ECO 4113 FISCAL ECONOMICS

1. ECO 4113 FISCAL ECONOMICS Assoc. Prof. Yeşim Kuştepeli

2. Prıncıples of taxatıon 1:effıcıenyandequıtyıssues • Adam Smithdevoted ,TheWealth of Nations (1776), to “therevenue of thesovereign,” including his famousdictumthatthetaxesonepaysshould be “proportionaltotherevenueenjoyedundertheprotection of thestate.” • DavidRicardo,titled his famousbook as Principles of PoliticalEconomyandTaxation. • Untilthelatterhalf of the 20th century,courses in thepublicsectorwereaptlynamedpublicfinance,becausetheyconcentratedsoheavily on therevenueside of thepublicsectortotheneglect of theequallyimportantdecisions on theexpenditureside. • Todaythebalance has shifted,but an understanding of theprinciples of taxdesign,boththeoreticalandapplied, is still a centralpart of thestudy of publicsectoreconomics.

3. Effıcıencyıssuesıntaxdesıgn • A tax is saidto be efficientif it does not changeany of theeconomicdecisionsthatfirmsandhouseholdswouldhavemade in theabsence of thetax. • A polltax,which is a flatchargeperpersonorperhousehold, is one of thefewtaxesthatdoes not distorteconomicdecisions. • Theburden of a polltaxdoes not changewithchanges in location, workeffort, consumptionspending, wealth, orany of theotherfactorsthataffectone’staxliabilityforincome, sales,property, excise,andestatetaxes. • Thepolltax is rarelyused in modern industrialnations, because it is extremelyregressive ; that is, it takesmuchhigherpercentage of incomefromthepoorthantherich. • But thepolltaxdoesprovide a usefulstandard of nondistortionagainstwhichtheeffects of othertaxes can be measured.

4. Consumersurplusandexcessburden • An analyticaltoolthat is useful in evaluatingthedistortingeffect of taxesandtheirimpact on consumerwelfare is theconcept of consumersurplus. • Consumersurplusfor a quantity Q2 is thedifferencebetweentheentireareaunderthedemandcurve,OABQ2, andtheamountactuallypaid,which is rectangle OP2BQ2 (pricetimesquantity) • Anythingthatchangesthepricepaidwillalsoaltertheamount of consumersurplusreceived. • A rightwardshift in supplywilllowerthepriceandincreaseconsumersurplus, whereas a leftwardshiftwillraisethepriceandreduceconsumersurplus. • Imposing a taxwillalsohavetheeffect of reducingconsumersurplus.

5. Taxesaregenerallyrepresentedgraphically as eithershadowdemandcurvesorshadowsupplycurves. • Thewordshadow is intendedtoconveythattheseconddemandorsupplycurvedoes not represent a shift in theoriginalcurve, but rather a wedgebetweenthedemandcurve as perceivedbythebuyerandthedemandcurve as perceivedbythe seller. • Thepiece of consumersurpluslost is known as excessburdenand is moregenerallyreferredto as deadweightloss. • Thisexcessburdenordeadweightlossrepresents a decline in consumersurplusandconsumerwelfarethatdoes not gettransferredtofirmsortogovernment but is lostentirely.

6. 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.

7. Differenttaxratesorlevelsordifferentelasticities of supplyordemandwillresult in triangles of differentsizesandshapesthatrepresentlargerorsmallerdeadweightlosses ,or in thecase of taxes, excessburden. • One of theobjectives of goodtaxandrevenuesystemdesign is to minimize theexcessburdenrepresentedbytheHarbergertriangles. • Theconcrete, intuitivemeaningbehindthesetriangles is theforcedadjustment in consumption (orsometimesproduction) patterns as a result of thetax, whichgenerates a loss of consumerwelfareoverandabovethe transfer of resourcesfromtheconsumertothegovernment.

8. Shıftıng,ıncıdence, andprıceelastıcıty • 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.

9. 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.

10. Ad valoremtaxes • All of theillustrationsthus far show a fairlysimpletype of tax,called a specifictax, which is imposed on thebasis of somequantitymeasure-units,volumeorweight. • Morecommononesaread valoremtaxes, which (as their name suggests) areimposed as a percentage of thepriceorvalue. • For a specifictax,theshadowdemandcurve is paralleltotheoriginaldemandcurve. • Thedistancebetweenthemmeasuresthetaxperunit. • For an ad valoremtax, thedistancebetweenthetwocurveschangeswiththeprice,andthe “taxwedge” getslargerandlarger as thepricegetshigher.

11. Taxıncıdencerevisited • Regardless of howthetaxlaw is written, orwhowritesthecheckforthetaxdue, alltaxesareultimatelypaidbyhouseholds in one form oranother. • Evenif a tax is absorbedbythe seller, theimpactdoes not endthere, becausethe seller is merely an intermediaryforworkers, suppliers, andowners - oftenstockholders. • Theshare of thetaxpaidbythe seller has tocomeout of theearnings of oneormore of thosegroups. • Itmayresult in lowerwagesforworkers, lowerdividendsforstockholders, lowerprofits in thecase of a privatelyownedfirm,orevenlowerpaymentstoproviders of inputs,depending on thedegree of competition in each of therelevantmarkets.

12. Locatıonaleffects • 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.

13. Multıpletaxbasesandexcessburden • 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)

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

15. Giventheinitialpriceandquantity,aboveequationconveys a veryimportantinsight. • The size of theexcessburdentriangle, orthewastethattakesplace in transferringrevenuetothegovernment, depends on twofactors. • Theexcessburden is inverselydependent on theelasticity of demand(thegreatertheelasticity, thesmallertheexcessburden). But excessburdenincreasesdirectly in proportionto, not justthetax rate,but thesquare of thetax rate.

16. Taxesshould be imposedtotheextentpossible on itemsforwhichdemand is relativelyinelastic. • Theinstinctiveresponsetothatobservation is tothink of addictivesubstancesorinexpensivenecessities. • Anotherresponse is suggestedbythefactthatelasticity is lowerwhentherearefewsubstitutes. • Theeasiestwaytodesign a taxwherethepossibility of substitution is minimal is tomakethebase as broad as possible. • A retailsalestax has a broderbasethan an excisetax,becauseconsumershavefewerpossibilitiesforsubstitution. • A retailsalestaxthatincludesservices as well as goodswill be lessdistortingthanonethatonlytaxestangiblegoods. • An incometaxthatincludesincomefrominvestmentswillresult in lessdistortion in behaviorthan a payrolltaxthatonlycoverswages.

17. 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.

18. Taxratesielastıcıty,andbaseerosıon • 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.

19. Iftaxratesgethighenough, peoplewillresorttobarterortaxevasion; theywillgo underground, reducetheirworkeffort, leavethecountry, buy abroad. • Underthesecircumstances, a reduction in taxratesmightactuallygeneratemorerevenueratherthanless. • Movingupthedemandcurve, eventuallyeventhemostinelasticdemandcurveenters an elasticrange in whichbuyersbecomemoreandmoresensitivetopriceincreases.

20. Usingtaxestoalterdecisions • Taxes can also be usedtodeliberatelyalterdecisionsbecause of thepositiveandnegativeexternalitiesassociatedwithcertainkinds of individualdecisions. • Taxes on alcohol, cigarettes, andgamblingareintended in parttodiscourageconsumption of thoseproducts, all of whichhavenegativeexternalities of onekindoranotjerassociatedwiththem. • Thesame is true of taxesorcharges on pollutionthataretiedtothevolume of emissions, in ordertodiscouragesociallyundesirableactivities. • Sometaxexpendituresorsubsidies of variouskindsaredesignedtoencourageactivitieswithsocialbenefits,such as givingtocharity, investing in one’sowneducation, orbecoming a homeowner. • Finally, certaintaxsubsidiesortaxexpendituresareintendedtobenefitonegroup of taxpayers in preferncetoothers,which is intentionalredistribution of incomeorwealth.

21. Short-runversuslongruneffects • 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.

22. Equityissues in taxdesign • 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.