Introduction to Chapters 1 through 4

• Author: Deborah A. Geier
• Pages: 1-2

Unit I:

The Core Structures of Income

and Consumption Taxation and Tax Policy

Introduction to Chapters 1 through 4

Taxation is the means by which all governments, including our Federal government, raise

revenue to pay for the costs of government, including the military, infrastructure, court system,

Federal agencies, Medicare, Social Security, basic research that the private sector cannot

accommodate, interest on loans used to smooth the peaks and valleys of the tax revenue stream

when economic activity decelerates with recessions, etc. We can call the aggregate tax collected

in any particular year $X. Regardless of whether you think $X is too high or too low, we must

decide how the economic burden of $X—whatever the amount—should be allocated across the

members of the population. Two attributes of a tax system that will affect the allocation of $X are

(1) the tax base, i.e., what is taxed and (2) the tax rate structure.

For example, suppose that Mary earns $75,000 in wages and no investment income. John earns

$50,000 in wages but also receives $30,000 in interest paid on his substantial investment in

corporate bonds. The burden of $X will be allocated very differently between Mary and John if we

choose to tax, say, only investment income (such as John’s interest), only wages, or both.

Similarly, suppose that Mary spends only $60,000 of her $75,000 in wages on personal

consumption purchases for the year (such as food, clothing, rent, entertainment, etc.) and saves the

remaining amount (after paying any tax that she owes) by depositing it in a bank savings account.

Of the aggregate $80,000 that John earns in wages plus interest, he spends $40,000 on consumption

purchases, depositing the remaining amount (after paying any tax that he owes) in a savings

account. The burden of $X will be allocated very differently between Mary and John if we choose

a tax base comprised only of amounts spent on personal consumption—and not amounts saved, as

well.

The tax rate structure also has an effect on how the burden of $X is apportioned across the

members of the population. If our tax base comprises only wages, for example, notice how the

allocation of the tax burden differs depending on whether we decide that a single tax rate should

apply to each and every dollar earned (including the first dollar earned), a single tax rate should

apply to wages exceeding a floor of tax-free wages, or progressively higher rates should apply to

each chunk of wages earned (such as, say, 0% of the first $20,000 of wages, 10% of the next

$30,000, 20% of wages between $40,000 and $100,000, 30% of wages between $100,000 and

$500,00, and 40% of wages above $500,000).

Finally, the tax rate structure is necessarily affected by our prior choice of tax base. Generally

speaking, the narrower the tax base, the higher rates must be to raise $X. The broader the tax base

(the more items that are taxed), the lower rates can be to raise that same $X. Thus, decisions to

accord preferential tax treatment to certain classes of activities or income affect not only those who

benefit from these decisions but every remaining taxpayer who does not so benefit because their

tax rates are higher than they would otherwise need to be to raise $X. In this way, decisions