Introduction to the Tax Theory
Outline
1. The Economics of Taxation
• The role of taxation.
• The main types of taxation.
Outline
1. The Economics of Taxation
• The role of taxation.
• The main types of taxation.
2. The Efficiency Cost of Taxation
• Marginal excess burden.
• Marginal cost of public funds.
Outline
1. The Economics of Taxation
• The role of taxation.
• The main types of taxation.
2. The Efficiency Cost of Taxation
• Marginal excess burden.
• Marginal cost of public funds.
3. Tax Incidence
• Formal and effective incidence.
• Tax capitalisation.
Outline
1. The Economics of Taxation
• The role of taxation.
• The main types of taxation.
2. The Efficiency Cost of Taxation
• Marginal excess burden.
• Marginal cost of public funds.
3. Tax Incidence
• Formal and effective incidence.
• Tax capitalisation.
4. 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.
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
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.
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 Policy)
– To manage risks individuals face (insurance).
– Macroeconomic stabilization
Taxation has a role in each of these
1. Efficiency
• Controls externalities.
• Raises revenue for the provision of public goods.
2. Equity
• Can redistribute income
• Can generate revenues that provide other forms of
poverty alleviation.
3. Stabilization
• A key instrument in controlling aggregate demand
• And the balance of trade
What are the criteria for a good tax system?
1. Fairness
• Horizontal Equity
• Vertical Equity
What are the criteria for a good tax system?
1. Fairness
• Horizontal Equity
• Vertical Equity
2. Efficiency
• Minimize the excess burden
• Poll tax
• Fiscal neutrality
• The correction of externalities
What are the criteria for a good tax system?
1. Fairness
• Horizontal Equity
• Vertical Equity
2. Efficiency
• Minimize the excess burden
• Poll tax
• The correction of externalities
3. Compliance and Administration Costs
• Compliance Costs = time, money inconvenience
• Administration costs
CANONS OF TAXATION
• In the 1770’s, Adam Smith in his “Wealth of Nations” book
outlined the canons of taxation which are just as applicable
today. He recognized that the levy of taxation should comply
with certain basic criteria/norms and propounded the
following 4 canons/principles of taxation:
1. CONVENIENCE – a convenience tax is one which causes
the payer and the collector to do little that they would not do
in the absence of tax. In other words, taxpayers should be
levied at the time or in the manner in which it is most
convenient for the taxpayer to pay it. Eg., for a salaried
employee it is convenient for the tax to be collected at the end
of the month when the salary is paid
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CANONS OF TAXATION
• 2. CERTAINTY – a tax has certainty if the taxpayer can
predict their tax liability with reasonable accuracy. It also
means that the tax should not be an arbitrary one. The
taxpayer should be aware of:
– (a) The time to pay
– (b) The manner of payment
– (c) The amount to be paid
• The information should be available to both the taxpayers as
well as to every other person – especially potential investors.
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CANONS OF TAXATION
• 3. ECONOMY – a tax is economical if the costs of
collection are small relative to the amount of tax
collected. The tax should be easy and cheap to collect and
should fall directly on the ultimate payer.
• If great resources must be diverted to the collection of
taxes, they are simply wasted.
• Economical taxes are those that have low administrative
costs and are therefore, efficient.
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CANONS OF TAXATION
• 4. EQUITY – The idea behind the question of equity as far as
taxation is concerned is that every citizen in country ought to
contribute towards the support of the government, as nearly as
possible, in proportion to their abilities.
• In other words, the citizen ought to contribute to the support of the
government in proportion to the revenue which they enjoy under the
protection of the government.
• This incorporates the issue of fairness, and with the income tax,
fairness is generally interpreted to mean that taxpayers should be
taxed in proportion to their “ability to pay”.
• How progressive the tax structure should be, is a matter of debate.
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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.
Equilibrium Before a Tax – P*Q*
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Now Introduce a Tax (lump sum)
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Tax
Q**
Some Obvious Consequences
1. Consumers are paying more for each unit. (bad)
2. Government is earning taxes. (might be good)
3. Consumers are buying fewer units. (bad)
4. Firms are making fewer units. (Neutral here as perfect
competition implies they make zero profit)
How do these costs and benefits add up?
Tax Revenue = Tax x Number of Units
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Tax
Revenue
Q**
Tax Revenue = Exactly the losses of
consumers who still buy
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Extra Paid by
Consumers
Q**
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.
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.
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.)
This person was prepared to pay this much
for the good.
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Q**
Actually had to pay less.
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Q**
But after the tax did not buy the good so this
value was lost
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Q**
Adding all these values then gives society’s
total loss.
Price
Quantity
Demand Curve
Supply Curve
P*
Q*
Supply Curve including tax
P**
Q**
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.
• Optimally, the marginal excess burden of each tax
instrument should be the same.
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?
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.
Taxes On Business
All taxes formally incident on business will have their final
incidence on customers, shareholders and employees:
VAT, ED (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.
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.
The Effect of a Sales Tax on a Market
A market before a tax is imposed at equilibrium
Price
Qs
Q
D
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
Qs
Q
D
TAX
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.
(3) The market has Supply > Demand and prices will fall.
(4) Thus prices for firms will fall until
Supply(Price less tax) = Demand (Price including tax)
The Effect of a Sales Tax on a Market
Notice also – less goods are produced.
Some consumers don’t buy at the higher price.
Some sellers don’t produce at the lower price.
Price
Qs
Q
D
This reduces consumer surplus and producer surplus
P
Q
s
Q
D
Lost consumer surplus
This reduces consumer surplus and producer surplus
P
Q
s
Q
D
Lost consumer surplus
Lost producer surplus
But generates tax revenue
P
Q
s
Q
D
Giving a net loss in value – Excess Burden (or DWL)
↓Q
Q
s
Q
D
WHO PAYS THE TAX?
When buyers are price sensitive “demand is elastic” it is the
sellers who pay the tax.
WHO PAYS THE TAX?
When buyers are price sensitive “demand is elastic” it is the
sellers who pay the tax.
WHO PAYS THE TAX?
When buyers are price sensitive “demand is elastic” it is the
sellers who pay the tax.
Tax Incidence on Buyers
WHO PAYS THE TAX?
When buyers are price sensitive “demand is elastic” it is the
sellers who pay the tax.
Tax Incidence on Buyers
Tax Incidence on Sellers
WHO PAYS THE TAX?
When sellers are price sensitive “supply is elastic” it is the
buyers who pay the tax.
Tax Incidence on Buyers
Tax Incidence on Sellers
Tax incidence in sum...
S
P
Q
D
S
Suppliers pay nominal incidence...
D
Consumers pay nominal incidence...
P
Q
D
S
P
Q
D
S
Suppliers pay nominal incidence...
S
P
Q
D
S
Consumers pay nominal incidence...
D
Deadweight Loss
P
Cigarettes
D
S
PC =P2
Q2
P1
Q1
PS
Stax
$1.50CSCS
P
PS
P
PS
Social CostTax Revenue
Deadweight Loss
Questions:
Who pays the taxes on
(1) Cigarettes
(2) Alcohol
(3) Petrol
(4) Labour?
4. Taxation and Equity
IF policy makes care about equity they will care about the
winners and losers associated with tax changes.
Recall
A tax is progressive if payment as a % of income increases as
income rises.
A tax is regressive if payment as a % of income decreases as
income rises.
A tax is neutral if payment as a % of income is constant as
income rises.
Tax Equity
• One theory of fairness is called the benefits-received
principle, which holds that taxpayers should contribute
to government (in the form of taxes) in proportion to the
benefits that they receive from public expenditures.
Tax Equity
• Another theory of fairness is called the ability-to-pay
principle, which holds that citizens should bear tax
burdens in line with their ability to pay taxes.
• Two principles follow: horizontal equity and vertical
equity.
Horizontal and Vertical Equity
• Horizontal equity holds that those with equal ability to
pay should bear equal tax burdens.
• Vertical equity holds that those with greater ability to
pay should pay more.
What is the “Best” Tax Base?
• The three leading candidates for best tax base
are:
– Income,
– Consumption, and
– Wealth
Distributional Effects of Taxes
We can assess the distributional effects of one tax or of the
tax system as a whole.
• The overall incidence is more important than the effects
of single taxes.
• But introducing progressive taxes may improve a
regressive system.
• Remember it is still important to focus on the economic
incidence of taxes not the formal incidence.
Marginal versus Average Tax Rates
There are 2 distinct ways of achieving progressive tax
systems:
(1) Raise the marginal rate of taxes at higher income
levels.
(2) Allow some income to not be liable for taxes (a taxfree
allowance) or introduce tax credit.
Increasing marginal rates
Example: 25% for first £30k and 50% tax rate thereafter.
Income
Marginal
Tax Rate
25%
50%
Average Rate
Example Continued
You earn £50k
Your tax bill =
£30k x 0.25 = £7,500
Plus (£50k-£30k) x 0.50 = £10,000
= £17,500
Average Tax Rate = 17500/50000 = 35%
Tax Free Allowance
Example: 0% for first £10k and 25% tax rate thereafter.
Income
Marginal
Tax Rate
25%
Average Rate