FIN 400 Week 4 Taxation and Government Debt Example

Taxing Haircuts or Raising the Income Tax: Incidence, Efficiency and Fairness in a State's Revenue Choice, With a Look at What Federal Debt Means for State Budgets

[Student Name]

University of Phoenix

FIN/400: Public Finance

Week 4 Assignment

[Instructor Name]

[Date]

The state and its revenue options are composites written for a model paper; tax concepts, federal debt figures and research findings come from the sources listed.

A composite state facing rising Medicaid and pension costs needs about $600 million a year in new revenue. Two proposals lead the debate. The first would extend the 6 percent sales tax to consumer services that are now exempt, such as haircuts, landscaping, auto repair and gym memberships, raising an estimated $620 million. The second would raise the top income tax rate from 5.75 percent to 7.5 percent on taxable income above $500,000, raising an estimated $590 million if taxpayers do not change their behavior. The two options raise similar sums, but they place the burden on different people and change behavior in different ways. Public finance offers a set of tests for comparing them.

Who Really Pays: Incidence

The party that sends money to the government is not always the one that bears the tax. When a tax is placed on a sale, the burden is split between buyers and sellers according to how strongly each responds to price; the side that responds less bears more (Gruber, 2022). Demand for many personal services is fairly steady, while local service businesses compete on price, so most of a services tax would likely be passed on to customers. Harberger (1962) showed that even a tax levied on corporations can be shared by owners of capital throughout the economy, which illustrates the general point: burdens travel through prices and wages.

For the income tax increase, the burden falls first on high earners. Some may reduce taxable income through timing, deductions or moving to another state, which would reduce the revenue raised and shift some cost to the state's economy.

Efficiency and Excess Burden

Every tax raises revenue and also changes behavior, and the value lost through changed behavior is the excess burden. The excess burden grows roughly with the square of the tax rate, which is why economists favor broad bases with low rates. The services tax broadens the base, ending an exemption that has favored services over goods, and so may reduce distortions. The income tax increase raises a high rate on a narrow base, which tends to raise excess burden, especially if high earners are mobile.

Visibility and Behavior

How taxes are shown to buyers also matters. Chetty et al. (2009) found in a grocery store experiment that posting tax-inclusive prices reduced demand for the affected products by about 8 percent, evidence that consumers pay less attention to taxes added at the register. A services tax added at checkout would be less visible than an income tax rate increase, which can make it politically easier but also less transparent to voters.

Fairness

Horizontal equity asks whether people in similar circumstances pay similar amounts; vertical equity asks whether those with more ability to pay contribute more. A sales tax on services takes a larger share of income from low-income households, who spend more of what they earn, making it regressive, though less so than a tax on groceries, since higher-income households buy more services. The income tax increase is progressive. The state could offset part of the services tax's regressivity with a larger earned income tax credit, at a cost of perhaps $60 million.

Administration

The services tax would add tens of thousands of small businesses to the sales tax rolls, raising compliance and enforcement costs. The income tax increase requires no new administrative structure.

Revenue Stability Over the Cycle

A state that must balance its budget every year also cares how a tax behaves in a recession. Sales taxes on services fall in a downturn, but less sharply than income taxes on top earners, whose income includes bonuses, business profits and capital gains that can drop by a third or more in a bad year. During the 2008 to 2009 recession, many states saw personal income tax collections fall far faster than sales tax receipts. A revenue source that holds up in recessions reduces the need for midyear cuts, which tend to fall on the same services, such as Medicaid and schools, that the new revenue is meant to protect. The state can manage the volatility of an income tax increase by sending part of the new revenue to its rainy day fund, but that reduces the amount available for spending in good years.

A Judgment

On efficiency, the broader services base is preferable. On fairness, the income tax increase is preferable unless the services tax is paired with a credit. On stability, the services tax yields steadier revenue, while top incomes swing with capital gains. A combined approach, a services tax with a low-income credit, would raise the needed revenue with smaller distortions and modest regressivity.

The Federal Debt

The state's choice takes place against a federal budget in persistent deficit. In February 2024, the Congressional Budget Office projected a federal deficit of about $1.6 trillion for 2024, rising to $2.6 trillion by 2034 (Congressional Budget Office, 2024), and debt held by the public growing from 99 percent of gross domestic product in 2024 to 116 percent in 2034, the highest level in the nation's history. Rising interest costs are a large part of that growth.

How Much Debt Is Too Much?

Economists disagree. Blanchard (2019) argued that when the interest rate on government debt stays below the economy's growth rate, debt can be rolled over without raising future taxes, making moderate debt less costly than often assumed. That condition held for much of the 2010s but weakened as rates rose after 2022. The CBO projections show net interest outlays larger than defense spending, which shows how a change in rates alters the debate.

What Federal Debt Means for the State

Federal grants pay for roughly a third of total state spending, much of it for Medicaid. If Congress narrows deficits by cutting grants, states would face pressure to raise their own taxes or cut services. The state's revenue decision should therefore leave some room for that risk rather than assuming current federal support continues.

Conclusion

A services sales tax and a top income tax increase raise similar amounts but differ on incidence, efficiency, fairness and stability. A broad base paired with a credit for low earners offers the best balance. Federal debt projections add a reason for caution, since federal efforts to reduce deficits could shift costs to the states.

References

Blanchard, O. (2019). Public debt and low interest rates. American Economic Review, 109(4), 1197-1229. https://doi.org/10.1257/aer.109.4.1197

Chetty, R., Looney, A., & Kroft, K. (2009). Salience and taxation: Theory and evidence. American Economic Review, 99(4), 1145-1177. https://doi.org/10.1257/aer.99.4.1145

Congressional Budget Office. (2024). The budget and economic outlook: 2024 to 2034. https://www.cbo.gov/publication/59710

Gruber, J. (2022). Public finance and public policy (7th ed.). Worth Publishers.

Harberger, A. C. (1962). The incidence of the corporation income tax. Journal of Political Economy, 70(3), 215-240. https://doi.org/10.1086/258636