Public Finance: Taxes and Fiscal Policy

1. Public Finance:Taxes and Fiscal Policy Fundamentals of Finance – Lecture 10

2. Outline • Income Taxes • Personal • Corporate • Consumption and Sales Taxes • Taxes on Wealth and Property • Fiscal Policy • The Keynesian View • The New Classical View • Fiscal Policy Changes and Problems of Timing • Supply-Side Effects of Fiscal Policy

3. 1. Income taxa) Personal tax

4. I = C + NW 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 Where I = Income C = Consumption NW = The Change in Net Worth

5. 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.

6. 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.

7. 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.

8. 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

9. 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

10. 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?

11. 1. Income taxb) Corporate tax

12. 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

13. 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.

14. 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.

15. 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 owner-supplied input so all profit, normal and economic, is taxed.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. Item All-Equity 50% Debt – 50% Equity Balance Sheet Total Assets $1,000,000 $1,000,000 Debt 0 $500,000 Shareholder’s Equity $1,000,000 $500,000 Income Statement Operating Income $150,000 $150,000 Interest Expense 0 $50,000 Taxable Income $150,000 $100,000 Income Tax $51,000 $34,000 Income after Corporate Tax $99,000 $66,000 Return on Equity 9.9% 13.2% Demonstrating the Bias toward Debt Finance Assumptions: 10% interest; 34 % tax rate 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.

23. 2. Consumption and sales taxes

24. 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.

25. 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.

26. 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

27. 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

28. Comparing a Tax on Income to a Tax on Consumption:Step 2 BConsumption Tax for the Saver • First Year • IB = CB+ TB+ SB • $30,000 = CB +.2CB+ $5,000 • CA= $20,583.33 • TA= $4,166.66 • SA= $5,000 • Second Year • IB + Proceeds from Saving = CB + TB • $35,500 = CB + .2CB • CA= $29,583.33 • 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

29. 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.

30. 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.

31. 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.

32. 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).

33. 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.

34. 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).

35. 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)

36. 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.

37. 3. Property Taxes

38. 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.

39. 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.

40. 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.

41. 4. Fiscal Policy

42. 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.

43. Budget Deficits and Surpluses • Changes in the size of the deficitor 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.

44. 4. Fiscal Policya) The Keynesian view

45. 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.

46. 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.

47. SRAS2 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. E2 Expansionary fiscal policy stimulates demand and directs the economy to full-employment E3 AD2 Expansionary Fiscal Policy SRAS1 PriceLevel LRAS P2 P1 e1 P3 AD1 Goods & Services(real GDP) Y1 YF • 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 .

48. 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.

49. SRAS2 E3 Restrictive fiscal policyrestrains demand and helps control inflation. E2 AD2 Restrictive Fiscal Policy PriceLevel LRAS SRAS1 P3 P1 e1 P2 AD1 Goods & Services(real GDP) Y1 YF • 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 AD1initially) and lead to equilibrium E2.

50. 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.