Chapter 8Chapter 8Principles of Taxation 1: Principles of Taxation 1:

Efficiency and Equity Issues Efficiency and Equity Issues

Chapter outline

1.Efficiency Issues in Tax Design

2.Equity Issues in Tax Design

1.Efficiency Issues in Tax Design1.Efficiency Issues in Tax Design A tax is said to be efficient if it does not change a

ny of the economic decisions that firms and households would have made in the absence of the tax.

①Consumer Surplus and Excess Burden Taxes reduce consumer surplus. Some of the co

nsumer surplus is transferred to the government to finance public services, but some portion of it is just lost.

That loss, namely excess burden or deadweight loss or Harberger triangle is the efficiency cost of collecting taxes.

②Shifting, Incidence, and Price Elasticity The burden of a tax on is apportioned between the

buyer and seller differently depending on the elasticities of supply and demand.

If demand is relatively inelastic, more of the burden falls on the buyer in the form of higher price paid, while if supply is relatively inelastic, more of the burden falls on the seller in the form of lower net price received.

The allocation of the burden is referred to as incidence.

Shifting refers to the change in incidence from the originally responsible for collecting and remitting the tax to another party.

③Ad Valorem Taxes Ad Valorem Taxes are imposed as a percentage of

the price or value. Specific taxes are imposed on the basis of some

quantity measures. For a specific tax, the shadow demand curve is par

allel to the original demand curve. The distance between them measures the tax per unit.

For an ad valorem tax, the distance between the two curves changes with the price, and the “tax wedge” gets larger and larger as the price gets higher.

④The Effect of Taxes on Work EffortIncome effect: work effort may increase to

maintain income because the tax reduces income.

Substitution effect: work effort may decrease as the opportunity cost of leisure declines.

⑤Tax Incidence RevisitedAll taxes ultimately fall on households in

one way or another as consumers, workers, stockholders, and owners of business firms.

⑥Locational Effects The kinds of taxes imposed, the rates, t

he coverage, and other features will impact differently on different people.

⑦Multiple Tax Bases and Excess BurdenThe excess burden is dependent on tw

o factors: the elasticity of demand and the square of the tax rate.

⑧Tax Rates, Elasticity, and Base Erosion In raising price, the tax will increase

revenue, but in reducing quantity, or eroding the tax base, it will reduce revenue.

⑨Using Taxes to Alter Decisions Although in general the goal of tax design is to mi

nimize distortions in people’s decision, taxes can also be used to deliberately alter decisions because of the positive and negative externalities.

But the revenue loss is greater than the increase in consumer surplus. Figure8-9 illustrates it.

⑩Short Run Versus Long Run Effects Short-run effects of tax changes are often diff

erent (more revenue, less base erosion) than long-run effects because long-run elasticities of demand are greater.

2.Equity Issues in Tax Design2.Equity Issues in Tax Design

Every change in the tax base, tax rates, or tax rules alters the distribution of the tax burden among tax-payers.

Equity in a tax system is based on two principles, ability to pay and the benefit principle.

①Measures of Ability to Pay There are three measures: income, consumption or

spending, and assets. Consumption is the easiest measure to track. Wage and salary income is easy to track, but other

forms of income are harder to uncover. Assets are the most challenging tax base of all. In

general some taxes just focus on certain kinds of property, such as real estate, automobiles, and boats.

②The Benefit Principle Benefit principle attempts to assign tax or fee

burdens in proportion to the intensity of use of the public service that is being financed from that revenue source.

③Horizontal and Vertical Equity Revisited④Regressive, Proportional, and Progressive

Taxation Taxes and tax systems are classified as regressive,

proportional, or progressive according to whether that percentage decreases, remains the same, or increases as income rises.

Table 8-1 A Simple Progressive Income Tax

Gross Income Taxable Income

Tax Tax as % of Income

$10,000 0 0 0

$20,000 0 0 0

$30,000 $10,000 $1,000 3.3%

$40,000 $20,000 $2,000 5.0%

$50,000 $30,000 $3,000 6.0%

$100,000 $80,000 $8,000 8.0%

$500,000 $480,000 $48,000 9.6%

Table 8-2 A Two-Rate Progressive Income Tax

Gross Income Taxable Income

Tax Tax as % of Income

$10,000 0 0 0

$20,000 0 0 0

$30,000 $10,000 $1,000 3.3%

$40,000 $20,000 $2,000 5.0%

$50,000 $30,000 $3,000 6.0%

$100,000 $80,000 $13,000 13.0%

$500,000 $480,000 $93,000 18.6%

Figure 8-10 Diminishing Marginal Utility of Income

True-false questions 1. If a shadow demand curve is used to

represent the effect of a tax on perceived demand, the shadow demand curve will lie above the actual demand curve.

2. If demand is more elastic, more of the tax burden will fall on the buyer rather than the seller.

3. Excess burden from imposing a tax is generally greater, other things being equal, if demand and supply are relatively elastic, because there will be a larger reduction in quantity.

4. If supply is perfectly inelastic, the entire burden of the tax falls on the seller.

5. A tax on earnings will always reduce work hours.

Answers:1. F (It lies below.) 2. F (More of the burden falls on the

seller.)3. T 4. T 5. F (Only if the income effect is stronger

than the substitution effect.)