Chapter 12: The Design of the Tax System

How governments raise revenue — and the trade-offs between efficiency and fairness

Section 1

A Financial Overview of the U.S. Government

The U.S. government runs on taxes. In 2022, the federal government collected about $4.9 trillion in revenue. Where does that money come from, and where does it go? Understanding the structure of the tax system is the first step to evaluating it.

Individual Income Tax ~47% largest federal source
Payroll Taxes ~36% Social Security & Medicare
Corporate Income Tax ~9% paid by corporations
Excise Taxes & Other ~8% gas, alcohol, tariffs, etc.

State and local governments have their own revenue streams: sales taxes (taxed on purchases), property taxes (on real estate), and their own income taxes. In many states, property taxes are the primary funding source for public schools.

Click a slice to highlight its details.

Revenue Details

Source Click a slice
Share —
Est. Revenue —

Select a slice to learn more about each revenue source.

On the spending side, the three biggest categories are: Social Security (~23%), national defense (~13%), and Medicare/Medicaid/health (~25%). Interest on the national debt has grown to ~8% as the debt has climbed.

Deficit vs. Surplus: When spending exceeds revenue, the government runs a budget deficit and must borrow. When revenue exceeds spending, it runs a surplus. The U.S. has run persistent deficits for most of the past two decades, adding to a national debt now exceeding $34 trillion.

Section 2

Taxes and Efficiency

Taxes raise revenue, but they also change behavior. When a tax makes a transaction more expensive, some trades that would have happened in a free market no longer occur. Those lost trades represent deadweight loss — a concept you saw in Chapter 8. Efficiency in taxation means raising revenue while minimizing this waste.

Marginal vs. Average Tax Rate

Two rates matter for different reasons:

Marginal rate tax on last $1 earned affects incentives
Average rate total tax / total income measures overall burden

The marginal tax rate is what economists care most about when analyzing incentives. If your marginal rate is 32%, every additional $1 of income costs you $0.32 in taxes. This is the rate that affects your decision to work an extra hour, take a second job, or invest in a new project.

The average tax rate tells you what fraction of your total income goes to taxes. It matters for fairness discussions — how much does a person actually pay as a share of their income? Note that in a progressive system, the average rate is always lower than the marginal rate.

Drag the slider to see marginal vs. average rates for the 2024 U.S. tax brackets.

$60,000

Your Tax Rates

Gross Income $60,000
Marginal Rate 22%
Average Rate —
Tax Owed —

2024 brackets for single filers. Simplified — does not include deductions.

The Administrative Burden

Beyond deadweight loss, taxes impose administrative costs: the time and resources spent filing returns, keeping records, and complying with tax rules. Americans spend roughly 6 billion hours per year on tax compliance. This is a real cost of the tax system, even if money doesn't change hands.

Lump-sum taxes: A tax that is the same for everyone regardless of income or behavior (like a $1,000 head tax) is the most efficient tax possible — it creates zero deadweight loss because it cannot be avoided by changing behavior. But it's deeply inequitable: $1,000 hurts a poor family far more than a wealthy one. This is the core efficiency-equity trade-off in tax policy.

Section 3

Taxes and Equity

Even if a tax system is perfectly efficient, it might be unfair. Economists and policymakers debate two main principles for deciding who should pay taxes.

Benefits Principle

You Pay for What You Use

People should pay taxes based on the benefits they receive from government services. The gas tax is the classic example: drivers pay per gallon, and that revenue funds roads. Those who use the roads more pay more.

Ability-to-Pay Principle

Pay What You Can Afford

People should pay based on their financial capacity. A millionaire and a minimum-wage worker both benefit from national defense, but the millionaire can afford to contribute far more without hardship.

Vertical Equity

More Income, More Tax

Taxpayers with higher ability to pay should pay more. This follows from the ability-to-pay principle and is the rationale for progressive taxation.

Horizontal Equity

Similar People, Similar Tax

Taxpayers in similar financial situations should face similar tax burdens. A doctor and a lawyer earning the same income should owe roughly the same taxes.

The debate: Should the wealthy pay a higher rate (progressive) or just a higher amount (proportional)? Vertical equity demands more from higher earners, but how much more is inherently a value judgment. Tax policy is always partly a political question.

Section 4

Progressive, Proportional, and Regressive Taxes

Every tax can be classified by how the average tax rate changes as income rises. Use the slider below to compare how the same income is taxed under three different structures.

Progressive Average rate rises with income. Higher earners pay a larger percentage. Example: U.S. federal income tax.
Proportional Average rate stays constant. Everyone pays the same percentage. Also called a "flat tax."
Regressive Average rate falls with income. Lower earners pay a higher percentage. Example: a flat sales tax on necessities.

Use the slider below to see how each structure treats different income levels:

$60,000
Tax Structure Income Tax Owed Average Rate
Progressive $60,000 — —
Proportional $60,000 — —
Regressive $60,000 — —

Progressive uses simplified U.S. brackets. Proportional uses a flat 15% rate. Regressive: lower-income earners pay 20%, falling as income rises (simulating a sales tax on necessities as share of income).

Tax Incidence and Equity

A tax's legal incidence (who writes the check) often differs from its economic incidence (who actually bears the burden). You studied this in Ch. 6! Key insight: the burden falls more heavily on the inelastic side of the market.

The corporate income tax is a famous example. Corporations legally pay it, but the burden is shared by: workers (lower wages), consumers (higher prices), and shareholders (lower returns). Economists disagree on the exact split, but all agree the legal payer is not the only economic burden bearer. This is called the flypaper theory: taxes don't always "stick" where they land.

The tax wedge splits between buyers (paying P_b) and sellers (receiving P_s). Both sides bear part of the burden.

Quick Review

The Big Ideas in Chapter 12

  • The federal government's main revenue source is the individual income tax (~47%), followed by payroll taxes (~36%). State and local governments rely heavily on sales and property taxes.
  • Taxes cause deadweight loss by distorting decisions. The efficiency cost of a tax rises sharply with the tax rate — this is why economists prefer broad-based, low-rate taxes over narrow, high-rate ones.
  • The marginal tax rate (tax on the last dollar) drives incentives. The average tax rate (total tax / income) measures the overall burden.
  • The benefits principle says pay for what you use. The ability-to-pay principle says pay what you can afford. Most modern tax systems mix both.
  • A progressive tax takes a higher percentage from higher earners. A regressive tax takes a lower percentage. A proportional tax (flat tax) takes the same percentage from everyone.
  • Tax incidence rarely stays where the law places it. The burden shifts to whichever side of the market is more inelastic. The corporate tax burden is partially borne by workers and consumers.
  • A lump-sum tax is perfectly efficient (no DWL) but deeply inequitable. This is the fundamental trade-off: efficiency vs. equity in tax design.