Download ECO 4113 FISCAL ECONOMICS Assoc. Prof. Yeşim Kuştepeli

ECO 4113 FISCAL
ECONOMICS
Assoc. Prof. Yeşim
Kuştepeli
PRINCIPLES OF TAXATION 1:
EFFICIENY AND EQUITY ISSUES
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Adam Smith devoted ,The Wealth of Nations (1776), to “the
revenue of the sovereign,” including his famous dictum that
the taxes one pays should be “proportional to the revenue
enjoyed under the protection of the state.”
David Ricardo,titled his famous book as Principles of
Political Economy and Taxation.
Until the latter half of the 20th century,courses in the
public sector were aptly named public finance,because they
concentrated so heavily on the revenue side of the public
sector to the neglect of the equally important decisions on
the expenditure side.
Today the balance has shifted,but an understanding of the
principles of tax design,both theoretical and applied, is still
a central part of the study of public sector economics.
EFFICIENCY ISSUES IN TAX DESIGN
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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.
A poll tax ,which is a flat charge per person or per household,
is one of the few taxes that does not distort economic decisions.
The burden of a poll tax does not change with changes in
location, work effort, consumption spending, wealth, or any of
the other factors that affect one’s tax liability for income,
sales,property, excise,and estate taxes.
The poll tax is rarely used in modern industrial nations,
because it is extremely regressive ; that is, it takes much
higher percentage of income from the poor than the rich.
But the poll tax does provide a useful standard of
nondistortion against which the effects of other taxes can be
measured.
CONSUMER SURPLUS AND EXCESS BURDEN
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An analytical tool that is useful in evaluating the distorting
effect of taxes and their impact on consumer welfare is the
concept of consumer surplus.
Consumer surplus for a quantity Q2 is the difference
between the entire area under the demand curve,OABQ2,
and the amount actually paid,which is rectangle OP2BQ2
(price times quantity)
Anything that changes the price paid will also alter the
amount of consumer surplus received.
A rightward shift in supply will lower the price and
increase consumer surplus, whereas a leftward shift will
raise the price and reduce consumer surplus.
Imposing a tax will also have the effect of reducing
consumer surplus.
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Taxes are generally represented graphically as either
shadow demand curves or shadow supply curves.
The word shadow is intended to convey that the
second demand or supply curve does not represent a
shift in the original curve, but rather a wedge
between the demand curve as perceived by the buyer
and the demand curve as perceived by the seller.
The piece of consumer surplus lost is known as
excess burden and is more generally referred to as
deadweight loss.
This excess burden or deadweight loss represents a
decline in consumer surplus and consumer welfare
that does not get transferred to firms or to
government but is lost entirely.
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A similar loss accrues to producers as long as
supply is not perfectly elastic.
Producers also suffer a loss in their surplus of
revenue over marginal or variable costs (which
may or may not be profit).
Both triangles (showing consumer surplus loss +
producer surplus) are also known as Harberger
Triangles.
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Different tax rates or levels or different elasticities of
supply or demand will result in triangles of different
sizes and shapes that represent larger or smaller
deadweight losses ,or in the case of taxes, excess
burden.
One of the objectives of good tax and revenue system
design is to minimize the excess burden represented
by the Harberger triangles.
The concrete, intuitive meaning behind these
triangles is the forced adjustment in consumption (or
sometimes production) patterns as a result of the tax,
which generates a loss of consumer welfare over and
above the transfer of resources from the consumer to
the government.
SHIFTING,INCIDENCE, AND PRICE
ELASTICITY
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With the imposition of an excise tax and the
excess burden of taxation, the price paid by the
buyer raises, but it rises by less than the amount
of the tax.
Economic factors, primarily price elasticities of
demand and supply, determine the division of the
tax burden between the seller and the buyer.
The division of the tax burden between the
parties involved, is known as tax incidence.
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In the 19th century, economist Henry George
reasoned that the most useful and appropriate
tax would be a single tax on land
(not improvements,such as buildings) because
land was fixed in supply,and the tax would cause
no distortions in behavior or deadweight loss.
More often, taxes are imposed on goods where the
supply is highly if not perfectly inelastic, because
the resulting excess burden triangle will be
smaller than it would be for a more elastic supply
curve.
AD VALOREM TAXES
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All of the illustrations thus far show a fairly simple
type of tax,called a specific tax, which is imposed on
the basis of some quantity measure-units,volume or
weight.
More common ones are ad valorem taxes, which (as
their name suggests) are imposed as a percentage of
the price or value.
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For a specific tax,the shadow demand curve is
parallel to the original demand curve.
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The distance between them measures the tax per
unit.
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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.
TAX INCIDENCE REVISITED
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Regardless of how the tax law is written, or who
writes the check for the tax due, all taxes are
ultimately paid by households in one form or another.
Even if a tax is absorbed by the seller, the impact
does not end there, because the seller is merely an
intermediary for workers, suppliers, and owners often stockholders.
The share of the tax paid by the seller has to come out
of the earnings of one or more of those groups.
It may result in lower wages for workers, lower
dividends for stockholders, lower profits in the case of
a privately owned firm,or even lower payments to
providers of inputs,depending on the degree of
competition in each of the relevant markets.
LOCATIONAL EFFECTS
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Another set of choices that is influenced by taxes
,is locational decisions.
Even within the same category (such as home
owners) ,the impact of various taxes will be
different.
MULTIPLE TAX BASES AND EXCESS
BURDEN
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Because the poll tax is very unsatisfactory on
equity grounds, public officials are forced to
employ other tax instruments that distort
people’s choices.
The area of an excess burden triangle is
measured as
ABC = 1/2t x P1 x (Q1-QT)
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Elasticity , ε, is equal to the percentage change in
quantity divided by the percentage change in
price:
t /( P1  PT ) (Q  Q ) /(Q  Q )
 
(Q1  QT ) /(Q1  QT )
t /( P1  PT )
1
T
1
T
1 / 2t 2 P1 x(QT  Q1 )
ABC 
x( PT  P1 )
 Given the initial price and quantity,above
equation conveys a very important insight.
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The size of the excess burden triangle, or the
waste that takes place in transferring revenue to
the government, depends on two factors.
The excess burden is inversely dependent on the
elasticity of demand(the greater the elasticity,
the smaller the excess burden). But excess
burden increases directly in proportion to, not
just the tax rate,but the square of the tax rate.
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Taxes should be imposed to the extent possible on items for which
demand is relatively inelastic.
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The instinctive response to that observation is to think of addictive
substances or inexpensive necessities.
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Another response is suggested by the fact that elasticity is lower
when there are few substitutes.
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The easiest way to design a tax where the possibility of substitution is
minimal is to make the base as broad as possible.
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A retail sales tax has a broder base than an excise tax,because
consumers have fewer possibilities for substitution.
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A retail sales tax that includes services as well as goods will be less
distorting than one that only taxes tangible goods.
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An income tax that includes income from investments will result in
less distortion in behavior than a payroll tax that only covers wages.
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The distortions caused by a tax are very sensitive
to changes in the tax rate,and that very high
rates cause substantially greater distortions in
people’s decisions and greater excess burden over
and above the revenue collected.
To avoid extremely high rates for a particular
tax,governments usually resort to more than one
broad-based tax combined with a variety of
special taxes on particular products or services.
TAX RATESIELASTICITY,AND BASE EROSION
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A tax on any kind of spending has two effects:It
raises the price and reduces the quantity.
In raising price, the tax will increase revenue,but
in reducing quantity,or eroding the tax base, it
will reduce revenue.
Laffer curve shows that,at a zero tax rate,there
is no tax revenue. At a 100% tax rate, taxable
economic activity is pointless,so there will be no
tax base and there will again be no revenue.
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If tax rates get high enough, people will resort to
barter or tax evasion; they will go underground,
reduce their work effort, leave the country, buy
abroad.
Under these circumstances, a reduction in tax
rates might actually generate more revenue
rather than less.
Moving up the demand curve, eventually even
the most inelastic demand curve enters an elastic
range in which buyers become more and more
sensitive to price increases.
USING TAXES TO ALTER DECISIONS
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Taxes can also be used to deliberately alter decisions because of the
positive and negative externalities associated with certain kinds of
individual decisions.
Taxes on alcohol, cigarettes, and gambling are intended in part to
discourage consumption of those products, all of which have negative
externalities of one kind or anotjer associated with them.
The same is true of taxes or charges on pollution that are tied to the
volume of emissions, in order to discourage socially undesirable
activities.
Some tax expenditures or subsidies of various kinds are designed to
encourage activities with social benefits,such as giving to charity,
investing in one’s own education, or becoming a home owner.
Finally, certain tax subsidies or tax expenditures are intended to
benefit one group of taxpayers in prefernce to others,which is
intentional redistribution of income or wealth.
SHORT-RUN VERSUS LONG RUN EFFECTS
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Elasticities are greater in the long run, once
contracts expire or people have had a chance to
gather information and consider alternatives.
In the short run, the decline in the quantity is
very small.
 But in the long run, there is a further decline.
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EQUITY ISSUES IN TAX DESIGN
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Equity is at least as important as
efficiency,sometimes more so to policy makers,
when designing and reforming tax systems.
Efforts to redistribute the burden, whether in the
interests of greater equity or in response to
lobbying by particular interests, are the source of
much of the complexity in the tax
system,especially the income tax.