ECO 4113 FISCAL ECONOMICS

Assoc. Prof. Yeşim Kuştepeli

PRINCIPLES OF TAXATION 1:EFFICIENY AND EQUITY ISSUES 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

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

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.

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.

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.

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

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.

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 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.

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.

TAX INCIDENCE REVİSİTED 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

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

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 asABC = 1/2t x P1 x (Q1-QT)

Elasticity , ε, is equal to the percentage change in quantity divided by the percentage change in price:

)/()(

)/(

11

1

TT

T

QQQQ

PPt

)/()(

)/(

11

1

TT

T

QQQQ

PPt

Given the initial price and quantity,above equation conveys a very important insight.

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.

)(

)(2/1

1

112

PPx

QQxPtABC

T

T

Taxes should be imposed to the extent possible on items for which demand is relatively inelastic.

The instinctive response to that observation is to think of addictive substances or inexpensive necessities.

Another response is suggested by the fact that elasticity is lower when there are few substitutes.

The easiest way to design a tax where the possibility of substitution is minimal is to make the base as broad as possible.

A retail sales tax has a broder base than an excise tax,because consumers have fewer possibilities for substitution.

A retail sales tax that includes services as well as goods will be less distorting than one that only taxes tangible goods.

An income tax that includes income from investments will result in less distortion in behavior than a payroll tax that only covers wages.

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 RATESİELASTICITY,AND BASE EROSION

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.

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.

USİNG TAXES TO ALTER DECİSİONS 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

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.

EQUİTY İSSUES İN TAX DESİGN

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.