Professor John Hudson

Professor John Hudson University of Bath www.bath.ac.uk/hssjrh/ These notes will be placed on my web page

BATH UNIVERSITY

We will look at some resources for you then two pieces of research in which we have been involved in

A Model of UK Economy • www.bized.co.uk/virtual/economy • Allows you to see the impact on unemployment, growth, government revenue etc of e.g. cutting tax on income or increasing VAT. Also the impact on various families of these changes • Has Case studies of these changes • A dictionary of economics • A set of biographies on the great economists

TAXATION COSTS The first known system of taxation was in Ancient Egypt around 3000 BC - 2800 BC in the first dynasty of the Old Kingdom.[ Records from the time document that the pharaoh would conduct a biennial tour of the kingdom, collecting tax revenues from the people. Early taxation is also described in the Bible. In Genesis it states "But when the crop comes in, give a fifth of it to Pharaoh. The other four-fifths you may keep as seed for the fields and as food for yourselves and your households and your children.“ We need tax to fund the state, hospitals, education and so on. But taxation imposes costs

ADMINISTRATIVE COSTS • These are the costs incurred by governments in the collection of taxes. The costs of tax inspectors, etc. • But there are also costs incurred by people who pay taxes:

COMPLIANCE COSTS OF TAXATION • These are the costs on the individual of paying taxes, e.g. the costs on you of filling in your tax forms. • For some taxes such as VAT these are substantial and may amount to say 3% of revenue collected. • At Bath we did work for the tax authorities on the compliance costs on firms of collecting income tax for government:

The firm – in my case Bath University – takes, from my salary, tax and a month or so later gives it to the government.

We sent questionnaires to several thousand businesses in the UK and found: • These costs penalise small business more than large because of economies of scale. • Are particular great for part time, seasonal workers and firms where workers tend to change a lot as some leave and new ones arrive

IMPACT • Because of this work the UK government is now committed to minimizing compliance costs and to make the paying of taxes as simple as possible. • But doing large questionnaires is expensive and the results quickly become out of date. • The Dutch have developed a technique based on what they call the MISTRAL model

First the Dutch…. • This attempts to estimate the costs of e.g. paying VAT by examining all the actions involved and (i) estimating the amount of time each action costs and (ii) putting a money value on this time. • They have done this with every single piece of work firms have to do for the government – e.g. health and safety, environmental laws, etc. • And the Dutch government are committed to keeping the burden on business of compliance with government activities stay fixed below a certain amount.

…. Then the EU • The EU as a whole is also taking an interest in this and soon the approach will spread throughout the UK including Slovakia. • Andre Nijsen is the person who developed MISTRAL. He retires next year and I am editing a book to celebrate his contribution. It will probably be published in 2008 and will represent an up to date account of this type of work across the world

EXCESS BURDEN OF TAXATION • In economics, the excess burden of taxation, also known as the distortionary cost or deadweight loss of taxation, is the economic loss society suffers as the result of a tax, over and above the revenue it collects. • Administrative & compliance costs are part of these but there are more involved with… • Distortions which occur because people or firms change their behaviour in order to reduce the amount of tax they must pay.

The cost of a distortion is usually measured as the amount that would have to be paid to the people affected by it, in order to make them indifferent to its presence.

The Tax =P3-P2 shifts the supply curve upwards P3

increasing price from P1 to P2. Government revenue is the square P2-P3-Q2 P3

But the lost profits to the firm is P3-P2 PLUS their share of the orange shaded area. (equals the difference in revenue less the difference in cost) P3

And for the consumer the cost in terms of having to change their expenditure plans is P1-P2-Q2 PLUS their share of the orange shaded area P3

The tax has forced people to change their behaviour buying less of a product it benefited both firm to produce and consumer to buy. P3

Of course the government gains revenue from the tax, but not as much as firms and consumers have lost. The DEADWEIGHT LOSS is the range shaded area P3

Who Pays Taxes?

Depends on slopes of the curves or elasticities, here the price rises a lot and the consumer pays.

But here the firm cannot pass the price increase on and it is the firm who pays. Inelastic supply, elastic demand

TAX EVASION • Tax evasion is against the law, it is when people/firms evade paying taxes the law says they should. They are part of the ‘shadow economy’. • Tax avoidance is not against the law it is about using the law to pay as little tax as you have to, by e.g. basing your firm in Lichtenstein where taxes are low.

Various estimates of the shadow economy in Selected Countries. • Year 1999/2000 2002/2003 • Country • Bulgaria 36.9% 38.3% • Czech Rep. 19.1% 20.1% • Hungary 25.1% 26.2% • Latvia 39.9% 41.3% • Poland 27.6% 28.9% • Romania 34.4% 37.4% • Slovak Rep. 18.9% 20.2% • Slovenia 27.1% 29.4% • USA 8.7% 8.4% • UK 12.7% 12.2% • Germany 16.0% 16.8% • Sweden 19.2% 18.3% • Phillipines 43.4% 45.6% • Notes: Sources SE: Schneider and Enste (2000), Schneider (2004)

M Orviská, A. Čaplánová, J. Medved & J. Hudson, A Cross Section Approach to Measuring the Shadow Economy (2006), Journal of Policy Modeling, Vol. 28, pp. 713-724. The size of the shadow economy has been investigated by a number of different methods. We have developed a method based on the amount of cash people have in their pocket (people engaged in ths shadow economy tend not to use banks, but carry cash) The analysis suggests that the relative figures are: Slovakia 23.2% Czech Republic 21.8%

Why People PAY Taxes • Fear of getting caught • Social Disgrace • Civic Duty • They obey the law • They do not have the opportunity

The Standard Economic Approach • Is that people pay taxes out of fear of the consequences of getting caught. In this sense the fine or penalty you have to pay if caught is ‘the price of breaking the law’ • This seems to narrow and ignores the fact that people pay taxes for other reasons:

Why People PAY Taxes • Fear of getting caught • Social Disgrace • Civic Duty • They obey the law • They do not have the opportunity

Think a bit: • output in Slovakia is about 20% greater than the official figures. • About the same proportion of taxes are not paid, meaning all honest citizens have to pay more and ….. • Your schools and health service are not as good as they should be because the government cannot fund them as much as if everyone paid taxes.

Policies to reduce the shadow economy • Increased frequency of tax audits and greater fines are two obvious measures which in many, perhaps most, countries would be justified. • Targeting audits at the likely participant in the shadow economy is another. One obvious example would be to target dishonest citizens, i.e. those who have been found to have broken the law within some other context (speeding on the motorway). • Publishing the identity of those found to have participated in the shadow economy, hence adding the social costs (your friends know you are a ‘bad person’) may also be an effective strategy.

AND FINALLY: • Of course the banks play a part in the shadow economy; particularly with the mafia and the laundering of money. The EU are aware of this and attempting to deal with it in a number of ways which will affect all banks in all EU countries. • But that is another story

Professor John Hudson