Econ 132 Public Finance, Foldvary

Holcombe, 13, Taxation of Income

The tax base: the object being taxed.

What is income?

Income as the object: gains that come in: payments from labor and assets.

real estate, stocks, bonds, financial instruments.

Also capital gains.

Business "income" has to be profits, not just receipts or revenue.

Government taxes nominal, not real, income.

So the “income” tax takes from wealth in addition to gains.

Some asset value is taxed that is not income.

Some income is exempt.

Income tax rates can be manipulated to favor various interests.

P. 269: Income taxes induce substitution to

tax avoidance and evasion, leisure, and less risk taking and investment.

The income effect can increase labor to obtain the same amount of private consumption,

but normally the substitution effect dominates.

If there were no savings and no borrowing, a total income tax would be equivalent to a total consumption tax.

Since there are savings and borrowing,

income taxes penalize savings, while consumption taxes penalize borrowing.

This is recognized by the government, which lets people shelter interest in retirement accounts.

In-kind employment benefits are not taxed.

Employees would have more utility getting paid in cash and choosing how to spend.

What is the economic meaning of income?

Consumption plus the change in net worth.

It is referred to as "Haig-Simmons" income.

Robert Haig and Henry Simmons.

It is net of all costs, such as inflation.

It includes imputed income, such as the rental value of owner-occupied housing.

It includes unrealized gains.

Today’s income tax is not adjusted for inflation for interest, depreciation, and capital gains.

There would be fewer distortions if the economic meaning of income were the tax base.

If the taxpayer lacks cash, no need to sell the asset;

the tax could be on installments or postponed.

P. 274: Imputed rental income, flow of housing services.

Homeowner pays no tax on imputed rental income, and gets a tax deduction.

What is the equitable policy?

p. 276 Income versus leisure

Leisure includes non-taxed home production.

Substitution effect: lower opportunity cost of leisure shifts activity towards leisure.

Substitution effect is a deadweight loss.

The income effect can increase labor to obtain the same amount of funds.

Usually the substitution effect dominates.

p. 281: Tax Rates and Revenues: the Khaldun-Laffer curve

Abu Said ibn Khaldun, Arab, 1332-1406

historian, sociologist and economist

held government positions

President Reagan cited Khaldun as supporting the view that

a reduction of tax rates can generate larger tax revenues.


Arthur Laffer popularized this idea: hence called the Laffer curve.

At high rates, lower taxes can increase revenue.

But taxes on land have no Laffer curve.

Some evidence that lower taxes in 1980s raised revenues.

Top one percent, 19% of taxes in 1980, 27% in 1988.

When tax rates were raised, the top paid a lower percentage.

P. 284: Average and marginal tax rates

For income tax, average tax rate = total taxes paid / total income.

Marginal tax rate: on extra income.

Progressive income tax: the tax rates progress with income.

Regressive: tax rates regress with income.

Proportional or flat rate: same rates for all income.

Can be progressive with a zero rate then one constant rate.

Progressive taxes: more redistribution.

With progressive taxes, the marginal tax rate is greater than the average tax rate.

That increases the excess burden.

P. 285: Flat-rate income tax.

Can be semi-flat with an exempt amount.

Not just one rate, but eliminate deductions, credits, special exemptions.

Still is progressive if the first amount of income is exempt.