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15.2: Financing Government

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    Learning Objective

    1. Explain the ability-to-pay and the benefits-received principles of taxation.
    2. Distinguish among regressive, proportional, and progressive taxes.
    3. Define tax incidence analysis and explain and illustrate the conditions under which the burden of an excise tax falls mainly on buyers or sellers.

    If government services are to be provided, people must pay for them. The primary source of government revenue is taxes. In this section we examine the principles of taxation, compare alternative types of taxes, and consider the question of who actually bears the burden of taxes.

    In addition to imposing taxes, governments obtain revenue by charging user fees, which are fees levied on consumers of government-provided services. The tuition and other fees charged by public universities and colleges are user fees, as are entrance fees at national parks. Finally, government agencies might obtain revenue by selling assets or by holding bonds on which they earn interest.

    Principles of Taxation

    Virtually anything can be taxed, but what should be taxed? Are there principles to guide us in choosing a system of taxes?

    Jean-Baptiste Colbert, a minister of finance in seventeenth-century France, is generally credited with one of the most famous principles of taxation:


    Economists, who do not typically deal with geese, cite two criteria for designing a tax system. The first is based on the ability of people to pay taxes and the second focuses on the benefits they receive from particular government services.

    Ability to Pay

    The ability-to-pay principle holds that people with more income should pay more taxes. As income rises, the doctrine asserts, people are able to pay more for public services; a tax system should therefore be constructed so that taxes rise too. Wealth, the total of assets less liabilities, is sometimes used as well as income as a measure of ability to pay.

    The ability-to-pay doctrine lies at the heart of tax systems that link taxes paid to income received. The relationship between taxes and income may take one of three forms: taxes can be regressive, proportional, or progressive.

    Regressive Tax

    A regressive tax is one that takes a higher percentage of income as income falls. Taxes on cigarettes, for example, are regressive. Cigarettes are an inferior good—their consumption falls as incomes rise. Thus, people with lower incomes spend more on cigarettes than do people with higher incomes. The cigarette taxes paid by low-income people represent a larger share of their income than do the cigarette taxes paid by high-income people and are thus regressive.

    Proportional Tax

    A proportional tax is one that takes a fixed percentage of income. Total taxes rise as income rises, but taxes are equal to the same percentage no matter what the level of income. Some people argue that the U.S. income tax system should be changed into a flat tax system, a tax that would take the same percentage of income from all taxpayers. Such a tax would be a proportional tax.

    Progressive Tax

    A progressive tax is one that takes a higher percentage of income as income rises. The federal income tax is an example of a progressive tax. Table 15.1 “Federal Income Tax Brackets, 2007” shows federal income tax rates for various brackets of income for a family of four in 2007. Such a family paid no income tax at all if its income fell below $24,300. At higher income levels, families faced a higher percentage tax rate. Any income over $374,000, for example, was taxed at a rate of 35%. Whether or not to make the tax system more progressive was a major debating point during the U.S. presidential election of 2008.

    Table 15.1 Federal Income Tax Brackets, 2007

    2007 adjusted gross income (family of four) Personal income tax rate applied to bracket
    Less than $24,300 Zero (family may receive earned income credit)
    $24,300–$88,000 15%
    $88,000–152,800 25%
    $152,800–$220,150 28%
    $220,150–$374,000 33%
    Greater than $374,000 35%

    The federal income tax is progressive. The percentage tax rate rises as adjusted gross income rises.

    While a pure flat tax would be proportional, most proposals for such a tax would exempt some income from taxation. Suppose, for example, that households paid a “flat” tax of 20% on all income over $40,000 per year. This tax would be progressive. A household with an income of $25,000 per year would pay no tax. One with an income of $50,000 per year would pay a tax of $2,000 (.2 times $10,000), or 4% of its income. A household with an income of $100,000 per year would pay a tax of $12,000 (.2 times $60,000) per year, or 12% of its income. A flat tax with an income exemption would thus be a progressive tax.

    Benefits Received

    An alternative criterion for establishing a tax structure is the benefits-received principle, which holds that a tax should be based on the benefits received from the government services funded by the tax.

    Local governments rely heavily on taxes on property, in large part because the benefits of many local services, including schools, streets, and the provision of drainage for wastewater, are reflected in higher property values. Suppose, for example, that public schools in a particular area are especially good. People are willing to pay more for houses served by those schools, so property values are higher; property owners benefit from better schools. The greater their benefit, the greater the property tax they pay. The property tax can thus be viewed as a tax on benefits received from some local services.

    User fees for government services apply the benefits-received principle directly. A student paying tuition, a visitor paying an entrance fee at a national park, and a motorist paying a highway toll are all paying to consume a publicly provided service; they are thus paying directly for something from which they expect to benefit. Such fees can be used only for goods for which exclusion is possible; a user fee could not be applied to a service such as national defense.

    Income taxes to finance public goods may satisfy both the ability-to-pay and benefits-received principles. The demand for public goods generally rises with income. Thus, people with higher incomes benefit more from public goods. The benefits-received principle thus suggests that taxes should rise with income, just as the ability-to-pay principle does. Consider, for example, an effort financed through income taxes by the federal government to clean up the environment. People with higher incomes will pay more for the cleanup than people with lower incomes, consistent with the ability-to-pay principle. Studies by economists consistently show that people with higher incomes have a greater demand for environmental improvement than do people with lower incomes—a clean environment is a normal good. Requiring people with higher incomes to pay more for the cleanup can thus be justified on the benefits-received principle as well.

    Certainly taxes cannot respond precisely to benefits received. Neither the ability-to-pay nor the benefits-received doctrine gives us a recipe for determining just what each person “should” pay in taxes, but these doctrines give us a framework for thinking about the justification for particular taxes.

    Types of Taxes

    Figure 15.6 Sources of Government Revenue, 2007 The chart shows sources of revenue for federal, state, and local governments in the United States. The data omit revenues from government-owned utilities and liquor stores. All figures are in billions of dollars.

    It is hard to imagine anything that has not been taxed at one time or another. Windows, closets, buttons, junk food, salt, death—all have been singled out for special taxes. In general, taxes fall into one of four primary categories. Income taxes are imposed on the income earned by a person or firm; property taxes are imposed on assets; sales taxes are imposed on the value of goods sold; and excise taxes are imposed on specific goods or services. Figure 15.6 shows the major types of taxes financing all levels of government in the United States.

    Personal Income Taxes





    Property Taxes



    Sales Taxes



    Excise Taxes



    Tax Incidence Analysis






    Figure 15.8 shows how tax incidence varies with the relative elasticities of demand and supply. All four panels show markets with the same initial price, P1, determined by the intersection of demand D1 and supply S1. We impose an excise tax, given by the vertical green line. As before, we insert this tax wedge between the demand and supply curves. We assume the amount of the tax per unit is the same in each of the four markets.

    Figure 15.8 Tax Incidence and the Elasticity of Demand and of Supply We show the effect of an excise tax, given by the vertical green line, in the same way that we did in Figure 15.7. We see that buyers bear most of the burden of such a tax in cases of relatively elastic supply (Panel (a)) and of relatively inelastic demand (Panel (d)). Sellers bear most of the burden in cases of relatively inelastic supply (Panel (b)) and of relatively elastic demand (Panel (c)).


    Panels (c) and (d) of the exhibit show the same tax imposed in markets with identical supply curves S1. With a relatively elastic demand curve D1 in Panel (c) (notice that we are in the upper half, that is, the elastic portion of the curve), most of the tax burden is borne by sellers. With a relatively inelastic demand curve D1 in Panel (d) (notice that we are in the lower half, that is, the inelastic portion of the curve), most of the burden is borne by buyers. If demand is relatively elastic, then sellers bear more of the burden of the tax. If demand is relatively inelastic, then buyers bear more of the burden.


    Table 15.2 Federal Tax Burdens in the United States

    Lowest quintile 24.0 $18,568 5.6
    Second quintile 22.8 $42,619 12.1
    Middle quintile 23.3 $64,178 15.7
    Fourth quintile 23.2 $94,211 19.8
    Highest quintile 24.3 $227,677 26.5
    All quintiles 118.3 $89,476 21.6


    Key Takeaways

    • Tax incidence analysis seeks to determine who ultimately bears the burden of a tax.
    • The federal tax system in the United States is progressive.

    Try It!

    Consider three goods, A, B, and C. The prices of all three goods are determined by demand and supply (that is, the three industries are perfectly competitive) and equal $100. The supply curve for good A is perfectly elastic; the supply curve for good B is a typical, upward-sloping curve; and the supply curve for good C is perfectly inelastic. Suppose the federal government imposes a tax of $20 per unit on suppliers of each good. Explain and illustrate graphically how the tax will affect the price of each good in the short run. Show whether the equilibrium quantity will rise, fall, or remain unchanged. Who bears the burden of the tax on each good in the short run? (Hint: Review the chapter on the elasticity for a discussion of perfectly elastic and perfectly inelastic supply curves; remember that the tax increases variable cost by $20 per unit.)

    Case in Point: What Are Marginal Tax Rates?

    Figure 15.9


    We speak often of the importance of tax rates at the margin—of how much of an extra dollar earned through labor or interest on saving will be kept by the decision-maker. It turns out, however, that figuring out just what that marginal tax rate is is not an easy task.

    Consider the difficulty of untangling just what those marginal tax rates are. First, Americans face a bewildering complex of taxes. They all face the federal income tax. Each state—and many cities—levy additional taxes on income. Then there is the FICA payroll tax, federal and state corporate income taxes, and excise taxes, as well as federal, state, and local sales taxes. A person trying to figure out his or her marginal tax rate cannot stop there. Gaining an additional dollar of income will affect not only taxes but eligibility for various transfer payment programs in the level of payments the individual or household can expect to receive. Given the enormous complexity involved, it is safe to say that no one really knows what his or her marginal rate is.

    Economists Laurence J. Kotlikoff and David Rapson of Boston University have taken on the task of sorting out marginal tax rates for the United States. They used a commercial tax analysis program, Economic Security Planner™, and added their own computer programs to incorporate the effect of additional income on various transfer payment programs. Their analysis assumed the taxpayer lived in Massachusetts, but the general tenor of their results applies to people throughout the United States.

    Consider a 60-year-old couple earning $10,000 per year. That couple is eligible for a variety of welfare programs. With food stamps, there is a dollar-for-dollar reduction in aid for each additional dollar of income earned. In effect, the couple faces an effective marginal tax rate of 100%. Considering all other taxes and welfare programs, the economists concluded that the couple faced a marginal tax rate of about 50% on labor income. Overall, they found that a pattern of marginal rates for various ages and income levels could be described in a single word: “bizarre.”

    The tables below give the economists’ estimates of marginal rates for current year labor supply for a single individual and for couples with children at various incomes and ages. While the overall structure of taxes in the United States is progressive, the special treatment of welfare programs can add a strong element of regressivity.

    Marginal Net Tax Rates on Current-Year Labor Supply (Couples, percentages)
    Total Annual Household Earnings (000s)
    Age 10 20 30 50 75
    30 −14.2 42.5 42.3 24.4 36.9
    45 −11.4 41.7 41.8 35.8 36.1
    60 50.9 32.0 36.3 36.3 45.5
    Age 100 150 200 300 500
    30 37.0 45.9 36.8 43.9 44.0
    45 36.1 45.1 35.9 40.0 43.2
    60 45.5 47.7 43.2 45.8 45.0
    Marginal Net Tax Rates on Current-Year Labor Supply (Individuals, percentages)
    Total Annual Household Earnings (000s)
    Age 10 20 30 50 75
    30 72.3 42.9 42.9 37.0 37.0
    45 −0.8 42.9 42.6 37.0 36.1
    60 39.5 37.3 37.7 46.4 45.5
    Age 125 150 200 250
    30 36.2 36.9 42.0 41.5
    45 36.1 36.5 42.0 41.5
    60 38.8 44.0 45.0 44.0

    Look again at our 60-year-old couple. It faces a very high marginal tax rate. A younger couple with the same income actually faces a negative marginal tax rate—increasing its labor income by a dollar actually increases its after-tax income by more than a dollar. Why the difference? The economists assumed that the younger couple would have children and thus qualify for a variety of programs, including the Earned Income Tax Credit. The couple at age 60 still faces the dollar-for-dollar reduction in payments in the Food Stamp program. No one designed these marginal incentives. They simply emerge from the bewildering mix of welfare and tax programs households face.

    Answer to Try It! Problem

    The tax adds a $20 wedge between the price paid by buyers and received by sellers. In Panel (a), the price rises to $120; the entire burden is borne by buyers. In Panel (c), the price remains $100; sellers receive just $80. Therefore, sellers bear the burden of the tax. In Panel (b), the price rises by less than $20, and the burden is shared by buyers and sellers. The relative elasticities of demand and supply determine whether the tax is borne primarily by buyers or sellers, or shared equally by both groups.

    Figure 15.10