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Chapter 8
Principles of Taxation 1:
Efficiency and Equity Issues
Chapter outline
1.Efficiency Issues in Tax Design
2.Equity Issues in Tax Design
1.Efficiency Issues in Tax Design

A tax is said to be efficient if it does not change
any of the economic decisions that firms and
households would have made in the absence of the
tax.
 ①Consumer Surplus and Excess Burden
Taxes reduce consumer surplus. Some of the
consumer surplus is transferred to the government
to finance public services, but some portion of it is
just lost.
That loss, namely excess burden or deadweight
loss or Harberger triangle is the efficiency cost of
collecting taxes.
②Shifting, Incidence, and Price Elasticity
 The burden of a tax on is apportioned between the
buyer and seller differently depending on the
elasticities of supply and demand.
 If demand is relatively inelastic, more of the
burden falls on the buyer in the form of higher
price paid, while if supply is relatively inelastic,
more of the burden falls on the seller in the form
of lower net price received.
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The allocation of the burden is referred to as
incidence.
 Shifting refers to the change in incidence
from the originally responsible for
collecting and remitting the tax to another
party.
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③Ad Valorem Taxes
Ad Valorem Taxes are imposed as a percentage of
the price or value.
Specific taxes are imposed on the basis of some
quantity measures.
For a specific tax, the shadow demand curve is
parallel to the original demand curve. The distance
between them measures the tax per unit.
For an ad valorem tax, the distance between the
two curves changes with the price, and the “tax
wedge” gets larger and larger as the price gets
higher.
④The Effect of Taxes on Work Effort
 Income effect: work effort may increase to
maintain income because the tax reduces
income.
 Substitution effect: work effort may decrease
as the opportunity cost of leisure declines.
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⑤Tax Incidence Revisited
 All taxes ultimately fall on households in
one way or another as consumers, workers,
stockholders, and owners of business firms.
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⑥Locational Effects

The kinds of taxes imposed, the rates,
the coverage, and other features will impact
differently on different people.
 ⑦Multiple Tax Bases and Excess Burden
The excess burden is dependent on two
factors: the elasticity of demand and the
square of the tax rate.

⑧Tax Rates, Elasticity, and Base Erosion

In raising price, the tax will increase
revenue, but in reducing quantity, or eroding
the tax base, it will reduce revenue.
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⑨Using Taxes to Alter Decisions
Although in general the goal of tax design is to
minimize distortions in people’s decision, taxes
can also be used to deliberately alter decisions
because of the positive and negative externalities.
But the revenue loss is greater than the increase in
consumer surplus. Figure8-9 illustrates it.
⑩Short Run Versus Long Run Effects
Short-run effects of tax changes are often
different (more revenue, less base erosion) than
long-run effects because long-run elasticities of
demand are greater.
2.Equity Issues in Tax Design

Every change in the tax base, tax rates, or
tax rules alters the distribution of the tax
burden among tax-payers.
 Equity in a tax system is based on two
principles, ability to pay and the benefit
principle.
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①Measures of Ability to Pay
There are three measures: income, consumption or
spending, and assets.
Consumption is the easiest measure to track.
Wage and salary income is easy to track, but other
forms of income are harder to uncover.
Assets are the most challenging tax base of all. In
general some taxes just focus on certain kinds of
property, such as real estate, automobiles, and
boats.
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②The Benefit Principle
Benefit principle attempts to assign tax or fee
burdens in proportion to the intensity of use of the
public service that is being financed from that
revenue source.
③Horizontal and Vertical Equity Revisited
④Regressive, Proportional, and Progressive
Taxation
Taxes and tax systems are classified as regressive,
proportional, or progressive according to whether
that percentage decreases, remains the same, or
increases as income rises.
Table 8-1 A Simple Progressive Income Tax
Gross Income
Tax
$10,000
Taxable
Income
0
0
Tax as % of
Income
0
$20,000
0
0
0
$30,000
$10,000
$1,000
3.3%
$40,000
$20,000
$2,000
5.0%
$50,000
$30,000
$3,000
6.0%
$100,000
$80,000
$8,000
8.0%
$500,000
$480,000
$48,000
9.6%
Table 8-2 A Two-Rate Progressive Income Tax
Gross Income
Tax
$10,000
Taxable
Income
0
0
Tax as % of
Income
0
$20,000
0
0
0
$30,000
$10,000
$1,000
3.3%
$40,000
$20,000
$2,000
5.0%
$50,000
$30,000
$3,000
6.0%
$100,000
$80,000
$13,000
13.0%
$500,000
$480,000
$93,000
18.6%
Figure 8-10 Diminishing Marginal Utility of Income
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True-false questions
 1. If a shadow demand curve is used to represent
the effect of a tax on perceived demand, the
shadow demand curve will lie above the actual
demand curve.
 2. If demand is more elastic, more of the tax
burden will fall on the buyer rather than the seller.
 3. Excess burden from imposing a tax is
generally greater, other things being equal, if
demand and supply are relatively elastic, because
there will be a larger reduction in quantity.
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4. If supply is perfectly inelastic, the entire
burden of the tax falls on the seller.
 5. A tax on earnings will always reduce
work hours.
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Answers:
 1. F (It lies below.)
 2. F (More of the burden falls on the seller.)
 3. T
 4. T
 5. F (Only if the income effect is stronger
than the substitution effect.)