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The Role of Government Chapter 10 Tax Policy In 2003, Budget Speech the financial secretary announced the salaries and corporate profits taxes would be raised by up to 1% and 2% respectively. What are the reasons for such a rise and what are the implications? The government believes that it must raise taxes to eliminate the operational budget deficit. Students Should Be Able To: Analyze distortions in the economy generated by taxes. Explain the Laffer curve. HK Spending by Category 1998/99 Community Affairs 3% Support 11% District and Community Relations 1% Recreation, Culture and Amenities 3% Economic 8% Social Welfare 10% Others 1% Education 17% Internal Security 7% Immigration 1% Environment 2% Infrastructure 9% Housing 15% Health 12% 30 % Government Expenditure (%GDP) 2000 60 50 40 20 10 US UK Sweden Spain Portugal Poland Norway New Zealand Netherlands Luxembourg Korea Japan Italy Ireland Iceland Hong Kong Greece Germany France Finland Denmark Czech Rep Canada Belgium Austria Australia 0 Sources of Revenue Direct Taxes: Taxes on Income such as Corporate Profits, Salary, Estate Taxes Indirect Taxes: Taxes on Spending, Gambling Revenues, Stamp Duties, Motor Vehicle Registration Fees Fees for Service Investment Income Sources of Revenue for Hong Kong Funds 16% Direct Tax 35% Investment Income 15% Fees and Charges 5% Miscellaneous 11% Indirect Tax 18% Why do we have government? For economic activity, marketplace is the baseline allocation mechanism. Government may step in when market (arguably) fails. Types of market failure Public Goods: Goods whose shared benefits cannot be charged for including police, fire services, national defense. Externalities: Some goods may produce costs or benefits not borne by the purchasers including parks, tourist sites or pollution (negative externalities). Coordination Failure: Some systems may work well only if everyone uses them the same way, i.e. traffic. Social Insurance Individuals in a society face certain risks such as unemployment or poor health or long life which are unpredictable at individual level but predictable at a social level. Various risks may be uninsurable in private markets due to imperfect information. Example: Lazy people might be most likely to buy unemployment insurance, preventing insurance companies from making a profit. Government often will offer social insurance. Expenditures: Transfer Payments vs. Government Consumption Economists think its important to classify government expenditures into two categories. Government consumption is spending on actual goods and services Transfer Payments are payments to individuals for welfare or other social purposes which does not require the recipients to offer anything of value to the government. HK September 2002 Categories of Government Expenditure 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Government Consumption Transfer Payments % of Expenditure Tax Distortions Taxes are necessary to raise revenues for public goods. Taxes reduce ability of taxpayers to consume private goods. Taxes also have distortionary effects which may affect the quantity of goods produced and result in a loss of efficiency for economic allocation. Capital and the Tax Wedge An increase in the tax wedge (the excess taxes paid on investing in capital equipment) increases the cost of capital and reduces optimal capital. The difference between the marginal product of capital and the cost of capital is the economic surplus value of the capital The value of the efficiency loss for the economy is specified by the triangle. MPK r g p tw p K K r g p pK Distortion K K** K* K Tax Distortions The size of tax distortions grows faster than the size of the tax rate. Intuition: Diminishing Marginal Returns. Small tax wedges eliminate only those investment projects which are slightly more profitable than the cost of capital. The larger the tax rate, the more valuable will be the projects that are eliminated. Simple models assume that distortions are proportional to the square of the tax wedge. Two implications 1. 2. “Laffer Curve” Tax Smoothing MPK r g Original Distortion K** K K* 2tw p K r g p tw p K r g p K K*** pK K p K Laffer Curve Revenue generated is not monotonically increasing in the tax rate. Mental experiment. Consider if tax rate on investing in physical capital were 0%. This would generate no revenues. Consider if the tax rate were 100%. No one would invest in capital and capital taxation would generate zero revenues. Cutting taxes a little would generate more revenue. Laffer Curve represents relationship between tax rates and total revenue. Most economists believe that all developed economies are on the left-hand side of the Laffer Curve. Laffer Curve Revenues Tax Rate Tax Smoothing Distortions increase rapidly in the size of the distortionary tax rate. This means that it is better to have a smooth tax rate over time. Example. Distortions are proportional to the square of tax wedge. Distortion = A∙tw2. Consider the government chooses tax wedges in two periods, periods zero and 1. Choice 1. tw0 = 0 and tw1 = .02.Atw0 Atw1 A 02 .022 A .0004 2 2 2 Average Distortion Choice 2. tw0 = 0 and tw1 = .02Atw2 Atw2 A A 2 2 0 1 .01 .01 Average Distortion 2 .0002 2 2 2 2 Both choices produce the same average tax wedge, but the smooth tax wedge produces a lower average distortion (and more revenue). Tax Policy Government should raise revenues from “inelastic” activities. These have low distortions since taxes have little effect on economic behavior. Consumption may be less elastic than investment suggesting it may be more efficient to impose a Government should distinguish between average tax rates and marginal tax rates. Marginal tax rates are taxes on marginal activity which affect activity. Poll taxes may not cause inefficiency. Problem: Most efficient types of taxes demand equal payments from rich and poor people. Is this fair?