Policy and Choice: Public Finance through the Lens of Behavioral Economics

Taxation and Revenue

173 7 Taxation and Revenue Running a government is expensive. Correcting for market failures, providing public goods, guaranteeing social insurance, and redistributing income and sustaining antipoverty efforts—functions of government within the purview of public finance—all involve various expenditures. Increasing the expense are functions of government that are outside the scope of public finance, such as administering court systems, maintaining regulatory bodies, and other endeavors . In a typical year, the federal government’s share of the U.S. economy is about 20 percent.1 About one-fifth of federal spending is on Social Security; one-fifth on health programs, including Medicare and Medicaid; one-fifth on national defense; and the remaining two-fifths on everything else. Spending by state and local governments from their own sources amounts to roughly another 15 percent of total output, of which the largest single fraction, about one-third, is on education.2 In order to spend in this way, governments have to raise revenue. While there are other means, primarily borrowing by issuing debt, governments finance their operations mainly through taxation. Taxes take a variety of forms in the United States. At the federal level, the personal income tax raises close to half of total revenue. Another third or so comes from payroll taxes, the taxes that fund Social Security and Medicare. The rest is from other sources, such as corporate income taxes, excise taxes, estate and gift taxes, and so on. State and local governments also have income taxes, which account for about one-quarter of their revenue. In addition, state and local governments also rely heavily on consumption taxes, such as sales taxes on consumer goods, which raise about a third of their total 07-0498-0 ch7.indd 173 1/3/11 3:30 PM 174 taxation and revenue revenue, as well as taxes on property, which account for another third. The remainder is from other sources. Raising revenue in this way, through taxes on goods, income, and so on, changes the prices of nearly every economic activity that people engage in. Taxes on labor income lower the return to working, earning, and saving. Taxes on consumption change the relative prices of goods and services. Taxes on capital lower the return to accumulation. In some cases the change in price can be subtle. For instance, sales taxes often are in the neighborhood of 5 to 10 percent.3 In other cases, it can be dramatic. At the federal level, current marginal income tax rates range from 10 percent up to 35 percent, and for many workers that is in addition to marginal payroll taxes of 15.3 percent. And effective marginal rates can be even higher when, for example, credits or deductions phase out. One calculation of effective marginal tax rates for labor income puts the rates at over 40 percent for workers across many income ranges.4 Because taxes change the terms of such choices, taxes affect how people act and behave. The standard economic analysis of taxation starts from understanding the relationship between taxes and behavior. The real consequences of taxation are largely a function of the magnitude and nature of the response to taxes. When taxes are imposed on income, do people work less? How much less? How are the impacts related to the level or rate of the tax? How are they related to its form and relationship with other elements of the tax code or broader policy? The questions are similar for effects on saving and investment, consumption, and so on. This margin of response—the elasticity of supply or demand with respect to the tax—is the key parameter for analysis. Taking a behavioral perspective on the economic analysis of taxation may be important because behavioral tendencies will mediate the response to taxes. For example, due to limited computational capacity, individuals may respond to complex tax schedules only approximately or with error, or they may fail to understand the relationship of taxes to their behavior. Due to limited attention, individuals may fail to notice some taxes at all, in particular when they are hidden or obscure. The key implication is that individuals will respond to taxes as they perceive them, not necessarily as they are set. As a result, the relationship between taxes and behavior may become much less straightforward than in the standard model. This relationship may be further complicated by the way that taxes might interact with nonstandard preferences. The impact of taxes on behavior might be determined in part by reference...