PA 546 Constantine Hadjilambrinos
Taxation: Evaluating
Revenue Sources
Lecture 5
September 27, 2005
PA 546 Constantine Hadjilambrinos
Taxation

The only method to share burden of provision
of public goods.

May also be used to share cost of commonpool and toll goods.

Only socially acceptable way to re-distribute
wealth.
PA 546 Constantine Hadjilambrinos
The levying of taxes requires coercive
authority
 For this reason, government must be careful
when it comes to designing and implementing
tax systems.
Criteria for designing a good tax system
 Equity
 Economic efficiency
 Collection costs (to collector & to society)
 Revenue consequences

PA 546 Constantine Hadjilambrinos
Equity
Distribution according to benefits
 Distribution according to ability to pay
Distribution according to benefits is impractical
for public goods.
How is ability to pay defined/measured?
 Property
 Income
 Net wealth

PA 546 Constantine Hadjilambrinos
Horizontal equity: Everyone with the same
ability to pay pays equal amount.
Vertical equity: Concerns proper relationship
between tax burdens of individuals with
different capabilities to pay.

Redistribution issue
 Regressive: People with greater ability to pay,
pay proportionately less.
 Proportional: People pay same proportion (of
income, wealth, etc.)
 Progressive: People with greater ability to pay,
pay proportionately more.
PA 546 Constantine Hadjilambrinos
Is there an economic justification for
a progressive tax structure?
Diminishing marginal utility argument: Lowincome individuals value additional unit of
income more than high-income
individuals.
Progressive tax structure increases overall
societal welfare.
PA 546 Constantine Hadjilambrinos
Who really pays? (Tax incidence)
Taxpayer may be able to shift some or all of the cost
of a tax to someone else.
 Forward shift: Shift to consumers—increase
prices.
 Backward shift: Shift to suppliers—reduce prices
paid to them.
 Absorption: Absorb tax—lower return to owners.
Businesses respond so as to maximize after-tax
returns to owners.
PA 546 Constantine Hadjilambrinos
Table 7-5 Federal Tax Distribution and Effective Rates by
Quintiles for All Families, 1980-1996
1980
Quintile
Income
Share
Tax
Share
1985
Eff.
Tax
Rate
Income
Share
8.1
1990
1995
Eff.
Tax
Rate
Income
Share
3.8
1.8 10.4
3.7
1.4
8.9
3.4
0.7
5.0
Tax
Share
Tax
Share
Eff.
Tax
Rate
Income
Share
Tax
Share
Eff.
Tax
Rate
Lowest
4.5
Second
10.3
6.9 15.6
9.4
6.9 15.9
9.2
6.4 15.8
9.0
5.6
14.9
Third
15.5
13.2 19.8
14.7
13 19.2
14.5
12.5 19.5
14.5
12.0
19.7
Fourth
22.5
22.1 22.9
21.9
21.9 21.7
21.7
21.2 22.1
21.3
20.2
22.6
Highest
47.5
56.1 27.6
50.7
56.2 24.1
51.4
58.2 25.5
52.1
61.4
28.1
Top 10%
31.7
39.1 28.7
35.0
39.2 24.4
36.1
41.6 26.0
36.9
45.3
29.2
Top 5%
21.4
27.4 29.7
24.5
27.5 24.4
25.7
29.8 26.2
26.5
33.6
30.2
Top 1%
9.4
12.8 31.9
11.8
13.3 24.5
12.8
14.9 26.3
13.4
18.4
32.7
Source:
1.6
Gregg Esenwein, The Size and Distribution of the Federal Tax Burden: 19501996, Report 96-386 (Washington, DC: Library of Congress, 1996)
PA 546 Constantine Hadjilambrinos
Individual or Business Taxes?


All taxes are ultimately paid by individuals.
Business taxes may be justified in certain
cases:


Business tax may be more effective and/or less
costly to collect.
Business tax may be necessary to internalize
externalities.
Business taxes are often used instead of
individual taxes for political reasons:
“exporting” or hiding the tax.
PA 546 Constantine Hadjilambrinos
Revenue Production
Accounting relationship between taxes and
revenue: R = t x B
Economic relationship between taxes and
revenue: R = t x B(t)
R = Revenue
t = Tax rate
B = Tax base
PA 546 Constantine Hadjilambrinos
PA 546 Constantine Hadjilambrinos
Stability of tax system

Cyclical stability of tax base
Tax diversification:
1.
2.
3.
4.
5.

Personal income taxes
Property taxes
General sales or value added taxes
Excises
Corporate profit taxes
Revenue (adequacy) stability
Economic growth = growth in demand for
services. Need revenue sources that also expand
(or contract) with income.
PA 546 Constantine Hadjilambrinos
Collectibility
Resources used to collect taxes are costs.
Efficiency requires minimization of costs.
There is usually a trade-off between equity
and collectibility.
PA 546 Constantine Hadjilambrinos
Economic Effects
1.
2.
3.
4.
5.
6.
Work vs. leisure: High marginal rates may induce a
preference for leisure.
Business operations: Taxes should not (generally)
affect business practices.
Shopping and business location: Sales taxes and
excises may affect shopping patterns and business
location.
Personal financial management: People manage
activities and finances to minimize tax burden.
Investment choices: Taxes may make less productive
investments preferable.
Savings: Taxes may adversely affect decisions to save.
PA 546 Constantine Hadjilambrinos
State & Local Taxes and Economic
Development
State and local governments worry that taxes
may adversely impact economic
development.


Taxes have a relatively small effect on
interregional location.
Taxes have a much larger effect within a region.
PA 546 Constantine Hadjilambrinos
Transparency
An effective tax system must be transparent
 Adoption: Taxes must be adopted by legitimate
process.
 Administration: Tax collection criteria must be
objective, explicit, knowable, and fair.
 Compliance requirements: How tax is to be
calculated should be clear to everyone.
 Amount of payment: Taxpayers should know
how much tax they are paying and to whom they
are paying it.
PA 546 Constantine Hadjilambrinos
Taxation and Externalities
An exception to standard of neutrality for tax
efficiency is to address negative externalities

Emission taxes: Taxes on polluting emissions.



Direct measurement of emissions necessary
Apply to last link—where emissions into environment take
place
Indirect taxes on goods and services: Taxes of
products and services the production of which
produces social costs (pollution, health costs, social
services).