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Tax Incidence and the Efficiency Cost of Taxation

Tax Incidence and the Efficiency Cost of Taxation

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Tax Incidence and the Efficiency Cost of Taxation

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  1. Tax Incidence and the Efficiency Cost of Taxation Topic 9

  2. Outline • The Economics of Taxation • The role of taxation. • The main types of taxation.

  3. Outline • The Economics of Taxation • The role of taxation. • The main types of taxation. • The Efficiency Cost of Taxation • Marginal excess burden. • Marginal cost of public funds.

  4. Outline • The Economics of Taxation • The role of taxation. • The main types of taxation. • The Efficiency Cost of Taxation • Marginal excess burden. • Marginal cost of public funds. • Tax Incidence • Formal and effective incidence. • Tax capitalisation.

  5. Outline • The Economics of Taxation • The role of taxation. • The main types of taxation. • The Efficiency Cost of Taxation • Marginal excess burden. • Marginal cost of public funds. • Tax Incidence • Formal and effective incidence. • Tax capitalisation. • Equity: Efficiency Trade offs in the design of the Tax System • The structure of income taxes. • Trade offs btwn equity and efficiency. • Income distribution and the structure of commodity taxes.

  6. 1. The Role of Taxation One potential classification of government functions – from an economic perspective would be • Efficiency • To reduce distortions in competition. • To alleviate the problems of incomplete markets

  7. 1. The Role of Taxation One potential classification of government functions – from an economic perspective would be • Efficiency • To reduce distortions in competition. • To alleviate the problems of incomplete markets • Equity • To provide merit goods • To alleviate poverty.

  8. 1. The Role of Taxation One potential classification of government functions – from an economic perspective would be • Efficiency • To reduce distortions in competition. • To alleviate the problems of incomplete markets • Equity • To provide merit goods • To alleviate poverty. • Stabilization (Macroeconomic Management) • To manage risks individuals face (insurance). • Macroeconomic stabilization

  9. Taxation has a role in each of these • Efficiency • Controls externalities. • Raises revenue for the provision of public goods. • Equity • Can redistribute income • Can generate revenues that provide other forms of poverty alleviation. • Stabilization • A key instrument in controlling aggregate demand • And the balance of trade

  10. Taxation and Politics Tax policy is highly politicised (an important election issue). Taxes signal societies values and approval/disapproval. Often there are intertemporal issues (balancing the budget today versus long term growth). Hidden taxes

  11. What are the criteria for a good tax system? • Fairness • Horizontal Equity • Vertical Equity

  12. What are the criteria for a good tax system? • Fairness • Horizontal Equity • Vertical Equity • Efficiency • Minimize the excess burden • Poll tax • Fiscal neutrality • The correction of externalities

  13. What are the criteria for a good tax system? • Fairness • Horizontal Equity • Vertical Equity • Efficiency • Minimize the excess burden • Poll tax • Fiscal neutrality • The correction of externalities • Compliance and Administration Costs • Compliance Costs = time, money inconvenience • Administration costs

  14. UK Fiscal Revenues 2003-04 = £407 bn Income Tax 122.1 30%

  15. UK Fiscal Revenues 2003-04 = £407 bn Income Tax 122.1 30% Corporation Tax 30.8 7.6%

  16. UK Fiscal Revenues 2003-04 = £407 bn Income Tax 122.1 30% Corporation Tax 30.8 7.6% National Insurance 74.5 18.3% Other Inland Revenue 13.0 3.2%

  17. UK Fiscal Revenues 2003-04 = £407 bn Income Tax 122.1 30% Corporation Tax 30.8 7.6% National Insurance 74.5 18.3% Other Inland Revenue 13.0 3.2% VAT 66.6 16.4% Excise Duties – fuel 23.0 5.6% - tobacco 8.0 2.0% - alcohol 7.4 1.8% Other Customs & Excise 7.8 1.9%

  18. UK Fiscal Revenues 2003-04 = £407 bn Income Tax 122.1 30% Corporation Tax 30.8 7.6% National Insurance 74.5 18.3% Other Inland Revenue 13.0 3.2% VAT 66.6 16.4% Excise Duties – fuel 23.0 5.6% - tobacco 8.0 2.0% - alcohol 7.4 1.8% Other Customs & Excise 7.8 1.9% Business Rates 18.6 4.6% Council Tax 18.6 4.6% Vehicle Excise Duties 4.8 1.2% Other 11.9 2.9%

  19. 2. The Efficiency Costs of Taxation Let us consider a Perfectly Competitive Market. In the Long Run we might treat supply as being a horizontal straight line.

  20. Equilibrium Before a Tax – P*Q* Demand Curve Price Supply Curve P* Q* Quantity

  21. Now Introduce a Tax Demand Curve Price Supply Curve including tax P** Tax Supply Curve P* Q* Q** Quantity

  22. Some Obvious Consequences • Consumers are paying more for each unit. (bad) • Government is earning taxes. (might be good) • Consumers are buying fewer units. (bad) • Firms are making fewer units. (Neutral here as perfect competition implies they make zero profit) How do these costs and benefits add up?

  23. Tax Revenue = Tax x Number of Units Demand Curve Price Supply Curve including tax P** Tax Revenue Supply Curve P* Q* Q** Quantity

  24. Tax Revenue = Exactly the losses of consumers who still buy Demand Curve Price Supply Curve including tax P** Extra Paid by Consumers Supply Curve P* Q* Q** Quantity

  25. This gain and loss exactly cancel The tax revenue = The extra paid by the consumers who still buy the taxed commodity. This is just a redistribution of income not an inefficiency. Summary: One effect of taxes is to transfer resources to the government. This reduces taxpayers’ disposable incomes.

  26. The Substitution Effect The price of this commodity has risen relative to other commodities. • This affects the incentives of the private sector. • It distorts markets.

  27. The Substitution Effect The price of this commodity has risen relative to other commodities. • This affects the incentives of the private sector. • It distorts markets. It generates “rents” A tax on tobacco makes growing it less attractive, therefore land prices fall. Tobacco machinery manufacturers lose as do tobacco workers. (Any input into a taxed commodity suffers.)

  28. This person was prepared to pay this much for the good. Demand Curve Price Supply Curve including tax P** Supply Curve P* Q* Q** Quantity

  29. Actually had to pay less. Demand Curve Price Supply Curve including tax P** Supply Curve P* Q* Q** Quantity

  30. But after the tax did not buy the good so this value was lost Demand Curve Price Supply Curve including tax P** Supply Curve P* Q* Q** Quantity

  31. Adding all these values then gives society’s total loss. Demand Curve Price Supply Curve including tax P** Supply Curve P* Q* Q** Quantity

  32. The Excess Burden This inefficiency is called “An Excess Burden” “A Deadweight Loss”

  33. The Excess Burden This inefficiency is called “An Excess Burden” “A Deadweight Loss” A poll tax (or any non-price related tax) will not have these costs. A US estimate has 20-30% of every $ raised generates this much extra burden.

  34. The Excess Burden Marginal Excess Burden := The excess burden of an extra £ raised in taxes. (This is generally higher than the average burden, as should tax least distorting commodities first.)

  35. The Excess Burden Marginal Excess Burden := The excess burden of an extra £ raised in taxes. (This is generally higher than the average burden, as should tax least distorting commodities first.) • A good tax system should impose taxes with least excess burden first.

  36. The Excess Burden Marginal Excess Burden := The excess burden of an extra £ raised in taxes. (This is generally higher than the average burden, as should tax least distorting commodities first.) • A good tax system should impose taxes with least excess burden first. • Then move on to those taxes with higher excess burden.

  37. The Excess Burden Marginal Excess Burden := The excess burden of an extra £ raised in taxes. (This is generally higher than the average burden, as should tax least distorting commodities first.) • A good tax system should impose taxes with least excess burden first. • Then move on to those taxes with higher excess burden. • Optimally, the marginal excess burden of each tax instrument should be the same.

  38. 3. Tax Incidence In other words – who bears the burden of taxes?

  39. 3. Tax Incidence In other words – who bears the burden of taxes? An important distinction: Formal Incidence: Who is legally obliged to pay the tax. Effective Incidence: Who actually bears the burden of the tax?

  40. 3. Tax Incidence In other words – who bears the burden of taxes? An important distinction: Formal Incidence: Who is legally obliged to pay the tax. Effective Incidence: Who actually bears the burden of the tax? These differ because prices can change as a result of a tax.

  41. Taxes On Business All taxes formally incident on business will have their final incidence on customers, shareholders and employees:

  42. Taxes On Business All taxes formally incident on business will have their final incidence on customers, shareholders and employees: Sales Taxes – Are Passed on and affect prices and customers also output and employees.

  43. Taxes On Business All taxes formally incident on business will have their final incidence on customers, shareholders and employees: Sales Taxes – Are Passed on and affect prices and customers also output and employees. Profits Tax – Affect shareholders and investment decisions (suppliers of capital).

  44. Taxes On Business All taxes formally incident on business will have their final incidence on customers, shareholders and employees: Sales Taxes – Are Passed on and affect prices and customers also output and employees. Profits Tax – Affect shareholders and investment decisions (suppliers of capital). Asset Taxes – Affect investment decisions.

  45. Effective Incidence is all that Matters to an Economist Who is legally obliged to pay a tax – is largely irrelevant if the taxed individuals can take actions to mitigate the effects the tax has.

  46. The Effect of a Sales Tax on a Market A market before a tax is imposed at equilibrium Price Q D Q s

  47. The Effect of a Sales Tax on a Market The tax raises the price paid by consumers. It lowers the price received by suppliers. Price Q D Q s TAX

  48. Why Does this Happen? Suppose the firms tried to raise their prices and pass on all the tax increase to the consumers, then:

  49. Why Does this Happen? Suppose the firms tried to raise their prices and pass on all the tax increase to the consumers, then: (1) The higher price for consumers would mean they would choose to buy less.

  50. Why Does this Happen? Suppose the firms tried to raise their prices and pass on all the tax increase to the consumers, then: (1) The higher price for consumers would mean they would choose to buy less. (2) However, the firms would still want to supply the same amount.