Download Presentation 3. Taxation

Taxation
Frederick University
2014
Taxation and Government
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For government to provide goods and services such
as national defense, social security, national parks,
etc. it must have money.
The Government raises money several ways including
user fees and taxes.
User Fees are fees paid by those that use the good
or service: it is a price.
Taxes may be paid by everyone or only those that
use a good or service: who pays depends on the type
of tax.
What is the Role of Government?
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The level of taxes is determined by the amount of government
services and goods provided.
The Government’s roles include:
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Providing a stable set of institutions, laws and rules.
Promoting effective and workable competition.
Correcting for externalities.
Creating an environment that fosters economic stability and
growth.
Providing public goods.
Adjusting for undesirable market results.
How Much Should
Government Tax?
The government must raise revenues
equal to the cost of providing the
amount of goods and services that its
citizens demand.
Types of Taxes
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There are many types of taxes:
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Personal Income taxes
Corporate Income taxes
Excise Taxes
Value Added Taxes (VAT)
Property Taxes
Social Security Taxes
Types of Taxes
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Direct taxes (income taxes, property
taxes)
Indirect taxes (VAT, excise taxes)
The Costs of Taxation
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The costs of taxation include:
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The direct cost of the revenue paid to
government
The loss of consumer and producer surplus
caused by the tax
The cost of administering the tax codes.
The Costs of Taxation
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When government institutes taxes,
there is a loss of consumer and
producer surplus that is not gained by
government.
This is known as deadweight loss.
The Costs of Taxation
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Graphically the deadweight loss is
shown on a supply-demand curve as
the welfare loss triangle.
The welfare loss triangle – a
geometric representation of the welfare
loss in terms of misallocated resources
caused by a deviation from a supplydemand equilibrium.
Consumer Surplus Before Tax: A + B + C
Consumer Surplus After Tax: A
Producer Surplus Before Tax: D + E + F
Producer Surplus After Tax: F
Deadweight Loss: C + E
Price
Consumer
surplus
S1
S0
A
P1
P0
P1–t
B
C
D
E
tax
Deadweight
loss
F
Producer
surplus
Q1
Demand
Q0
Quantity
The Costs of Taxation
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There are other costs of taxation.
Resources must be devoted by the
government to administer the tax codes
and by citizens and businesses to
comply with it.
The Costs of Taxation
Payroll accounting has become so
onerous, businesses large and small
often pay payroll-accounting firms to
keep up with changing municipal and
state payroll rules and actually issue
paychecks for their clients’ employees.
The Benefits of Taxation
The benefits of taxation are the goods
and services that government provides
 Some of these benefits are part of the
basic institutional structure of a market
economy that allows it to work
efficiently.
- the basic legal system is an example.
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The Benefits of Taxation
Still other benefits take on the qualities
of a public good – national defense, for
example.
The Benefits of Taxation
Other benefits are provided for reasons
of equity or because they provide
positive externalities.
The Benefits of Taxation
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The policy debate about the benefits of
taxation generally focuses on goods
that could be supplied by the market
but are publicly supplied.
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Education and health care are examples.
The Benefits of Taxation
Measuring the benefits of these goods
is difficult since they are not provided in
a market setting.
Principles of Taxation
Benefits received
 Ability to pay
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Principles of Taxation
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The benefit principle states that the
individuals who receive the benefit of
the good or service should pay the tax
necessary to supply the good.
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Examples are gasoline taxes and airport
taxes, both paid by travelers.
Principles of Taxation
The ability-to-pay principle states that
individuals who are most able to bear the
burden of the tax should pay the tax. Those
who have higher incomes can afford to pay a
greater proportion of their income in taxes,
regardless of the benefits
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The best example of this is a progressive
tax, such as the income tax in Cyprus.
Difficulty of Applying the
Principles of Taxation
The principles of taxation are difficult to
apply because, among other reasons, the
two principles often conflict.
Difficulty of Applying the
Principles of Taxation
In funding health care, for example, the
poor should pay because they benefit the
most, while under the ability-to-pay
principle, the rich should pay.
Difficulty of Applying the
Principles of Taxation
The elasticity concept helps us to
understand the tradeoffs as well as who
is likely to bear the burden of a tax.
Burden Depends on Relative
Elasticity
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Elasticity is a measure of how easy it
is for the supplier and consumer to
change their behavior and substitute
other goods.
Consequently, the more one group
(consumers or suppliers) is able or
willing to change its behavior relative to
the other group the more likely it is to
avoid the tax burden.
Burden Depends on Relative
Elasticity
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The person who physically pays the tax
is not necessarily the person who bears
the burden of the tax.
The burden of the tax is rarely shared
equally since the elasticities are rarely
equal.
Burden Depends on Relative
Elasticity
The relative burden of the tax dictates
that the more relatively inelastic the
behavior of one’s group (supply or
demand), the larger the tax burden one
will bear.
Burden Depends on Relative
Elasticity
If demand is more inelastic than
supply, consumers will pay the higher
share. If supply is more inelastic than
demand, suppliers will pay the higher
share.
Burden Depends on Relative
Elasticity
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Who pays a tax is not necessarily who
bears the burden.
The person who actually pays the tax
does not matter, and the person who
bears the burden can differ from the
person who pays.
Difficulty of Applying the
Principles of Taxation
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Since the free market system is very
efficient, Governments with free market
economies desire to change the behavior
of suppliers and buyers as little as possible.
Hence, Governments should tax inelastic
goods or services.
In the language of consumer and producer
surplus, if the government seeks to
minimize welfare loss, it should tax goods
with inelastic supplies and demands.
Who Bears the Burden of a
Tax?
Price of luxury boats
Supplier Pays Tax
S1
$70,000
60,000
50,000
40,000
30,000
20,000
10,000
tax
Consumer pays
S0
Supplier pays
Demand
510
200
400
600 Quantity of luxury boats
Price of luxury boats
Who Bears the Burden of a
Tax?
$70,000
60,000
50,000
40,000
30,000
20,000
10,000
Demand is inelastic
S1
S0
tax
Consumer pays
Supplier pays
Demand
590
200
400
600 Quantity of luxury boats
Who Bears the Burden of a
Tax?
Price of luxury boats
Consumer Pays Tax
$70,000
60,000
50,000
40,000
30,000
20,000
10,000
S0
Consumer pays
Supplier pays
tax
D0
D1
510
200
400
600 Quantity of luxury boats
Tax Incidence and Current
Policy Debates
The analysis of tax incidence is helpful
when discussing current policy debates.
Social Security Taxes
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Social Security taxes are payroll taxes
for a government-run retirement
program.
Both employer and employee contribute
a percentage of before-tax wages to
the Social Security fund.
Social Security Taxes
On average, labor supply tends to be
less elastic than labor demand, so the
Social Security tax burden is primarily
on employees.
Value Added Tax
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VAT is paid by retailers on the basis of
their sales revenue.
Demand is inelastic so consumers bear
the greater burden of the tax.
Government Intervention as
Implicit Taxation
Government intervention can be seen as a
combination tax and subsidy.
The Difference Between Taxes and
Price Controls
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The effects of taxation and price
controls are similar.
They are different in that price ceilings
create shortages and taxes do not.
Shortages also create black markets.
Both taxes and price controls create
deadweight loss.
Rent Seeking, Politics, and
Elasticities
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An enormous amount of time and
money is spent in the political arena to
increase one’s surplus at the expense of
another group.
This activity is called rent seeking
behavior – the effort to transfer
surplus from one group to another.
What is the
average tax rate?
Total tax due divided
by total taxable
income
What is the
marginal tax rate?
The change in taxes
due divided by the
change in taxable
income
What is a
progressive tax?
A tax that charges a
higher percentage of
income as income rises
What is a
regressive tax?
A tax that charges a lower
percentage of income as
income rises
What is a
proportional tax?
A tax that charges the same
percentage of income,
regardless of the size of
income
What is a flat rate tax?
Same as a proportional tax
VAT, excise, and flat-rate taxes
are examples of a regressive tax
because each results in a
greater burden on the poor than
the rich.
46
Progressive income taxes follow
the ability-to-pay principle
because there is a direct
relationship between the average
tax rate and income size.
47
Which principle dominates in Cyprus?
The ability-to-pay principle dominates the
benefits-received principle