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L11200 Introduction to Macroeconomics 2009/10 Lecture 21: Taxation Reading: Barro Ch.13 18 March 2010 Summary • Last time: introduced topic of government expenditure – Large proportion of GDP and employment – Spent on transfer payments and activities – Offsets private consumption • Today: understanding tax structures – More realistic structures than a lump-sum tax Lump-Sum Taxation • Last week modelled taxation as a lump-sum transfer to the government C1 C2 / (1 r1 ) ... (1 r0 ) ( B0 / P K0 ) (w / P)1 L (w / P)2 L / (1 r1 ) ... s 1 s 2 (Vt T1 ) (V2 T2 ) / (1 r1 ) (V3 T3 ) /[(1 r1 ) (1 r2 )] ... • Each period households paid T and (maybe) received V, irrespective of current income or wealth Forms of Taxation • In reality, taxation takes two forms: income tax and asset income tax • Income tax: tax paid on earned income from employment • Asset income tax: tax paid (per annum) on value of asset income gained by the household • Two forms have different implications for household behaviour Income Taxation • IFS SLIDE ON MARGINAL TAX RATES Modelling Income Tax • Household budget constraint: C (1/ P) B K ( w / P) Ls r ( B / P K ) V T • Now assume that tax is taken in proportion to income. • Tax rate τ, so every extra unit of income earned raises net income by (1-τ) Substitution and Income Effects • Taxing income affects labour supply decision – Hour of work now yield less income, so negative substitution effect (encourages leisure) – Less overall income causes negative income effect, households demand less leisure / consumption and so work more – Plus, income effect is offset if additional tax is used to increase transfer, V – So net effect likely to increase leisure Effect on factor inputs • Less labour supply means MPK also falls – Labour and capital combined in production via Cobb-Douglas production function – So fall in labour supply causes MPL to increase (wage increase) – But causes MPK to fall as capital-labour ratio now increased – Fall in MPK reduces demand for capital services Effect on Output • Income tax reduces supply of labour and demand for capital services – So overall production in the economy falls – Lower output produced in current and future periods – Hence taxation isn’t neutral (as in the case of a lump-sum tax), it does influence the production decision. Tax on Asset Income • Tax levied on income arising from asset returns C (1/ P) B K ( w / P) Ls r ( B / P K ) V T • Now income earned from bond / capital holdings is taxed at rate τ • So after-tax real interest rate is (1 ) r • So households have incentive to defer consumption Effect on factor inputs • But does taxing asset income also affect factor inputs? – New return on capital investment: (1 ) r (1 ) R / P ( ) after-tax real interest rate = after-tax rate of return on ownership capital – So households now seek to maximise this modified return when making capital investment decisions Effect on factor inputs • Modifying return to capital supply leaves optimal supply unchanged – MPK remains the same, so demand for capital services as before – Modified capital income expression implies no change to optimal κ, so utilisation also unchanged – Households employ the same capital services as before Effect on Output • Asset income tax does not change output decision – But does encourage households to bring consumption forward – Higher consumption now means lower investment, so lower long-run growth – Effect of asset income tax is to reduce GDP in the long-run Which is better? • Which form of taxation is to be preferred? – Income taxation lowers output permanently – Asset income taxation reduces investment in the short-run and output in the long-run – i.e. asset income taxation similar to a consumption tax which taxes future consumption more heavily Summary • Taxing the return to factor inputs alters the decision about how much of those inputs to use – Taxation labour income discourages labour supply – Taxing asset income discourages investment – Lump-sum taxation created neither of these distortions, but taxed individuals irrespective of their wealth – So trade-off between efficiency and equity Summary • Taxation is not ‘neutral’: – Money neutrality: changing money supply has no effect on real activity – Tax non-neutrality: taxing income / asset returns does affect real activity • Next time: – Governments tax and spend, but also have debt – Consider the ‘public budget’