Theme 8 – Taxation and Tax
Theory
Public Economics
1
Public Revenues
• In general, public revenue may be considered to
include any revenue flowing to the public budgets.
Among those public budgets there may be budgets
of governments, lower regional administration units
(districts and municipalities), parafiscal funds and
also budgets of health insurance funds. The most
substantial item on the revenue side of public
budgets are taxes. It further contains non-tax
public revenue (interest revenue, fees and fines,
and revenue from selling and renting out state or
municipal property).
2
A tax is
• a payment in money
• required by a government
• that is unrelated to any specific benefit
or service received from the government.
3
Other definition… A tax is …
• a financial, mandatory, nonequivalent,
non-specific charge or other levy
imposed on a taxpayer by a state.
• The tax is implemented by law.
• The failure to pay taxes is punishable by
law.
• The taxes can be paid regularly or
occasionally based on certain conditions
stipulated by the tax legislation.
4
The three criteria necessary to be a tax are
• the payment is required (by the law)
– free rider theorem of public goods
• imposed by a government
• not tied directly to the benefit received by
the taxpayer.
5
Sources of finance
– Tax = MAIN SOURCE
– User charges
• Prices charged for the delivery of certain public goods
and services
• Examples: Toll roads, public swimming pools
– Administrative fees
• Definition of service/benefit is broad & imprecise
• Examples: TV licences, parking tickets
– Borrowing
6
The Main Issues of Tax Theory
There are two main issues related to tax theory:
- Normative: How to design taxes to promote social welfare
in terms of the public interest in efficiency and equity
- Positive: The economic effects of the various taxes that
governments use
- What effects do taxes have on people’s desires
to consume, save, supply their labor, or on firms’
desire to invest?
- Who bears the burden of various taxes?
- Public officials need to be able to answer these questions
to design taxes that promote social welfare
7
Tax Principles
Economists believe that any broad-based tax should possess
five characteristics:
(1)
Ease of collection
(2)
Ease of compliance
(3)
Flexibility
(4)
Promotion of economic efficiency
(5)
Promotion of end-results equity
8
Tax Principles
(1) Ease of Collection and
(2) Ease of Compliance
To successfully implement a tax policy, it is necessary
to incur the costs associated with administering and
enforcing it
Given that society must incur these costs, it wants to
get the most possible revenue at the least possible
cost
Requires that individuals be able to calculate tax bills
fairly easily and that it be difficult for individuals to
hide information on taxable assets
9
Ease of collection (direct
adminis. cost)
• CIT, VAT – 2% of total tax revenue
• Payroll Tax – 1 %
• Bad results for… (why? Due to very low
tax rates)
– PIT – self employed persons – 30 %
– Road tax – 5 %
– Heritage tax (now abolished) - !169 %
10
Ease of compliance (indirect
adminis. cost) in Czech
Republic
• CIT, VAT – 5% of total tax revenue
• Payroll Tax – 1 %
• PIT – self employed persons – 30 %
• Road tax – 20 % (very low tax rates)
11
Tax Principles
(3) Flexibility
- Tax policy is a primary tool of macroeconomic policy (i.e.
economic stabilization)
- To be able to respond quickly to address potential
difficulties in the economy, tax authorities must be able to
change tax liabilities easily and quickly and those
changes must quickly be felt throughout the economy
12
Tax Principles
(3) Flexibility (II)
13
Tax Principles
(4) Economic Efficiency
Individuals must face same prices for economy to reach
Pareto-optimal outcome
Broad-based taxes are distorting (i.e. drive wedge between
price paid by consumer and prices kept by firms) so they
violate this property
The goal then is to design a tax that introduces the least
distortion and keeps society as close to the Paretooptimal outcome as possible
(5) End-Results Equity
Tax policy is designed to work with redistribution programs
to achieve this goal
14
Six Main Taxes (1)
(1)
A personal income tax
Tax on income received by individuals
Typically collected from firms who withhold pay
Tax liability calculated once a year and refund or extra
payment made depending on whether enough was
withheld
(2) A payroll tax
Tax levied on the wage and salary component of
income
Half tax collected from employers / half from workers
Earmarked for Social Security in US
(3) A corporate income tax
Tax levied on accounting profits of corporations
15
Six Main Taxes (2)
(4)
An excise tax
Tax on the sale of a single product (e.g. gasoline,
alcohol, cigarettes)
Designed to reduce consumption of good
(5) A property tax
Tax on value of items of wealth – usually residential,
commercial and industrial properties
Levied on owner of property
Value assessed periodically by tax authorities
(6) A value-added tax
Tax on value added of firms (which is the difference
between sales revenue and input purchases)
Levied on firms
16
The Six Main Taxes (3)
Use of the six main taxes
- Governments in Europe also use personal and corporate
income taxes, payroll taxes (to support social security
payments) and property taxes
- They levy a value-added tax on businesses
- Recently, advocates have argued for a personal consumption
tax rather than a personal income tax
→ Biggest difference is that it would allow individuals to
subtract saving from income before calculating tax
bill (because consumption = income - saving)
17
The Ability-to-Pay Principle
-
-
Dates from Adam Smith and John Stuart Mill in late 1700s
and early 1800s
Holds that people must be willing to sacrifice for the public
good
Gave rise to view of taxes as necessary evil
Key question: How to determine what people should
sacrifice?
Two potential approaches based on ability to pay
- Horizontal Equity: Two people deemed equal in
every relevant economic dimension should pay
same tax
- Vertical Equity: It is permissible to tax unequals
unequally
18
The Ability-to-Pay Principle continued
-
-
-
Both principles raise important and difficult questions
In what sense are people to be deemed to be equal or
unequal?
How unequally can unequal be taxed?
The issue of horizontal equity is the quest for the ideal tax
base (i.e. the item to be taxed)
People with identical tax bases will pay identical tax bill
The issue of vertical equity is the quest for the ideal tax
structure, as defined by chosen tax rates and deductions
Differences in chosen tax rates and deductions make it
so that different people pay different tax bills
19
Horizontal Equity: The Ideal Tax Base
(OPTIONAL)
-
Robert Haig (1921) and Herbert Simons (1938) proposed a
method of thinking about optimal tax base that relied on three
principles:
(1) People ultimately bear the burden of taxation
(2) People sacrifice utility when they bear the burden of taxation
Horizontal equity: Two people with equal utility before tax
should have equal utility after tax
Vertical equity: If person has more utility than another before
tax they should also have more after tax
(3) The ideal tax base is the best surrogate measure of utility
Because utility cannot be measured, society must rely on
something else, which should be best surrogate
20
Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
Haig–Simons income
Argues that the best surrogate for utility is the increase in
purchasing power during the year
YHS = consumption + change in net worth = C + ∆NW
Concludes that people with the same YHS should be considered
equals and should pay the same tax because they will sacrifice the
same utility
Once YHS is accepted as ideal tax base it implies that the optimal
tax structure is the broadest possible personal income tax
→ This requirement is never met in practice
21
Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
-
Under the Haig–Simons definition of income, there are a number of
distinctions that should not matter (but usually do)
Factors that should be treated the same, but usually are not
Sources of Income
Uses of income
- Personal income and capital
gains (portion of capital gains
usually excluded from tax base)
- Earned and unearned income
(receipt of transfer payments
usually excluded from tax base)
- Different sources of earned
income (interest earned on
savings and fringe benefits
usually excluded)
- Consumption and saving (saving
usually excluded)
- Various forms of consumption
(medical care, mortgage interest
payments, etc. usually excluded)
- Form of capital gains (accrued
capital gains usually excluded,
realized usually included)
22
Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
-
-
These differences usually exist because policymakers often use
tax policy to try to promote social ends which might run counter to
the concept of horizontal equity
Business expenses should be excluded because they subtract
from purchasing power out of income
Calculation of YHS must be indexed to inflation because increasing
prices reduces purchasing power
Conclusion: Combined, these facts suggest that the ideal tax
base is (YHS - business expenses), indexed for inflation
23
Horizontal Equity: The
Ideal Tax Base
Continued (OPTIONAL)
Haig-Simons income and utility
Is this a good surrogate measure
of utility? Almost certainly not!
Whether income is good measure
of utility depends on whether
people are identical
People receive utility from
income and leisure
Income comes from work and leisure comes from not working
If every person has same preference for income and leisure and
same opportunities (i.e. same wage) they will choose same point
and have same utility
In such a case, income would be a good surrogate for utility
24
Horizontal Equity: The
Ideal Tax Base Continued
(OPTIONAL)
- But people do not have identical tastes and
opportunities
- Suppose people earn different wages
- Person with higher wage can receive
higher utility with same income by
taking more utility (i.e. can earn same
income with fewer hours work)
- Suppose people have different tastes
- Person with stronger preference for
consumption works more and earns
more income but both are on second
indifference curve which represents
same utility
25
Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
Consumption as the ideal tax base
Recognizes that consumption is not a perfect surrogate measure
of utility but is likely better than income
Consumption most directly generates utility
Consumption changes over time are more directly tied to
utility changes over time than are income changes over time
Implication is that to meet the concept of horizontal equity, two
people with equal lifetime consumption before tax should have
equal lifetime consumption after tax
26
Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
-
-
This suggests that tax should be annual tax on consumption rather
than annual tax on income
Two people with same lifetime income might have very
different lifetime consumption due to differences in annual
consumption/savings decisions
Note that it would be possible to design an annual income tax that
would be equivalent to an annual consumption tax
Would require allowing people to subtract saving from
income, which would actually make it a consumption tax
27
Horizontal Equity:
The Ideal Tax Base (OBLIGATORY)
Musgrave’s view of horizontal equity
Argues that questioning whether income or consumption tax is
better is the wrong question
Instead, believes that horizontal equity should only consider
whether taxes discriminated against people in inappropriate ways
Either income or consumption tax is appropriate surrogate for
utility so long as people are not treated differently based on
gender, race, religion, etc.
Society should just accept one type of tax and then worry
more about the specific tax structure (i.e. vertical equity)
28
Vertical Equity
-
-
-
This is the quest for distributive justice, which generates heated
debate without a satisfactory conclusion
Key question: Should tax structure be progressive,
proportional, or regressive
Let YhHS and Th be individual h’s income and tax burdens
→ If Th/ YhHS increases as YhHS increases, tax is progressive
→ If Th/ YhHS is constant as YhHS increases, tax is proportional
→ If Th/ YhHS decreases as YhHS increases, tax is regressive
Societies tend to have a strong preference for proportional or
progressive taxes
29
Progressive, Proportional, and
Regressive Taxes
• Proportional tax
– Percentage of taxpayers income
• Progressive tax
– Larger percentage of income as income rises
• Regressive tax
– Smaller percentage of income as income
rises
30
Progressive, Proportional, and
Regressive Taxes
31
Income and Consumption over
Life Cycle
32
Measuring of Consequences of
Taxation to Income Distribution I.
Lorenz Curve
33
Measuring of Consequences of
Taxation to Income Distribution II.
Gini‘s Coefficient
G is usually 0.2 to 0.5
Consequence of Linear or Progressive Tax:
Gini before tax > Gini after tax
34
Measuring of Consequences of
Taxation to Income Distribution III.
35
36
37
Tax Incidence
• Two main concepts of how a tax is
distributed:
– Statutory incidence – who is legally
responsible for tax
– Economic incidence – the true change in
the distribution of income induced by tax.
– These two concepts differ because of tax
shifting.
38
Tax Incidence: General Remarks
• Only people can bear taxes
– Business paying their fair share simply shifts
the tax burden to different people
– Can study people whose total income
consists of different proportions of labor
earnings, capital income, and so on.
– Sometimes appropriate to study incidence of
a tax across regions.
39
Tax Incidence: General Remarks
• Both Sources and Uses of Income should
be considered
– Tax affects consumers, workers in industry,
and owners
– Economists often ignore the sources side
40
Tax Incidence: General Remarks
• Incidence depends on how prices are
determined
– Industry structure matters
– Short- versus long-run responses
41
Tax Incidence: General Remarks
• Incidence depends on disposition of tax
revenue
– Balanced budget incidence computes the combined
effects of levying taxes and government spending
financed by those taxes.
– Differential tax incidence compares the incidence of
one tax to another, ignoring how the money is spent.
• Often the comparison tax is a lump sum tax – a tax
that does not depend on a person’s behavior.
42
Tax Incidence: General Remarks
• Tax progressiveness can be measured in
a number of ways
– A tax is often classified as:
• Progressive
• Regressive
• Proportional
– Proportional taxes are straightforward: ratio
of taxes to income is constant regardless of
income level.
43
Tax Incidence: General Remarks
• Can define progressive (and regressive)
taxes in a number of ways.
• Can compute in terms of
– Average tax rate (ratio of total taxes total
income) or
– Marginal tax rate (tax rate on last dollar of
income)
44
Tax Incidence: General Remarks
(optional)
• Measuring how progressive a tax system is
present additional difficulties. Consider two simple
definitions.
– The first one says that the greater the increase in
average tax rates as income rises, the more progressive
is the system.
v1 
T1
I1

T0
I0
I1  I 0
45
Tax Incidence: General Remarks
(optional)
– The second one says a tax system is more progressive
if its elasticity of tax revenues with respect to income is
higher.
– Recall that an elasticity is defined in terms of percent
change in one variable with respect to percent change in
another one:
%T
v2 

%I
 T1  T0 
T0
 I1  I0 
I0
46
Tax Incidence: General Remarks
(optional)
• These two measures, both of which
make intuitive sense, may lead to
different answers.
• Example: increasing all taxpayer’s liability
by 20%
47
Partial Equilibrium Models
• Partial equilibrium models only examine
the market in which the tax is imposed,
and ignores other markets.
• Most appropriate when the taxed
commodity is small relative to the
economy as a whole.
48
Partial Equilibrium Models:
Per-unit taxes
• Unit taxes are levied as a fixed amount
per unit of commodity sold
– Excise tax on cigarettes, for example, is 2.37
CZK per piece; sparkling wine 2340.- CZK
per 1 hl.
• Assume perfect competition. Then the
initial equilibrium is determined as (Q0,
P0) in Figure 1.
49
Partial Equilibrium Models:
Per-unit taxes
• Next, impose a per-unit tax of $u in this
market.
– Key insight: In the presence of a tax, the
price paid by consumers and price received
by producers differ.
– Before, the supply-and-demand system was
used to determine a single price; now there
is a separate price for each.
50
Partial Equilibrium Models:
Per-unit taxes
• How does the tax affect the demand schedule?
– Consider point a in Figure 1. Pa is the maximum
price consumers would pay for Qa.
– The willingness-to-pay by demanders does NOT
change when a tax is imposed on them. Instead, the
demand curve as perceived by producers changes.
– Producers perceive they could receive only (Pa–u) if
they supplied Qa. That is, suppliers perceive that the
demand curve shifts down to point b in Figure 1
– .
51
Figure 1
52
Partial Equilibrium Models:
Per-unit taxes
• Performing this thought experiment for all
quantities leads to a new, perceived
demand curve shown in Figure 2.
• This new demand curve, Dc’, is relevant
for suppliers because it shows how much
they receive for each unit sold.
53
Figure 2
54
Partial Equilibrium Models:
Per-unit taxes
• Equilibrium now consists of a new
quantity and two prices (one paid by
demanders, and the other received by
suppliers).
– The supplier’s price (Pn) is determined by the
new demand curve and the old supply curve.
– The demander’s price Pg=Pn+u.
– Quantity Q1 is obtained by either D(Pg) or
S(Pn).
55
Partial Equilibrium Models:
Per-unit taxes
• Tax revenue is equal to uQ1, or area kfhn
in Figure 2.
• The economic incidence of the tax is split
between the demanders and suppliers
– Price demanders face goes up from P0 to Pg,
which (in this case) is less than the statutory
tax, u.
56
Partial Equilibrium Models:
Taxes on suppliers vs. demanders
• Incidence of a unit tax is independent of
whether it is levied on consumers or producers.
• If the tax were levied on producers, the supplier
curve as perceived by consumers would shift
upward.
– This means that consumers perceive it is more
expensive for the firms to provide any given quantity.
• This is illustrated in Figure 3.
57
Figure 3
58
Partial Equilibrium Models:
Elasticities
• Incidence of a unit tax depends on the
elasticities of supply and demand.
• In general, the more elastic the demand curve,
the less of the tax is borne by consumers,
ceteris paribus.
– Elasticities provide a measure of an economic
agent’s ability to “escape” the tax.
– The more elastic the demand, the easier it is for
consumers to turn to other products when the price
goes up. Thus, suppliers must bear more of tax.
59
Partial Equilibrium Models:
Elasticities
• Figures 4 and 5 illustrate two extreme cases.
– Figure 4 shows a perfectly inelastic supply curve
– Figure 5 shows a perfectly elastic supply curve
• In the first case, the price consumers pay does
not change.
• In the second case, the price consumers pay
increases by the full amount of the tax.
60
Figure 4
61
Figure 5
62
Partial Equilibrium Models:
Ad-valorem Tax
• An ad-valorem tax is a tax with a rate given in
proportion to the price.
• A good example is the sales tax.
• Graphical analysis is fairly similar to the case
we had before.
• Instead of moving the demand curve down by
the same absolute amount for each quantity,
move it down by the same proportion.
63
Partial Equilibrium Models:
Ad-valorem Tax
• Figure 6 shows an ad-valorem tax levied
on demanders.
• As with the per-unit tax, the demand
curve as perceived by suppliers has
changed, and the same analysis is used
to find equilibrium quantity and prices.
64
Figure 6
65
Partial Equilibrium Models:
Ad-valorem Tax
• The payroll tax, which pays for Social Security
and Public Health Care, is an ad-valorem tax
on a factor of production – labor.
• Statutory incidence in the CR is split unevenly
with a total of 34% paid by employer and 11%
paid by employee.
• The statutory distinction is irrelevant – the
incidence is determined by the underlying
elasticities of supply and demand.
• Figure 7 shows the likely outcome on wages.
66
Figure 7
67
Tax Efficiency I.
• Administrative Efficiency – costs of tax
collection, salaries of financial officers, tax
forms, time spent fulfilling forms, cost of tax
advisors etc.
– Direct costs – costs for the state
– Indirect costs – costs for the taxpayers
• Administratively Efficient Tax – low
administrative costs and high revenue.
68
Tax Efficiency II.
– Economic Efficiency –measures loss of
benefits to consumers & producers
– Excess Burden = Welfare Cost =
Deadweight Loss (DWL)
– Excess Burden (DWL) is a result of tax
shifts: prices are distorted by the tax and
economic subjects (people) are moved from
their Pareto equilibrium and consequently
their welfare is diminished by DWL
69
The magnitude of the excess
burden of a unit tax
Shaded area = Excess Burden,
Deadweight Loss = DWL
DWL = (Q0 – Q1)*Tax/2
Tax
70
The effect of demand elasticity
on excess burden (optional)
71
The effect of tax rates on
excess burden
72
Excess Burden Measurement
• Implications of Figuers
– Higher (compensated) elasticities lead to
larger excess burden
– Excess burden increases with the square of
the tax rate
– The greater the initial expenditure on the taxed
commodity, the larger the excess burden
73
Excess Burden Review – Unit Tax
74
Excess Burden Review – Ad Valorem
Tax
75