearer, maybe more nuanced understanding of tax systems and all the incredibly complex choices involved in designing them.

From the entire Last Minute Lecture team, thank you so much for joining us on the Deep Dive.