Margaret Thatcher and the Lump-Sum Head or Poll Tax

Great Britain’s Lump-sum Community Charge

Lump-sum taxes had their moment in the sun in Great Britain during the third administration of Prime Minister Margaret Thatcher. Thatcher’s government enacted a law in 1989 requiring local authorities to replace their system of local property taxes based on rental values with a lump-sum head or poll tax.¹ Every adult would now pay the same amount of tax, called the Community Charge, to the local government, with the amount determined by each locality. The only exceptions were students, pensioners and the unemployed, who received 80% rebates on the tax. The Community Charge was instituted in Scotland in 1989 and in England and Wales in 1990.²

PERCEIVED ADVANTAGES OF THE COMMUNITY CHARGE

Thatcher and her Conservative Party colleagues perceived that the Community Charge would have both equity and efficiency advantages relative to the local property taxes. Both advantages arose from the same source – that the Community Charge was a tax levied on the benefits-received principle of taxation.

Equity Advantages

As the name suggests, the benefits-received principle says people should pay directly for the public services they receive from their governments. This is widely viewed as a fair way to levy taxes in capitalist countries because this is how the market asks people to pay for goods and services. If you want the benefits of a particular good or service, you buy it; if not, you do not buy it. Some public expenditures, such as transfers to the poor, cannot be paid for on a benefits-received basis. There would be no net transfers if the poor were taxed for the transfers they received. A different equity principle is needed when designing taxes to pay for transfers. But the idea is that if the benefits-received principle can be applied to particular goods and services, it should be.

Regarding the lump-sum Community Charge, not everyone within a locality receives the same benefits from the local government services. For example, some people do not have children in the local schools. Nonetheless, charging everyone the same tax was felt to be fairer than the existing system of property taxes, under which there had developed a large disconnect between taxes paid and services received. Only 18 million of the 35 million voters in England paid local taxes, and only 34% of the 18 million paid the full rates because there were numerous rebates available. Also, businesses paid 60% of all local taxes yet they had no direct say in local governance.³ The Community Charge was viewed as a much closer approximation to the spirit of the benefits-received principle than the existing property taxes and thus a much fairer tax.

Efficiency Advantages

There were a number of perceived efficiency advantages in basing local taxes more closely on the benefits-received principle. First, the Community Charge would bring the discipline of the marketplace into the public sector by forcing people to pay for the services they receive. Under the existing property tax system, the local officials could pursue their own political agendas, pushing expenditure programs that they desired knowing that the majority would be likely to approve because so many voters would not have pay for the expenditures. Under the Community Charge, in contrast, increases in public expenditures would require increases in taxes for everyone. A majority of voters would no longer agree to programs unless they were willing to pay for them. Second, public officials now had an incentive to contract out some local public services to private firms if the private sector could offer the services more cheaply in order to keep the Community Charge as low as possible. For both reasons, it was felt that the local officials would begin to act more like public administrators giving people the services they wanted at the lowest possible costs rather than as politicians pushing their own favorite programs.

Finally, we noted in Chapter 2 the conjecture by Charles Tiebout that a system of local governments promote efficiency by more closely matching people’s preferences for public services to the public services they actually receive. By tying taxes directly to the public services provided, the Community Charge would encourage what economists refer to as Tiebout sorting. People who like the local public services and are willing to pay for them would move to high-tax/ high-public service communities. Those who were less willing to pay for the local public services would move to low-tax/low-public service communities. As a result, more people would live in communities that more closely matched their preferences for public services, and everyone would be made better off in the process.

THE REACTION

The verdict on the Community Charge came swiftly – it was a disaster. Protestors gathered throughout the land and millions of people refused to pay the tax. A protest in Trafalgar Square involving over 200,000 people escalated into one of the worst riots in British history. Voters held the national government responsible for the tax and the Conservative Party responded in an attempt to remain in power. Just seven months after the enactment of the tax, the government increased the VAT from 15% to 17.5% in order to give each adult a £140 reduction in their Community Charge bill. But the voters made it known that they were still not satisfied⁴, and Thatcher’s plummeting popularity led to a direct leadership challenge from Michael Heseltine. Though he was unsuccessful, Thatcher was damaged past repair and she resigned in 1990. In the leadership election that followed, all candidates promised to repeal the tax, and the eventual victor, John Major, replaced it with the Council Tax in 1993. The Council Tax, still in place today, is a system of local tax rates that were much like the property tax rates that the Community Charge had replaced. Though the Conservative government held on to power until 1997, it arguably never recovered fully from the Poll Tax debacle.

What went wrong? Whenever outrage against a public policy is so broad and vehement as the reaction to the Community Charge was, you can be sure that people’s sense of equity is offended. There is another principle of equity in taxation that is as widely embraced as the benefits-received principle: the ability-to-pay principle. It says that people should pay taxes in accordance with their ability to pay, that is, in accordance with their incomes or wealth. (The ability-to-pay principle is discussed in Chapter 11 of the textbook.) As it happened, the Community Charge led to huge changes in most people’s tax liabilities. Sixty percent of the voters experienced at least a 20% change in their local tax liabilities, with much of the tax burden shifted from high to low-income voters.⁵ This redistribution of the tax burden was seen as highly unfair. The ability-to-pay principle had clearly trumped the benefits-received principle in the public’s view of the fairness of the new head tax.

The perceived efficiency advantages of the Community Charge were obviously not sufficient to overcome the public’s sense that the tax was unfair. A likely reason for this was that any efficiencies resulting from the tax would take some time to evolve, whereas voters immediately experienced the inequity of the tax. In any event, the tax was not in place long enough to test its efficiency properties.

That Britain’s experiment with this lump-sum tax could bring down the Thatcher government so quickly was really quite remarkable. Margaret Thatcher led the government from 1979 to 1990, the longest term of any Prime Minister since 1827, and had been extremely popular until the Community Charge undid her. One suspects that the lump-sum head tax has been relegated to the dustbin of history in light of the British experience.

NOTES:
¹Great Britain has a unitary as opposed to a federal government, so that the national government controls
local tax policies.
² J. Meadowcroft, "The Failure of the Poll Tax and Classical Liberal Political Economy: Lessons for the Future," The Future of Local Government, Institute of Economic Affairs, Blackwell Publishing, Oxford, 2006, p. 25. This example relies heavily on Meadowcroft’s analysis of the Community Charge.
³Ibid., p. 26.
⁴ Ibid., p. 28.
⁵ Ibid., p. 27.

Source: Public Sector Economics by Richard W. Tresch, 2009.

Lump-Sum Taxes / Poll Taxes / Head Taxes

An example of an extremely efficient tax is a lump-sum tax. A lump-sum tax is a tax that is the same monetary amount for every person. For example, a lump-sum tax might require every person to pay $50. The marginal tax rate of a lump-sum tax is equal to zero. If a person earns additional income, he or she does not pay any additional lump-sum tax. A lump-sum tax is very efficient because it does not reduce people’s incentive to work because the tax does not vary with their income. There is also very little administrative burden. The only records that need to be kept are whether each person has paid the tax. For example, the government does not need any information about a person’s income to levy a lump-sum tax.

Lump-sum taxes are also called poll taxes or head taxes because they have been imposed as a prerequisite for voting and are assessed per person (i.e., per head).

According to the Smithsonian National Museum of American History, poll taxes were used in the late 19th and early 20th centuries in the United States by local governments in the former Confederacy and neighboring states as part of an effort to reestablish a society based on white supremacy :

Poll taxes required citizens to pay a fee to register to vote. These fees kept many poor African Americans, as well as poor whites, from voting. The poll tax receipt displayed here is from Alabama:

Denying black men the right to vote through legal maneuvering and violence was a first step in taking away their civil rights. Beginning in the 1890s, southern states enacted literacy tests, poll taxes, elaborate registration systems, and eventually whites-only Democratic Party primaries to exclude black voters.
The laws proved very effective. In Mississippi, fewer than 9,000 of the 147,000 voting-age African Americans were registered after 1890. In Louisiana, where more than 130,000 black voters had been registered in 1896, the number had plummeted to 1,342 by 1904.

Here is a poll tax receipt from Jefferson County, Louisiana in 1917:


It was not until January 23, 1964 that the ratification of the 24th Amendment to the U.S. Constitution made it illegal to use poll taxes as a requirement for voting in federal elections.

AMENDMENT XXIV
Passed by Congress August 27, 1962. Ratified January 23, 1964.

Section 1.
The right of citizens of the United States to vote in any primary or other election for President or Vice President, for electors for President or Vice President, or for Senator or Representative in Congress, shall not be denied or abridged by the United States or any State by reason of failure to pay poll tax or other tax.

Section 2.
The Congress shall have power to enforce this article by appropriate legislation.

See also: "Margaret Thatcher and the Lump-Sum Head or Poll Tax".

Who Gets U.S. Foreign Aid?

In the December 14, 2008 Parade article "Who Gets U.S. Foreign Aid," Rebecca Davis O'Brien reports:

The U.S. will give an estimated $26 billion in foreign aid in 2008—70% more than when President George W. Bush took office (the figure doesn’t include funds related to the wars in Iraq and Afghanistan). More than 150 countries get financial assistance from the U.S. Here are the six that received the most this year.

U.S. FOREIGN AID - 2008
COUNTRY	AID	PURPOSE
1. Israel	$2.4 billion	Virtually all of this money is used to buy weapons (up to 75% made in the U.S.). Beginning in 2009, the U.S. plans to give $30 billion over 10 years.
2. Egypt	$1.7 billion	$1.3 billion to buy weapons; $103 million for education; $74 million for health care; $45 million to promote civic participation and human rights.
3. Pakistan	$798 million	$330 million for security efforts, including military-equipment upgrades and border security; $20 million for infrastructure.
4. Jordan	$688 million	$326 million to fight terrorism and promote regional stability through equipment upgrades and training; $163 million cash payment to the Jordanian government.
5. Kenya	$586 million	$501 million to fight HIV/AIDS through drug treatment and abstinence education and to combat malaria; $15 million for agricultural development; $5.4 million for programs that promote government accountability.
6. South Africa	$574 million	$557 million to fight TB and HIV/AIDS; $3 million for education.
7. Mexico	$551 million	Click here for details.
8. Colombia	$541 million	Click here for details.
9. Nigeria	$491 million	Click here for details.
10. Sudan	$479 million	Click here for details.

*Source: Estimates based on figures and documents from the U.S. Department of State. Click here for more information.

Alternatives to the Current Individual Income Tax

Alternatives to the Current Individual Income Tax

Because of the inefficiencies of the current individual income tax structure, some people advocate replacing it with a more efficient tax structure.

Lump-Sum Taxes

The Flat Tax

Consumption Taxes
A National Sales Tax
The Fair Tax
A Value-Added Tax (VAT)

Marginal Tax Rates Versus Average Tax Rates

To help understand how a tax structure could be more efficient, it may be useful to distinguish between average and marginal tax rates.


Marginal Tax Rates Versus Average Tax Rates

The average tax rate is the total taxes paid divided by total income.

The marginal tax rate is the tax paid on an additional dollar of income.

The average tax rate measures the sacrifice made by a taxpayer. The marginal tax rate measures how much the tax system discourages people from working.


An Example to Illustrate the Difference Between Marginal and Average Tax Rates

According to the table at the top of page 258, if a single worker had $30,000 of taxable income in 2005, the worker would owe $4,165 in federal income tax.

· 10% federal income tax on the first $7,300 of taxable income

· 15% federal income tax on income earned above $7,300 but less than $29,700

· 25% federal income tax on income earned above $29,700 but less than $71,950

The worker owes $730 on the first $7,300 of taxable income.

(.10)($7,300) = $730

The worker owes $3,360 on the taxable income above $7,300 but less than $29,700.
$29,700 - $7,300 = $22, 400
Thus, the worker pays 15% tax on $22,400 of his or her income.
(.15)($22,400) = $3,360

The worker owes $75 on the taxable income above $29,700 but less than $71,950.

$30,000 - $29,700 = $300
Since the worker’s taxable income is $30,000, the worker pays 25% tax on $300 of his or her income.
(.25)($300) = $75

Thus, the total federal income tax owed is $4,165.

Federal income tax owed = (.10)($7,300) + (.15)($22,400) + (.25)($300)
. = $730 + $3,360 + $75
= $4,165

The average income tax rate is the tax paid divided by income. If the workers total income is $30,000, then this worker’s average tax rate is:

average tax rate = $4,165 / $30,000 = 0.138 or 13.8%

The marginal tax rate is the tax paid on an additional dollar of income. If this worker earns additional income above the current $30,000, it will be taxed at 25%. (See the table for 2005 on page 258.)

Thus, this worker’s average tax rate is 13.8% and the marginal tax rate is 25%. The worker is paying 13.8% of his or her income in federal income tax. This represents the sacrifice the worker is making to financially support the federal government. The marginal tax rate is significantly higher in this case. If this person chooses to work more (and increase his or her income above $30,000 per year), the government will be owed 25 cents of each additional dollar earned. This may reduce the person’s incentive to do the additional work. If the person works enough to earn an additional $1,000, the federal government will collect $250. Thus, the worker’s disposable income increases by only $750.

Social Insurance Taxes

...

The Individual Income Tax

The Individual Income Tax

These marginal tax rates for a single taxpayer in 2003, 2004, and 2005 are listed below.

Federal Income Tax Rates: 2005
On Taxable Income . . .
The Tax Rate is . . .
Up to $7,300
10%
From $7,300 to $29,700
15%
From $29,700 to $71,950
25%
From $71,950 to $150,150
28%
From $150,150 to $326,450
33%
Over $326,450
35%
This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on the marginal tax rates up to his or her income. For example, a taxpayer with income of $26,000 pays 10 percent of the first $7,300 of income, and then 15 percent of the rest.

Federal Income Tax Rates: 2004
On Taxable Income . . .
The Tax Rate is . . .
Up to $7,150
10%
From $7,150 to $29,050
15%
From $29,050 to $70,350
25%
From $70,350 to $146,750
28%
From $146,750 to $319,100
33%
Over $319,100
35%
This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on the marginal tax rates up to his or her income. For example, a taxpayer with income of $26,000 pays 10 percent of the first $7,150 of income, and then 15 percent of the rest.

Federal Income Tax Rates: 2003
On Taxable Income . . .
The Tax Rate is . . .
Up to $7,000
10%
From $7,000 to $28,400
15%
From $28,400 to $68,800
25%
From $68,800 to $143,500
28%
From $143,500 to $311,950
33%
Over $311,950
35%
This table shows the marginal tax rates for an unmarried taxpayer. The taxes owed by a taxpayer depend on the marginal tax rates up to his or her income. For example, a taxpayer with income of $26,000 pays 10 percent of the first $7,000 of income, and then 15 percent of the rest.

Source: U.S. Internal Revenue Service
http://www.irs.gov

The Sources of U.S. Federal Government Revenues

The two largest sources of revenue for the U.S. federal government are the individual income tax and social insurance taxes. Social insurance taxes were created by the Federal Insurance Contributions Act (FICA), the 1939 law that authorized the Internal Revenue Service to collect additional taxes from the paychecks of workers to support the Social Security and Medicare programs.

The Equity of a Tax System

The Equity of a Tax System

In addition to tax efficiency, another consideration of tax systems is their equity. The equity of a tax system concerns whether the tax burden is distributed fairly among the population.

Vertical equity is the idea that taxpayers with a greater ability to pay taxes should pay larger amounts. Vertical equity is a justification for wealthy people to pay more in taxes than poor people.

Horizontal equity is the idea that taxpayers with similar abilities to pay taxes should pay the same amount. Horizontal equity suggests that a married couple should pay the same amount of taxes as an unmarried couple with the same combined income. In 2004, President George W. Bush initiated a reform of the U.S. tax code that eliminates the penalty on taxpayers who file jointly as a married couple.

Most disagreements about taxation occur because of different opinions about what is fair. According to the benefits principle, it is fair for people to pay taxes based on the benefits they receive from the government. Admission fees for parks are based on the benefits principle. A person who visits a park and pays the admission fee every week would pay more in total park fees over the course of a year than a person who visits the park once a month. Most people consider this fair since the person who visits the park each week probably receives more benefits from the park than the person who visits it less frequently. Taxes on gasoline and diesel fuel are also based on the benefits principle. The income generated by fuel taxes is used primarily to pay for the construction and maintenance of roads and highways. People who drive a lot pay more in fuel taxes over the course of a year than people who drive very little. Most people consider this fair since people who drive a lot receive more benefits from the roads and highways than people who drive very little.

There are some situations, however, in which it is difficult to use the benefits principle. If the government provides additional income for people who cannot afford the necessities of life, it does not make sense to ask the beneficiaries to pay the taxes to fund these transfer payments. Taking $1000 from a low-income family and using it to provide $1000 of income for that family does not increase their net income. Consequently, another principle is used in the construction of many tax systems. According to the ability-to-pay-principle, it is fair for people to pay taxes based on their capability to handle the financial burden. Progressive taxes, such as the individual income tax system in the United States, are based on the ability-to-pay principle. A progressive tax is a tax for which high-income taxpayers pay a larger percentage of their income than do low-income taxpayers. The U.S. individual income tax structure is based on income minus deductions, and the marginal tax rate rises as income rises.

A proportional tax, by contrast, is a tax for which high-income and low-income taxpayers pay the same percentage of income. An example of a proportional tax is a flat tax in which all people pay the same percentage of their income in tax. Flat taxes have been proposed as alternatives to the current individual income tax structure. Proponents of flat taxes argue they have a smaller administrative burden because much less information is needed to calculate them compared to the current individual income tax structure. For the simplest form of a flat tax, the only information needed is total income.

A regressive tax is a tax for which high-income taxpayers pay a smaller percentage of their income than do low-income taxpayers. A lump-sum tax, in which every person pays the same dollar amount, is an example of a regressive tax. A park entrance fee of $10 per person is an example of a lump-sum tax. An example of a poll tax in literature occurs in the story of Robin Hood and his band of merry men who rob or steal from the rich and give the money to the poor. Part of their motivation was that King John imposed a poll tax that required everyone to pay the same amount, regardless of their income. One could argue that Robin Hood considered the poll tax to be unfair because it is not based on the ability-to-pay principle.

The fines for speeding in the United States are not based on a person’s income. Thus, receiving a speeding ticket is a kind of regressive tax. In some European countries, however, the fines vary with the speeder’s income and can be proportional or progressive.

Most sales taxes are regressive. Even though everyone pays a tax that is the same percentage of the purchase price (e.g., 7%), the amount of tax paid is a higher percentage of income for a poor person than a rich person. To illustrate this, consider two people, Chris Cash and Pat Poor, who both buy a portable television with a price of $142.85. Suppose both pay 7% sales tax on their purchases. Thus, each person pays $10 in sales tax on the purchase of the portable television. [($142.85)(.07) = $10]. Suppose Chris has an income of $1000 per week and Pat has an income of $100 per week. The $10 sales tax on the purchase of the television is ten percent of Pat’s weekly income, but is only one percent of Chris’s weekly income. Even though Chris and Pat pay the same dollar amount in sales tax (both pay $10) and both pay the same percentage of the purchase price in sales tax (both pay 7% of the price of the television), the amount of sales tax paid is a larger percentage of Pat’s income than of Chris’s income. Thus, sales taxes are usually regressive.

Social Security taxes are also regressive because they are not paid on incomes above a certain level. For 2004, the income ceiling was $87,900. So someone earning $100,000 or $1,000,000 per year pays the same Social Security tax as someone earning $87,900 per year. This makes the Social Security tax one of the most regressive U.S. taxes.


The following table illustrates progressive, proportional, and regressive taxes for three people with different incomes.

Examples of Progressive, Proportional, and Regressive Taxes

Progressive Tax
Proportional Tax
Regressive Tax

Income
Amount
of Tax
Percent of Income
Amount
of Tax
Percent of Income
Amount
of Tax
Percent of Income
Lee
$ 25,000
$5,000
20%
$6,250
25%
$7,500
30%
Sandy
$50,000
$12,500
25%
$12,500
25%
$12,500
25%
Tracy
$100,000
$30,000
30%
$25,000
25%
$20,000
20%
Table 1. Examples of Progressive, Proportional, and Regressive Taxes


Although people have different opinions about the fairness of tax structures, most people agree they would prefer that someone else pay the taxes. Very few people are eager to pay more taxes. One way everyone can pay less tax is to reduce the size of government. Yet, all governments, regardless of size, must be funded somehow.

In a representative democracy, such as in the United States, elected politicians make governmental decisions on behalf of the people. Politicians tend to be much more popular (1) when they reduce taxes and increase government spending on constituents than (2) when they increase taxes and decrease government spending on constituents. For example, the two most popular U.S. presidents of recent history are Ronald Reagan and George W. Bush. Both Reagan and Bush made tax cuts a major priority in their campaigns and administrations. Presidents George H.W. Bush and Bill Clinton, by contrast, increased taxes during their administrations. Most analysts agree this contributed to a reduction in their popularity.

While cutting taxes may be popular, it might not be fiscally responsible. Proponents of tax cuts usually argue that the increased economic activity (stimulated by the tax cuts) will offset the reduction in tax rates. Opponents of tax cuts usually argue that (1) there will still be a decrease in government revenues even with the increased economic activity, or (2) the tax cuts are directed at the wrong beneficiaries.

A nonpartisan, grassroots organization that promotes fiscal responsibility is the Concord Coalition.[1] The Concord Coalition was founded in 1992 by the late former Senator Paul Tsongas (D-Mass.), former Senator Warren Rudman (R-N.H.), and former U.S. Secretary of Commerce Peter Peterson. Former Senator Bob Kerrey (D-Ne.) was named a co-chair of the Concord Coalition in January 2002.

The Efficiency of a Tax System – the Administrative Burden

The Efficiency of a Tax System – the Administrative Burden

Some tax systems are also criticized because of their administrative burden. Individual income taxes, for example, place a large administrative burden on the government, businesses, and individuals. The Internal Revenue Service (IRS) of the United States uses many economic resources to collect taxes and enforce the tax laws. Each American business must devote resources to the calculation of payroll taxes for each worker, the submission of these taxes to the government, and extensive record keeping. Individuals in the United States also devote time and resources to record keeping, tax preparation assistance, and seeking ways to minimize their tax burden. If the United States had a simpler individual income tax structure, Americans might be able to spend less time and money on tax preparation. They might then spend this time and money on things that are more productive and provide a higher standard of living or quality of life. Taxes with a relatively high administrative burden are less efficient than those with a relatively low administrative burden.

In 1997, the Congressional majority leader Richard K. Armey, a Republican from Texas, announced that Americans spend 5.4 billion hours a year preparing income tax returns at a total cost of $200 billion, or $700 for every man, woman and child. During his 18 years in Congress, Rep. Armey was a strong advocate for tax reform.

The Efficiency of a Tax System – the Effect on Incentives & Behavior

The Efficiency of a Tax System – the Effect on Incentives & Behavior

Income taxes can be inefficient if they alter people’s behavior. If income tax rates are high, for example, people may choose to work less than if the tax rates are low. Suppose a doctor earns $5,000 per week and the marginal tax rate for people with this income level is 70%. The marginal tax rate is the tax paid on an additional dollar of income. The government will collect $3,500 of this doctor’s weekly income and the doctor’s take-home pay will be only $1,500 per week. (Seventy percent of $5,000 is $3,500. Thirty percent of $5,000 is $1,500.) Because taxes take such a large share of the doctor’s earnings, the opportunity cost of vacation or leisure time is significantly smaller. The opportunity cost is what is sacrificed or foregone when a choice is made. At this tax rate, if the doctor spends a week on vacation, he or she only foregoes $1,500 of income. If the tax rate were 10%, however, the government would collect $500 of the surgeon’s weekly income and the surgeon’s take-home pay would be $4,500 per week. In this case, if the surgeon spends a week on vacation, he or she foregoes $4,500 of income. Thus, high marginal income tax rates provide an incentive for people to work less by reducing the opportunity cost of leisure. Working less may be an inefficient allocation of the economy’s resources. When people work less, the society produces less output. The reduced production of goods and services causes the economy to have a smaller gross domestic product (GDP) and thus a lower standard of living. The increased leisure time might increase the quality of life of the society, however. Standard of living measures the amount of goods and services consumed by an average person. Quality of life attempts to measure the fulfillment people receive. People may receive more fulfillment from having more leisure time and fewer goods and services.

Income earned from most types of personal investments is also subject to taxation. If the tax rates are high, individuals may be inclined to save less of their income for personal investments than if the tax rates are low. For example, if a person saves $10,000 and invests it in a savings account that pays 5% interest per year, then this person receives $500 of interest income each year from this personal investment. (Five percent of $10,000 is $500.) Suppose the tax system is structured so income from personal investments is taxed at a 50% marginal tax rate. Thus, the government is owed $250 annually from the $10,000 savings. The saver is left with only $250 on interest income. ($500 interest earned - $250 taxes = $250 net interest after taxes.) This rate of return may be so low that the person would rather spend it on consumption than save it for personal investments. Since savings is a major source of investment funds for the economy, this distortion may also lead to an inefficient allocation of resources. There may not be enough savings and personal investment, and thus not enough economic investment, because the structure of the tax system discourages it.

The Effective Unemployment Rate

In the December 5, 2008 National Public Radio (NPR) story "U.S. Unemployment at 15-Year High," Jim Zarroli includes an explanation of the effective unemployment rate. It includes discouraged workers (those that have stopped looking for work) and the underemployed (those who are not working as much as they want or need to work, such as part-time workers who want to work full-time).

The U.S. economy shed jobs at a blistering pace in November, pushing the overall unemployment rate to 6.7 percent and putting new pressure on federal officials to approve another big stimulus package sometime soon.

Employers cut 533,000 jobs from their payrolls during the month, the worst decline since December 1974 and a much bigger drop than economists had predicted.

Companies also eliminated more jobs than first thought in September and October. That brings total job losses since the recession began in December 2007 to about 2.7 million, according to the Labor Department.

"Today's employment report reflects the difficulties in our economy. It is devastating when Americans lose their jobs, and many are worried about their future job security," said Commerce Secretary Carlos Gutierrez.

"These are really God-awful numbers. The economy's headed downhill and really the brakes are not working," said Sung Won Sohn, professor of economics and finance at California State University, Channel Islands.

Nearly every sector of the employment market lost jobs, including manufacturing (85,000), professional and business services (101,000), and leisure and hospitality (76,000). Unemployment rose for both adult women (5.5 percent) and adult men (6.5 percent).

"Right now I would take anything; I'd go down to $6 or $7 [an hour] just to have a job," says Ray Ross of Nashville, Tenn., who was recently laid off from his job as a security guard. His former employer has put him on call, but he isn't getting much work.

The retail sector lost 91,000 jobs, with auto dealers alone down by 24,000, underscoring the way Detroit's troubles are filtering through the broader economy. The drop comes in a week when officials of the big U.S. automakers are on Capitol Hill seeking financial assistance, and it is likely to make it harder for Congress to turn them down.

As high as it appears, the 6.7 percent unemployment rate actually underestimates the number of people hurt by the declining jobs market, because it doesn't include people who have given up searching for work or part-timers who would like to work full time, Sohn said. The report says more than 400,000 people left the labor market this year because they believe no jobs are available, he said.

Forty-eight-year-old Edward Stewart Jr., of Kansas City, Mo., has been subsisting on day jobs and occasional temporary gigs, but he would prefer to work a full week.

"Right now, I'm searching the Web and trying to make some phone calls and trying to get some work for like a janitorial service maybe, whatever comes up," he says.

In addition, the Labor Department estimates that about 600,000 workers have simply stopped looking for jobs, up from about 259,000 a year ago.

When these two groups are included, the effective unemployment rate is actually much higher than it appears, about 12.5 percent, Sohn says.

November's big drop puts new pressure on the incoming Obama administration and Congress to approve an economic stimulus package as quickly as possible. The president-elect has talked about a plan to create 2.5 million new jobs, at least in part by funneling money to the states to pay for large infrastructure projects.

"The jobs picture painted today is staggering, and it should be all the evidence Washington needs to act swiftly and decisively to shore up this economy," said Sen. Charles Schumer (D-NY).

Bush administration officials tried to sound a more optimistic note, saying the financial rescue package put into place by the Treasury Department would ultimately help the job market. U.S. officials have taken a number of steps to try to stabilize the financial system, such as buying stock in major banks and guaranteeing certain kinds of securities.

"it's going to take time for all the actions we've taken to have their full impact, but I am confident that the steps we're taking will help fix the problems in our economy and return it to strength," said President Bush, meeting with reporters at the White House today.

"My administration is committed to ensuring that our economy succeeds, and I know that the incoming administration shares the same commitment," he added.

The gloominess of the report sent stock prices down sharply early in the day, but they later rebounded. The Dow Jones industrial average rose by 259 points, finishing at 8635.

The Efficiency of a Tax System - Overview

Tax Efficiency

The Efficiency of a Tax System - Overview

The efficiency of a tax system refers to the relative costs it imposes on taxpayers. There are two costs of taxes beyond the monetary payments from taxpayers to the government. The first cost arises as taxes alter incentives and behavior. The second cost is the administrative burden of complying with the tax laws. If these two costs are relatively low, then the tax system is efficient. If these two costs are relatively high, then the tax system is inefficient. Inefficient taxes cause an inefficient allocation of economic resources and thus are generally considered to be less desirable than efficient taxes.

Taxation

Part 1: Taxation

The primary purpose of taxation is to generate revenue for the government. Some taxes are designed to alter people’s behavior, however. The main purpose of import tariffs, for example, is to discourage people from buying an imported product in the hope that consumers will buy a similar product from a domestic producer. Taxes on cigarettes and alcohol are designed to discourage the consumption of those products by making them more expensive. (It may cost only a few cents to manufacture a pack of cigarettes.)

The most important taxes for the federal government are individual income taxes and payroll taxes for social insurance (i.e., Social Security and Medicare). The most important taxes for state governments are sales taxes. The most import taxes for local governments are property taxes.

People have various opinions about the best way to structure tax systems. Two important considerations are efficiency and equity.

Using Fiscal Policy to Manage the Economy

Using Fiscal Policy to Manage the Economy

Fiscal policy is taxing and spending by the government. At the federal level, it is primarily conducted by the U.S. Congress. The annual budget is proposed by the President, however, who has veto power over legislation. Fiscal policy can be used as a tool to manage the economy, but it has a large political bias.

Aggregate demand (AD), which is overall spending on newly produced goods and services, is composed of consumption (C), investment (I), government purchases (G), and net exports (X-M). Thus AD = C + I + G + X – M. Expansionary fiscal policy attempts to stimulate the economy by increasing overall spending on newly produced goods and services through (1) increased government purchases (G), or (2) decreased taxes to encourage more consumption (C) and investment (I) spending. Expansionary fiscal policy can be used to fight unemployment. It also promotes economic growth if it generates investment in physical capital, human capital, and technology, which tend to increase productivity.

Contractionary fiscal policy attempts to slow the economy by decreasing overall spending on newly produced goods and services through (1) decreased government purchases, or (2) increased taxes to discourage consumption and investment spending. Contractionary fiscal policy can be used to fight inflation.

Fiscal policy’s political bias is that politicians are reluctant to conduct contractionary fiscal policy because increasing taxes and reducing government spending on constituents are politically unpopular. Using fiscal policy to manage the economy is similar to driving a car with an accelerator pedal, but no brakes.