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1- How to finance government expenditure?
The main source of financing government expenditures is taxes. The main
targets of levying taxes in any society are the following:
a. To finance government expenditures.
b. To achieve social equity or to decrease the gap between high-income
persons and low-level income persons.
c. To achieve economic stability, through decreasing inflation and
unemployment rate in any society.
2- Taxes can be classified into two main categories:
A. Direct Taxes :
Any tax levied on incomes, wealth, and persons is considered direct tax.
There are 3 main kinds of income: wages, interest, profit.
Taxes levied on salaries are called salaries tax, while on profit are
called profit taxes, and taxes on wealth taxes.
A lump-sum tax is a fixed amount of tax levied on persons, regardless
of their income, their consumption or their savings. A lump-sum tax is a
direct tax.
Ex:
- Tax on mobile capital revenue is an interest tax.
- Taxes on persons such as a head tax are a direct tax.
When government levy a tax as a lump-sum tax leading to a decrease
in income, consumption and saving it is considered a direct tax.
Income
=
consumption + saving
Imposition of a tax will decrease consumer satisfaction as his
consumption and/or savings will decrease. The decrease in consumption due
to the imposition of tax is called income effect. However, as market process
does not change due to imposition of direct tax, there is no substitution effect.
Direct tax has only an income effect and no substitution effect.
Q.
Why direct tax has only income effect and no substitution effect?
(Figure)
- AB budget constraint line, were any point on it represents different
combination of expenditure on tow goods x1 and x2 .
- Equilibrium occurs where indifference curve u1 is tangent to original budget
line at e1 indicating consumption of quantities x1 and x2.
- After taxation budget line shift inward parallel to AB and becomes A’B’,
because of no change in market price, only income has decrease.
- Consumer now chooses a new point on a lower indifference curve u 2. New
equilibrium occur at e2 where u2 is tangent to A’B’, and new quantities
consumed of the two goods are x1 ‘ and x2’.
So the only thing that happened here is income effect (decrease in
consumption due to imposition of income tax) and no substitution effect (no
change in market prices)
B. Indirect Taxes :
Taxes levied indirectly on persons, such as unit tax and Ad-valorem tax .
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Unit tax is a fixed amount of tax per unit produced, consumed, or sold;
all should pay the same amount of tax.
Ad-valorem tax is a tax imposed on a percentage of the value of good,
sales ….etc. Ex: an item sold with a 100 pounds, an ad-valorem tax of 10% is
equal to 10 pounds.
(Figure)
If government imposes a tax on x1 (indirect unit tax), price of x1 will
increase (P1), while P2 (price of x2) will not change.
P1/P2 and relative price P2/P1 after the imposition of a tax.
The money income will not change, but the real income (amount of
goods that could be purchase with the money income) will decrease.
The consumer has now the choice to substitute x2 instead of x1 as it is
more cheaper (x2 increase consumer satisfaction while x1 decreases it) and
the result is substitution effect.
After imposition of an indirect unit tax, budget line AB to AB’ rotate from
one side only (the taxed good), and consumption falls for the two goods.
Hence consumer level of satisfaction decrease from u 1 to u3 as a result of
both income and substitution effects.
Q. From the consumer point of view, which is better direct or indirect
tax?.
(Figure)
After imposition of an indirect tax, budget line rotate from AB to . AB2’
and consumer move from e1 equilibrium to e3, quantity decrease from x11 to
x13 due to income and substitution effects.
Suppose now the government impose a direct tax with the same tax
revenue:
TR from direct = TR from indirect .
As a result of a direct tax, budget line shift inward parallel to become
A’B1’ and the new equilibrium becomes e 2 on indifference curve u2, where
quantity decreases from x11 to x12 as a result of only income effect.
SO direct tax is better for consumers as their level of satisfaction with direct
tax is greater that with an indirect tax (u2 is higher that u3).
Indirect tax and excess burden:
An equilibrium of a good sold in competitive market (before the
imposition of a tax) occurs at E1 were q*quantity of equilibrium and P*price of
equilibrium.
There is no external costs and no external benefits (EC = 0, EB = 0).
Suppose government levy a unit tax on producer, supply curve will shift
inward as supplier are now willing to supply smaller quantity as increases
from P* to P1 and quantity consumed decrease from q* to q1.
SO the result for consumer is paying more prices for less quantity.
2
Satisfaction will decrease by P* P1 E2 E 1 and this is the negative effect
on consumer satisfaction.
While the decrease in producer satisfaction due to the negative effect
is labeled E1MP1P*
The negative effect of imposing a tax = decrease in consumer
satisfaction + decrease in producer satisfaction
P*P1E2E1
+
E1MP 1 P*
=
P1E2E1MP1
(shaded)
(Doted)
(Negative effect)
On the other hand, imposing a tax will yield revenue for the
government. Tax revenue is the difference between old price and new price
(P* and P1) times quantity consumed (q1) times quantity consumed (q1) on
consumer, and difference between old price (P*) and price received by
consumers after taxes (P1) times again quantity consumed (q1) on producer.
SO tax revenue for the government or in other words the positive effect of
taxes:
TR positive effect =
T x q1
=
P1 E2 MP1
Q. Compare between the negative and the positive effects of imposing a
tax.
(Figure)
Negative effect
Positive effect
=
=
P1E2E1M1P1
P1E2MP1
SO the negative effect is bigger by the area E2E1M that is the excess burden
of an indirect tax. Where E2E1X is an excess burden on the consumer and
E1MX is an excess burden on the producer.
Ex :
if
T
=
TR
=
Negative effect =
=
10 and q = 100
Txq1
= 10 x 1000
TR + E2E1M
1000 + ½ x 10 x 50 = 1250
Excess burden =
=
negative effect - position effect
1250 - 1000 = 250
Remember that E1 is equilibrium efficient point because as we
assumed no external costs and no external benefits.
While E2 is an equilibrium non-efficient point, as government
intervention in imposing indirect tax achieve loss and excess burden:
EB
=
½ T x (q* - q1)
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What is the relationship between excess burden and elasticity’s of
demand and supply?.
W (excess burden) =
½ T2 q*/ P*
Es Ed
Es - Ed
(1) W and Es have a positive relationship
(2) W and Ed have a positive relationship
Q. Suppose Ed = 0, determine graphically the excess burden, the
decrease in
producer satisfaction, and the tax revenue.
(Figure)
-
Suppose the government levy a unit tax on producer.
Equilibrium before tax E1, where quantity of equilibrium is q1 and
equilibrium price is P.
After imposition of a tax, equilibrium occur at E 2, where the market
price increase by the full amount tax and becomes P 2, while the quantity
remains constant due to inelastic demand curve.
SO consumer satisfaction decreases by the area E 2E1PP2.
Producer will keep on producing the same quantity and receiving the same
price and hence, producer satisfaction does not change.
SO positive effect (tax revenue Q x T) = Negative effect (decrease in
consumer satisfaction) = the area E2E1PP2, and no excess burden (when Ed
= 0,w = 0)
Q. What is the relationship between excess burden and elasticity of
demand?
If government levy a tax, supply curve shift inward from S to S’ and the
results are as following:
AAccording to D1 (elastic demand) equilibrium move from E* (q* and P*)
to E1 (q1 and P1)
SO excess burden = E1E*N
EB = ½ T x (q* - q1)
BAccording to D2 (inelastic demand), equilibrium move from E* (q* and
P*) to e2 (q2 and P2)
SO excess burden = e2E*M
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The excess burden in the case of inelastic demand curve D2 is less than
the excess burden in the case of elastic demand curve D1.
E1E*N > e2 E*M
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Tax Shifting
When government levies a tax on producer, he is called the legal
taxpayer.
When government levies a tax on consumer, he is called the legal
taxpayer.
(A) If the government levies a tax on producer:
The producer will try to shift his tax to consumer through decreasing the
quantity supplied and hence increase the price. This will cause an
“Upward tax shifting”.
(Figure)
Tax = consumer burden + producer burden
(T)
(CB)
(PB)
PB = T - CB
(B) If the government levies a tax on consumer:
The consumer will try to shift his burden to the producer through
decreasing the quantity demanded and hence decreasing the price. This
will cause a “Backward tax shifting”.
(Figure)
CB = T - PB
Tax shifting is determined by the following factors:
1) Elasticity of supply and elasticity of demand.
2) The degree of competition in the market.
3) The different kinds of taxation.
4) The cost behavior.
(1)
Elasticities: are the main factors, which can affect the ability to shift
tax.
The elasticity of demand can take five shape: Ed = 0, Ed = , Ed = 1, Ed>1,
and Ed < 1.
The elasticity of supply can also take five shapes : Es = 0, Es = , Es = 1,
Es > 1,
The shapes of demand:
1. Ed = 0
Tax levied on supplier will shift the supply curve
Upward (inward, leftward) leading to an increase
In price leaving quantity constant.
The consumer bears all the tax, which means:
CB = T
PB = 0. positive relationship between elasticity
of demand and producer burden (Ed=0,and PB=0)
(Figure)
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2. Ed = infinity
Tax on supplier, will shift supply curve inward.
(Figure)
CB = 0
PB = T
3. Ed = 1
CB = PB
T = CB + PB
Ed > CB
(Figure)
4. Ed > 1
PB > CB
Producer bears more of the tax, as elasticity
Of demand is bigger than one.
(Figure)
5. Ed < 1
PB < CB
(Figure)
The shapes of supply :
1.
Es = O
Tax levied on consumer will shift the demand
Curve inward (leftward, downward) decreasing
The price but leaving the quantity constant.
(Figure)
PB = T
CB = 0, positive relationship between elasticity
Of supply and consumer burden .
(Es = 0, and CB = 0)
2.
ES = infinity
CB = T
PB = 0
(Figure)
3.
ES = 1
CB = PB
T = CB + PB
(Figure)
4.
Es > 1
CB > PB
(Figure)
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5.
Es < 1
CB < PB
(Figure)
Two extreme cases :
1. Es > Ed
(Figure)
PB < CB
Whether tax was levied on supplier
(shifting supply curve inward)
Or tax levied on consumer (shifting demand curve inward)
PB < CB
2. Ed > Es
(Figure)
PB > CB
Whether tax was levied on supplier (shifting supply curve inward)
Or tax levied on consumer (shifting demand curve inward)
PB > CB
(2)
The degree of competition:
A- Perfect competition : AR = MR
(Figure)
B- Monopolistic competition : - Monopoly: only one producer
- Monopolistic : few producers
(Figure)
(3)
Cost Behavior:
A- Marginal cost decreasing:
(Figure)
B- Marginal cost increasing:
(Figure)
(4)
C- Marginal cost constant:
(Figure)
Different Kind of taxation:
A- Unit tax :a fixed amount per unit
B- Head tax or lump-sum tax : a fixed amount per person.
C- Proportional tax: tax rate will be a constant percentage of the tax
base..
D- Progressive tax: tax rate, as a percentage of the tax base will
increase in income.
E- Regressive tax: tax rate will decrease with any increase in the
tax base.
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Example 1: Suppose the government levy a head tax on the producer, MC is
increasing. The market is competitive, and Es > Ed.
Determine: PB, CB and T.
(Figure)
Solution:
Units
1
2
3
4
MC
100
200
300
400
(T)
100
100
100
100
Tax/Unit
100/1=100
100/2=50
300/3=33.3
100/4=25
MC will shift up by the amount of Tax/Unit.
Example 2:
Suppose that the market is competitive but MC is
decreasing, unit tax on producer, EMC > Ed
Determine: CB, PB, and T.
(Figure)
Solution:
Units
MC
(T)
Tax/Unit
1
400
10
10
2
300
20
10
3
200
30
10
4
100
40
10
In this case CB, which is A2C, is greater than T, which is A 2B by the
amount of BC, Why?.
Because CB = Tax + increase of cost( due to decrease in production as
MC increase when production decrease)
Example 3: Suppose that the market is a monopoly market, the government
levy a tax on producer as a proportional tax, MC is increasing and
EMC > EMR.
(Figure)
Solution:
Units
MC
(T)
Tax/Unit
1
100
10%
10%X100=10
2
200
10%
10%X200=20
3
300
10%
10%X300=30
4
400
10%
10%X400=40
CB = P1 P2
T = (difference between MC before and MC after tax)
PB = T - CB
Because EMC > EMR, PB < CB,
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Example 4: Suppose that we are in a competitive market, the government
levy a tax on consumer as a unit tax, where MC is increasing and Es > Ed.
Determine: PB, CB, and T.
In case of consumer, we will only have the kind of a unit tax and
competitive market, and what can change only is MC.
A- MC is increasing.
(Figure)
T= CB + PB
PB < CB
Ex. 5 :
B- MC is decreasing
(Figure)
Here the price should have decreased (due to shift id demand) but it
increased because the consumer have failed to shift his tax to producer (or
even par of the tax) and hence, the consumer will have to pay all of the tax.
PB = 0 (no decrease in price)
CB = T + increase in costs (due to decrease in production)
CB = A 2 B + increase in price (due to increase costs resulted from the
decrease in production)
Ex. 6:
C- MC is constant.
(Figure)
PB = 0 as price is constant after tax
Consumer fails to shift any part of his tax to producer
T= CB
Example 7 :
The government levy a tax on producer as a progressive tax and at the same
time the government levy a tax on consumer as a unit tax, MC is constant, Ed
< Es
Determine : PB, CB, and T from the two cases.
(Figure)
Solution:
Units
MC
(T)
Tax/Unit
1
100
10%
10
2
100
10%
10
3
100
10%
10
4
100
10%
10
CB = consumer tax + producer tax
PB = = 0
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Example 8: Suppose that MC increasing, Es > Ed, the government levy a
tax on producer as a unit tax, at the same a unit tax on consumer.
Determine: CB, PB, and T.
(Figure)
Es > Ed
PB < CB
CB = consumer tax + part of producer tax
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