Taxes, Transfers, and Income Distribution Lesson

Government intervention in imperfect markets can create efficiency if the policy correctly addresses the incentives that led to the market failure. Government can use price regulation to address inefficiency due to monopoly. Remember a natural monopoly will require a lump-sum subsidy to produce at the allocatively efficient quantity. Governments use antitrust policy in an attempt to make markets more competitive.

One of the most significant roles the government plays in the economy is through the use of taxation. Taxes serve a variety of purposes. They can be used to raise revenue, discourage an activity, redistribute wealth, and provide for public goods and services. There are two general principles to taxation - the ability to pay principle and the benefit principle.

Who Should Pay A Tax? Principles of Taxation

Ability to Pay Principle

The belief that the burden of taxes should be based on a person's income level. People with greater ability to pay the tax (think higher income) should be responsible for a greater portion of the tax.

Benefit Received Principle

The belief that the burden of taxes should be based on who receives the benefits of the goods/services being provided by the tax. People who use the goods or services the most should be responsible for a greater portion of the taxes for those items.

Types of Taxes

There are three basic types of taxes:

Progressive Tax - A tax for which the percentage paid increases as income increases
Regressive Tax - A tax for which the percentage paid decreases as income increases
Proportional Tax - A tax for which the percentage paid stays the same as income increase

Taxes and Budgets Video

View the video below to learn more about taxes and budgets. To make the video full screen, select the double arrows at the bottom right corner of the object.

Transfer Payments and Income Redistribution

The government is able to provide transfer payments thanks to the revenue it generates through taxation. We have already discussed some forms of transfer payments (subsidies to producers, etc). These transfers have been used to promote the production or consumption of a good or service. However, there are other transfer payments that are used to confront a growing problem in the country - income inequality.

In the last module, we looked at income distribution in the United States. Some startling information was revealed through the Lorenz Curve. It demonstrated that the lowest 60% of the population controlled approximately 21% of the nation's wealth. The bottom 80% of the population controlled only 40% of market income. Through transfer payments, such as welfare, social security benefits, Medicare (health insurance for the elderly), Medicaid (health insurance for low income households), and unemployment insurance, the government aims to redistribute wealth and lessen income inequality in the nation. Let's see the impact of transfer payments on improving income inequality.

Impact of Transfer Payments
Quintile	Percent of Market Income	Cumulative Percent Market Income	Percent of Market Income After Tax	Cumulative Percent Market Income After Tax
Lowest 20%	2%	2%	4%	4%
2nd	7%	9%	9%	13%
3rd	12%	21%	14%	27%
4th	19%	40%	20%	47%
Highest	60%	100%	53%	100%

Lorenzo Curve
Income Concentration Graph

X-axis – Cumulative Share of Population (0 to 100)
Y-axis – Percent Cumulative Share of Income (0 to 100)

Line of Perfect Income Equality – from point A (0,0) to Point C (100, 100)
Point B (100,0)
Two curves are shown – After-Tax Income and Market Income

IMAGES CREATED BY GAVS