When taxes induce people to change their behaviorsuch as inducing Jane to buy

When taxes induce people to change their behaviorsuch

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When taxes induce people to change their behavior—such as inducing Jane to buy less pizza—the taxes cause  deadweight losses and make the allocation of resources less efficient. As we have already seen, much government  revenue comes from the individual income tax. In a case study in  Chapter 8 , we discussed how this tax discourages  people from working as hard as they otherwise might. Another inefficiency caused by this tax is that it discourages  people from saving. Consider a person 25 years old who is considering saving $1,000. If he puts this money in a savings account that  earns 8 percent and leaves it there, he would have $21,720 when he retires at age 65. Yet if the government taxes  one-fourth of his interest income each year, the effective interest rate is only 6 percent. After 40 years of earning 6  percent, the $1,000 grows to only $10,290, less than half of what it would have been without taxation. Thus,  because interest income is taxed, saving is much less attractive. Some economists advocate eliminating the current tax system's disincentive toward saving by changing the basis of  taxation. Rather than taxing the amount of income that people earn, the government could tax the amount that  people spend. Under this proposal, all income that is saved would not be taxed until the saving is later spent. This  alternative system, called a  consumption tax , would not distort people's saving decisions. Various provisions of the current tax code already make the tax system a bit like a consumption tax. Taxpayers can  put a limited amount of their saving into special accounts—such as Individual Retirement Accounts and 401(k)  plans—that escape taxation until the money is withdrawn at retirement. For people who do most of their saving  through these retirement accounts, their tax bill is, in effect, based on their consumption rather than their income. European countries tend to rely more on consumption taxes than does the United States. Most of them raise a  significant amount of government revenue through a value-added tax, or a VAT. A VAT is like the retail sales tax  that many U.S. states use, but rather than collecting all of the tax at the retail level when the consumer buys the  final good, the government collects the tax in stages as the good is being produced (that is, as value is added by  firms along the chain of production).
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