Questions for Review with Answers
Chapter 19. Markets and the Government III. Taxation
I. Basics. All Sorts of Taxes
Chapter 19 – Question 1
List the most important sorts of direct and indirect taxes.
* The most important direct taxes are income tax including PAYE-taxes, corporate tax and inheritance tax. The most important indirect taxes are VAT or sales taxes and excise duties.
Chapter 19 – Question 2
Explain how VAT works.
* VAT is paid by final consumers only. It is charged at each stage of the production and marketing process. To avoid double taxation, producers and sellers are refunded what they have been charged on the inputs for their own products.
Chapter 19 – Question 3
What is the difference between present indirect taxes such as VAT and sales taxes and the proposed consumption tax?
* The consumption tax would replace all income taxes. It would therefore be much higher than present indirect taxes. It would lead to a regressive tax system and would favour savers and investors.
Chapter 19 – Question 4
Define tax incidence.
* Tax incidence is the distribution of the entire tax burden on taxpayers.
II. Taxes and Equity
Chapter 19 – Question 5
Explain the benefit rule.
* The rule states that taxes should equal the benefits an individual or firm has received from government policies.
Chapter 19 – Question 6
And the ability-to-pay rule.
* The rule states that people who are able to pay higher taxes should pay them.
Chapter 19 – Question 7
Why do wealthy people pay more when tax rates are proportional?
* When everybody is charged the same percentage of his income, the absolute amount that rich people pay is higher than that of poor people. Moreover, zero brackets make proportional tax rates progressive.
Chapter 19 – Question 8
Distinguish between a flat-rate tax and a poll tax.
* A flat-rate tax levies the same percentage on all incomes. A poll tax levies the same sum on all incomes.
Chapter 19 – Question 9
Why are indirect taxes always regressive?
* Because poor people spend larger percentages of their incomes on consumption while rich people spend higher percentages on savings and rent, which are not subject to indirect taxation. (Remember that tax systems are classified according to the proportions of incomes that taxes absorb, not according to absolute amounts paid in taxes.)
Chapter 19 – Question 10
What is the difference between the average tax rate and the marginal tax rate?
* The marginal tax rate is the tax rate levied on the last dollar earned. The average tax rate is (total tax/total income) x 100. (Total income, not taxable income).
III. Taxes and Efficiency
Chapter 19 – Question 11
Explain why and how taxes create disincentives.
* Taxes create disincentives to do or buy on what they are imposed, because they lower incomes and make commodities more expensive.
Chapter 19 – Question 12
And why they cause excess burdens.
* There are two kinds of excess burdens, i.e. costs over and above the tax. (1) Fees for tax consultants, (2) losses of total surplus for people who no longer produce or consume the taxed good. The loss they suffer is not offset by the tax received by the government, because they do not pay the tax.
Chapter 19 – Question 13
Draw the Laffer curve and explain it.
* At a tax rate of zero, tax revenues are zero. At a tax rate of 100 percent, tax revenues are also zero. Between these extremes, there must be an optimal tax rate. The Laffer curve suggests that, if the tax system is on the right declining part of the curve, tax revenues can be raised by lowering tax rates.
IV. An Excursus on Post-War Taxation
Chapter 19 – Question 14
What tax reforms did Milton Friedman propose?
* He proposed that progressive taxes, corporation taxes, inheritance taxes, and corporate tax-deductible contributions to charities and educational institutions must go. Completely.
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