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Public Finance:
Taxes and Fiscal Policy
Fundamentals of Finance – Lecture 10
Outline
1. Income Taxes
a) Personal
b) Corporate
2. Consumption and Sales Taxes
3. Taxes on Wealth and Property
4. Fiscal Policy
a)
b)
c)
d)
The Keynesian View
The New Classical View
Fiscal Policy Changes and Problems of Timing
Supply-Side Effects of Fiscal Policy
1. Income tax
a) Personal tax
Comprehensive Income:
The Haig-Simons Definition
It is “the exercise of control over the use of society’s
scarce resources.”
Algebraically it is defined as
I = C + NW
Where
I = Income
C = Consumption
NW = The Change in Net Worth
Implications of the Haig-Simons Definition
• If a person borrows to consume, there is no increase
in income because the change in net worth is
negative.
• If a person sells an asset so as to consume, there is
no increase in income.
Capital Gains
• Capital gains are the increased value of assets that a
person holds.
• If a person owns a stock that has gone up in value,
their net worth increases and therefore they have an
increase in income by this definition.
• This is true whether or not they actually sell the
asset and see the money in their bank accounts.
Realized and Unrealized Capital Gains
• Realized Capital Gains are those gains that a person
has received by selling an asset.
• Unrealized Capital Gains are those gains that a
person has not yet received by selling an asset but
exist only on paper as the market price of the asset
they hold has increased.
An Income Statement
• Sources of Funds:
– Earnings from Sale of Productive Services
– Transfer Payments Received
– Capital Gains (or Losses)
• Uses of Funds:
– Consumption
– Taxes
– Donations
– Gifts
– Saving (Increases in Net Worth)
Sources = Uses
So
• Earnings + Transfer Payments + Net Capital Gains =
Consumption + Taxes + Donations + Gifts + Saving
Modifications to the Income Definition
• The cost of acquiring income needs to be accounted
for in the definition.
• Earnings + Transfer Payments + Net Capital Gains –
Cost of Acquiring Income
=
Consumption + Taxes + Donations + Gifts + Saving –
Cost of Acquiring Income
Problems with Measuring Income
using the Haig-Simons Definition
• How do you measure unrealized capital gains on an
asset that is not regularly traded?
• Is the cost of an automobile used to drive to and from
work a “cost of acquiring income?” Are child care
expenses? Union Dues? Education expenses?
• How do you distinguish what part of an expense is a
cost of acquiring income and what part is merely
consumption?
1. Income tax
b) Corporate tax
Forms of Business
• Sole Proprietorships
• Partnerships
• Corporations
– Corporations are granted the legal status of people.
– This means that they can own property and borrow money
Corporate Taxes
• Corporations are subject to a corporate income tax;
• Since the corporation is not really a person, the
people who bear the burden of this tax depend on
the shifting of the tax;
• The tax could be shifted backwards to employees,
shifted forward to consumers or borne by the
shareholders.
The Tax Base: Measuring Business Income
• Using the comprehensive definition of income,
business income is receipts + net capital gains
income – labor, interest, material, and other business
costs.
• Only realized capital gains are included in net taxable
income for corporations.
Taxation of Owner-Supplied Inputs
• In a small business setting, the owner works for him
or herself. The profit from the business is what this
owner is “paid.”
• Some of this is normal profit, some economic profit.
• When there is a corporation there is no ownersupplied input so all profit, normal and economic, is
taxed.
Corporate Profits and Where They Go
• Corporate Profits = Corporate Taxes + Retained
Earnings + Dividends
• Retained Earnings are the portion of after-tax
corporate profits that a company keeps to invest in
the business.
• Dividends are the portion of after-tax corporate
profits that are distributed to households.
Economic Depreciation
• Economic Depreciation is the amount that an asset
devalues over time.
• When a business buys an expensive capital asset, it
cannot deduct from corporate profits the entirety of
the value of the asset.
• Because the asset will be productive for a substantial
period of time, companies can only deduct a portion
of the value of the asset.
Accelerated Depreciation
• Accelerated depreciation allows businesses to deduct
the loss in the value of an asset before it occurs.
• The ultimate in accelerated depreciation is the
allowance for expensing an asset in the year it is
purchased.
• Typically assets are allowed to be depreciated on a
straight-line basis, which means in equal increments
for the life of an asset.
Double Taxation of Corporate Income
• Corporate Income is considered to be double-taxed
because it faces taxes on the same income twice.
• The Corporation must pay taxes on the profits then
the shareholders must pay taxes on the amount they
receive in either dividends or capital gains.
• Under a comprehensive income tax this would not
happen. Corporate profits, either retained or paid in
dividends, would enter individual income tax
structures according to the percentage of the
corporation owned by each shareholder.
Arguments in Favor of Double Taxing
Corporate Income
• Unrealized Capital Gains and the Stepped-Up Basis:
– A major source of unrealized capital gains for individuals is
corporate stocks. If the business profit were not taxed at
the corporate level, it may never be taxed.
• Compensation for Bankruptcy Protection:
– Individuals are not liable for the bankruptcy of assets they
hold in corporations whereas they are in cases of
proprietorships and partnerships.
The Consequence of Double Taxation:
A Bias Toward Debt Finance
• A corporation can raise money by borrowing or it can
raise money by selling stock.
• The corporation can deduct from its profits the
amount it pays in interest to its bondholders.
• It cannot deduct the dividends it pays to its
stockholders. This encourages debt finance over
equity finance.
Demonstrating the Bias toward Debt Finance
Assumptions:
10% interest;
34 % tax rate
Item
Balance Sheet
Total Assets
Conclusion:
The taxation of corporate profits
combined with the deductibility of
interest raises the after-tax return on
equity to firms in greater debt thereby
motivating firms to increase their debt
burdens to an inefficiently high level.
50% Debt –
50% Equity
All-Equity
$1,000,000
$1,000,000
0
$500,000
$1,000,000
$500,000
$150,000
$150,000
0
$50,000
$150,000
$100,000
Income Tax
$51,000
$34,000
Income after
Corporate Tax
$99,000
$66,000
9.9%
13.2%
Debt
Shareholder’s Equity
Income Statement
Operating Income
Interest Expense
Taxable Income
Return on Equity
2. Consumption and sales taxes
Consumption as a Tax Base
• Consumption can be an alternative to income
as a measure of ability to pay.
• Comprehensive consumption:
Income-Savings
Note that capital gains would not be taxed if it were not spent.
Comparing a Tax on Income
to a Tax on Consumption
Assumptions
• Two equally situated persons with no physical capital
• Wages = $30,000 per year
• Interest rates = 10%
• Flat rate tax for either consumption or income of 20%.
• Two earning periods.
They have equal ability to pay taxes over their lifetime so they
should pay equal taxes over their lifetime.
Comparing a Tax on Income to a Tax on
Consumption: Step 1 An Income Tax
• IA = IB = $30,000
• SA = 0
• SB = $5,000
• TA = $6,000 + $6,000/(1+.1)
= $6,000 + $5,455 = $11,455
• TB = $6,000 + $6,100/(1+.1)/(1+.1)
= $6,000 + $5,545 = $11,545
Comparing a Tax on Income to a Tax on Consumption:
Step 2 A Consumption Tax for the Non-Saver
Income = Consumption + Consumption Tax +Savings
First and Second Year
• IA = CA + TA + SA
• $30,000 = CA + .2CA + 0
• CA = $25,000
• TA = $5,000
• SA = 0
Present Value of All Taxes
• TA = $5,000 + $5,000/(1+.1)
= $5,000 + $4,545.45 = $9,545.45
Comparing a Tax on Income to a Tax on Consumption:
Step 2 B Consumption Tax for the Saver
First Year
Second Year
IB = CB + TB + SB
IB + Proceeds from Saving
$30,000 = CB +.2CB + $5,000
= CB + TB
CA = $20,583.33
$35,500 = CB + .2CB
TA = $4,166.66
CA = $29,583.33
SA = $5,000
TA = $5,916.67
Present Value of All Taxes
TB
= $4,166.66 + $5,916.67/(1+.1)
= $4,166.66 + $5,378.79 = $9,545.45
Comparing a Tax on Income
to a Tax on Consumption
• Under an Income tax, savers pay more in tax than
non-savers.
• Under a consumption tax, they pay the same present
value of taxes.
Impact of a Sales Tax on the Efficiency
in Labor Markets
• A substitution of a consumption tax for an income
tax (with equal yields) would require a higher tax rate
because of savings.
• The net efficiency change depends on whether the
gain in the investment market is greater than the loss
in the labor market.
• Estimates suggest such a change would have a
positive impact on GDP.
A Sales Tax
• A retail sales tax is typically a fixed percentage on the
dollar value of retail purchases.
• Sales taxes are a major source of tax revenue for
state and local governments. Some state rates are as
high as 7% with local governments adding an
additional 3% on top of that.
• Often food and medicine are exempt.
An Excise Tax
• An excise tax is a selective tax on particular goods.
• In Bulgaria excise taxes exist on alcohol, tobacco and
tobacco products, and energy resources (petrol,
natural gas, oil, electricity).
The Incidence of Sales and Excise Taxes
• Generally, sales taxes are regressive when food and
medicine are not exempt.
• A national sales tax would be borne by labor income
and would lack the progressive rate structure of the
personal income tax.
Turnover Taxes
• Turnover taxes are multistage taxes that are levied at
some fixed rate on transactions at all levels of
production.
• The effective rate of tax depends on the number of
times the good is sold during the production process.
• This creates a significant bias toward vertical
integration (where all production stays within the
same firm).
A Value-Added Tax
A value-added tax (VAT) is a consumption-based tax
levied at each stage of production.
Value Added = Total Transactions – Intermediate Transactions
= Final Sales
= GDP
= Wages + Interest + profits + Rents + Depreciation
Tax Liability = Tax on Payable Sales – Tax Paid on Intermediate Purchases
= t(sales) – t(purchases)
= t(sales – purchases)
= t(value added)
The VAT in Europe
• The VAT accounts for about 20% of EU member
nation revenue.
• The average rates within the EU are between 15 and
20%.
• Different rates apply to different types of goods with
luxury items facing the highest rate and necessities
facing the lowest.
• The tax applies to services as well as goods.
• Economists find the VAT a good alternative to an
income tax because it does less to discourage savings
and investment.
3. Property Taxes
A Comprehensive Wealth Tax Base
• Real Property is property such as land and the
structures on the land.
• Intangible Property is wealth that is held as paper or
financial assets.
• Personal Property is wealth that is held in the form of
cars, furniture, clothing, jewelry, etc.
Measuring Wealth
• Market value can be used to establish the value of
most real property and intangible property but
personal property has no acceptable resale market.
• Serious inequities can arise from mismeasurement of
wealth and serious shifting can take place when one
form of wealth is taxed while another is not.
Assessment of Property Value
• For the property tax, the assessed value of a
home and the land upon which it sits is quite
subjective. Real-estate markets exists for many
homes but not others.
4. Fiscal Policy
Budget Deficits and Surpluses
• Budget deficit:
Present when total government spending exceeds
total revenue from all sources.
• When the money supply is constant, deficits
must be covered with borrowing.
• Governments borrow by issuing bonds.
• Budget surplus:
Present when total government spending is
greater than total revenue.
• Surpluses reduce the magnitude of the
government’s outstanding debt.
Budget Deficits and Surpluses
• Changes in the size of the deficit or surplus are often
used to gauge whether fiscal policy is stimulating or
restraining demand.
• Changes in the size of the budget deficit or surplus
may arise from either:
• A change in the state of the economy, or,
• A change in discretionary fiscal policy.
• The budget is the primary tool of fiscal policy.
• Discretionary changes in fiscal policy:
Deliberate changes in government spending and/or
taxes designed to affect the size of the budget deficit
or surplus.
4. Fiscal Policy
a) The Keynesian view
The Keynesian View of Fiscal Policy
• Keynesian theory highlights the potential of fiscal
policy as a tool capable of reducing fluctuations in
aggregate demand.
• Following the Great Depression, Keynesians
challenged the view that governments should always
balance their budget.
• Rather than balancing their budget annually,
Keynesians argue that counter-cyclical policy
should be used to offset fluctuations in aggregate
demand.
• This implies that the government should
plan budget deficits when the economy is weak
and budget surpluses when strong demand
threatens to cause inflation.
Keynesian Policy
to Combat Recession
•
When an economy is operating below its potential output, the
Keynesian model suggests that the government should institute
expansionary fiscal policy, by:
• increasing the government’s purchases
of goods & services, and/or,
• cutting taxes.
Expansionary Fiscal Policy
Price
Level
Keynesians believe that
allowing for the market to
self-adjust may be a lengthy
and painful process.
LRAS
SRAS2
E2
P2
P1
SRAS1
e1
P3
E3
Expansionary fiscal policy
stimulates demand and
directs the economy to
full-employment
AD1 AD2
Y1 YF
Goods & Services
(real GDP)
• At e1 (Y1), the economy is below its potential capacity YF .
There are 2 routes to long-run full-employment equilibrium:
• Wait for lower wages and resource prices to reduce costs,
increase supply to SRAS2 and restore equilibrium to E3, at YF.
• Alternatively, expansionary fiscal policy could stimulate
AD (shift to AD2) and guide the economy back to E2, at YF .
Keynesian Policy
To Combat Inflation
• When inflation is a potential problem,
Keynesian analysis suggests a shift toward
a more restrictive fiscal policy by:
• reducing government spending, and/or,
• raising taxes.
Restrictive Fiscal Policy
Price
Level
P3
LRAS
SRAS1
E3
P1
P2
SRAS2
e1
E2
Restrictive fiscal policy
restrains demand and
helps control inflation.
AD2 AD1
YF Y1
Goods & Services
(real GDP)
• Strong demand such as AD1 will temporarily lead to an
output rate beyond the economy’s long-run potential YF.
• If maintained, the strong demand will lead to the long-run
equilibrium E3 at a higher price level (SRAS shifts to SRAS2).
• Restrictive fiscal policy could reduce demand to AD2 (or keep
AD from shifting to AD1 initially) and lead to equilibrium E2.
The Crowding-out Effect
• The Crowding-out effect
– indicates that the increased borrowing to
finance a budget deficit will push real interest
rates up and thereby retard private spending,
reducing the stimulus effect of expansionary
fiscal policy.
• The implications of the crowding-out analysis are
symmetrical.
• Restrictive fiscal policy will reduce real interest
rates and "crowd in" private spending.
• Crowding-out effect in an open economy:
Larger budget deficits and higher real interest
rates lead to an inflow of capital, appreciation
in the dollar, and a decline in net exports.
Crowding-Out in an Open Economy
Decline in
private investment
Increase in
budget deficit
Higher real
interest rates
Inflow of financial
capital from abroad
Appreciation
of the dollar
Decline in
net exports
• An increase in government borrowing to finance an enlarged budget
deficit places upward pressure on real interest rates.
• This retards private investment and Aggregate Demand.
• In an open economy, high interest rates attract foreign capital.
• As foreigners buy more domestic currency to buy domestic bonds and
other financial assets, the domestic currency appreciates.
• The appreciation of the domestic currency causes net exports to fall.
• Thus, the larger deficits and higher interest rates trigger reductions in
both private investment and net exports, which limit the
expansionary impact of a budget deficit.
4. Fiscal Policy
b) The New Classical view
The New Classical View of Fiscal Policy
• The New Classical view stresses that:
• debt financing merely substitutes higher future
taxes for lower current taxes, and thus,
• budget deficits affect the timing of taxes, but not
their magnitude.
• New Classical economists argue that when debt is
substituted for taxes:
• people save the increased income so they will be
able to pay the higher future taxes, thus,
• the budget deficit does not stimulate aggregate
demand.
The New Classical View of Fiscal Policy
• Similarly, New Classical economists believe that
the real interest rate is unaffected by deficits as
people save more in order to pay the higher
future taxes.
• Further, they believe fiscal policy is completely
impotent – that it does not affect output,
employment, or real interest rates.
Expansionary Fiscal Policy
Price
Level
SRAS1
P1
AD1
Y1
AD2
Goods & Services
(real GDP)
• New Classical economists emphasize that budget deficits
merely substitute future taxes for current taxes.
• If households did not anticipate the higher future taxes,
aggregate demand would increase (from AD1 to AD2).
• However, when households fully anticipate the future taxes
and save for them, demand remains unchanged at AD1.
Expansionary Fiscal Policy
Loanable Funds
Market
Real
interest
rate
S1
S2
r1
e1
e2
Here, fiscal policy exerts
no effect on the interest rate,
real GDP, or unemployment.
D1
Q1
Q2
D2
Quantity of
loanable funds
• To finance the budget deficit, the government borrows from
the loanable funds market, increasing the demand (to D2).
• Under the new classical view, people save to pay expected
higher future taxes (raising the supply of loanable funds to S2.)
• This permits the government to borrow the funds to finance
the deficit without pushing up the interest rate.
4. Fiscal Policy
c) Changes and problems of timing
Problems with Proper Timing
• There are three major reasons why it is difficult to time fiscal
policy changes in a manner that produces stability:
• It takes time to institute a legislative change.
• There is a time lag between when a change is instituted & when it
exerts significant impact.
• These time lags imply that sound policy requires knowledge of
economic conditions 9 to 18 months in the future. But our ability to
forecast future conditions is limited.
• Discretionary fiscal policy is like a
two-edged sword; it can both harm and help:
• If timed correctly, it may reduce economic instability.
• If timed incorrectly, however, it may increase economic instability.
Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
• Consider a market at long-run equilibrium E0 where only
the natural rate of unemployment is present.
• An investment slump and business pessimism result in an
unanticipated decline in AD (to AD1). Output falls (to Y1)
and unemployment increases.
Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS1
Suppose that shifts in AD
are difficult to forecast.
P0
P1
E0
e1
AD1
Y1 Y0
AD0
Goods & Services
(real GDP)
• After a time, policymakers consider and implement
expansionary fiscal policy seeking to shift AD1 back to AD0.
• But it will take time to institute changes in taxes and
expenditures. Political forces will slow this process.
Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS1
P0
P1
E0
e1
AD1
Y1 Y0
AD0
AD2
Goods & Services
(real GDP)
• By the time a more expansionary fiscal policy is instituted
and begins to exert its primary effect, private investment
may have recovered and decision makers may therefore be
increasingly optimistic about the future.
• Hence, the more expansionary fiscal policy may over-shift
AD to AD2.
Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS2
SRAS1
P3
E3
P2
e2
P0
P1
E0
e1
AD0
AD1
Y1 Y0 Y2
AD2
Goods & Services
(real GDP)
• The price level in the economy rises (from P1 to P2) as the
economy is now overheating. Thus, incorrect timing leads
to inflation.
• Unless the expansionary fiscal policy is reversed, wages and
other resource prices will eventually increase, shifting SRAS
back to SRAS2 (driving the price level up to P3).
Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS1
P2
P0
e2
E0
AD0
Y0 Y2
AD2
Goods & Services
(real GDP)
• Alternatively, suppose an investment boom disrupts the
initial equilibrium shifting AD out to AD2, and prices upward
P 2.
• to
Policymakers
consider and eventually implement an increase
in taxes and a cut in government expenditures.
Timing of Fiscal Policy is Difficult
Price
Level
LRAS
SRAS1
P2
e2
P0
P1
Suppose that shifts in AD
are difficult to forecast.
E0
e1
AD0
AD1
Y1 Y0 Y2
AD2
Goods & Services
(real GDP)
• By the time the more restrictive fiscal policy takes affect,
investment may have returned to its normal rate (shifting
AD2 back to AD0).
• In this case, the incorrect timing of the shift to the more
restrictive fiscal policy to deal with potential inflation throws
the economy into a recession (by over shifting AD to AD1).
Why Timing of Fiscal Policy
Changes Are Difficult: A Summary
• Because fiscal policy does not work instantaneously,
and since dynamic forces are constantly influencing
private demand, proper timing of fiscal policy is not an
easy task.
• Further, political incentives also influence fiscal policy.
Public choice analysis indicates that legislators are
delighted to spend money on programs that directly
benefit their own constituents but are reluctant to raise
taxes because they impose a visible cost on voters.
• There is a political bias towards spending and budget
deficits. Predictably, deficits will be far more
common than surpluses.
• Incorrectly timed policy changes may, them-selves, be a
source of economic instability.
Automatic Stabilizers
• Automatic Stabilizers:
Without any new legislative action, they tend to increase the
budget deficit (or reduce the surplus) during a recession and
increase the surplus (or reduce the deficit) during an
economic boom.
• The major advantage of automatic stabilizers is that they
institute counter-cyclical fiscal policy without the delays
associated with legislative action.
• Examples of automatic stabilizers:
Unemployment compensation
Corporate profit tax
A progressive income tax
4. Fiscal Policy
d) Supply-side Effects of Fiscal policy
Supply-side Effects of Fiscal Policy
• From a supply-side viewpoint, the marginal tax rate is of
crucial importance:
A reduction in marginal tax rates increases the reward
derived from added work, investment, saving, and other
activities that become less heavily taxed.
• High marginal tax rates will tend to retard total output
because they will:
discourage work effort and reduce the productive
efficiency of labor,
adversely affect the rate of capital formation and the
efficiency of its use, and,
encourage individuals to substitute less desired taxdeductible goods for more desired non-deductible
goods.
Supply-side Effects of Fiscal Policy
• So, changes in marginal tax rates, particularly high
marginal rates, may exert an impact on aggregate
supply because the changes will influence the relative
attractiveness of productive activity in comparison to
leisure and tax avoidance.
• Impact of supply-side effects:
Usually take place over a lengthy time period.
There is some evidence that countries with high taxes
grow more slowly—France and Germany versus United
Kingdom.
While the significance of supply-side effects are
controversial, there is evidence they are important for
taxpayers facing extremely high tax rates – say rates of 40
percent or above.
Supply Side Economics and Tax Rates
Price
Level
LRAS1
LRAS2
SRAS1
SRAS2
P0
E1
E2
AD1
YF1
YF2
With time, lower tax rates
promote more rapid growth
(shifting LRAS and SRAS
out to LRAS2 and SRAS2).
AD2
Goods & Services
(real GDP)
• What are the supply-side effects of a cut in marginal tax rates?
• Lower marginal tax rates increase the incentive to earn and use
resources efficiently. AD1 shifts out to AD2, and SRAS & LRAS
shift to the right.
• If the tax cuts are financed by budget deficits, AD may expand
by more than supply, bringing an increase in the price level.
Have Supply-siders Found
a Way to Soak the Rich?
• Since 1986 the top marginal personal income tax rate in
the United States has been less than 40% compared to
70% or more prior to that time.
• Nonetheless, the top one-half percent of earners have
paid more than 25% of the personal income tax every
year since 1997.
• This is well above the 14% to 19% collected from these
taxpayers in the 1960s and 1970s when much higher
marginal personal income tax rates were imposed on
the rich.