Tax Incidence and the Efficiency Cost of Taxation

Chapter 7-8

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

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 public goods– To alleviate poverty.

• Stabilization (Macroeconomic Management)– 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

Principles of Taxation

Tax base is a measure or value upon which a tax is levied.

Three categories of tax bases:- income- consumption- wealth

Types of Tax Rate Structure:- Regressive- Progressive- Proportional

Approaches to Tax Equity

Tax system should be equitable, i.e. that each taxpayer should contribute his or her “fair share” to the cost of the government.

Benefit principle: each taxpayer contributes in line with the benefits which he or she receives from public services.

Ability-to-pay: each taxpayer is asked to contribute in line with his or her ability to pay.

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• Fiscal neutrality• The correction of externalities

3. Compliance and Administration Costs• Compliance Costs = time, money

inconvenience• Administration costs

Indirect Tax

2. Economic Analysis of Taxation

Price Distorting Tax- alters the relative price of the goods- causes the net price received by sellers to diverge from the gross price paid by buyers.

Excess burden of tax The loss of well-being of the taxpayer when he

pays taxes under the price-distorting tax instead of under the lump-sum tax.

Price-Distorting Tax vs a Lump Sum Tax

3. Tax Incidence

Statutory vs Economic Incidence (Tax Burden)

• Statutory tax burden is the amount of tax collected from a person.

• Economic tax burden is the amount of tax paid by a person.• Example:

- With no taxes, the price of petrol is RM3 per litre.- The govt. imposes a 50 sen per litre tax.- The tax is collected from the seller.- In response to the tax, the seller raises the price to RM3.50

Who bears the statutory and economic burden of the tax? Statutory burden is on the seller, but economic burden is on the consumer.

• Example:- With no taxes, the price of petrol is RM3 per litre.

- The govt. imposes a 50 sen per litre tax.- The tax is collected from the seller.- In response to the tax, the seller does not change the price of petrol.

Who bears the statutory and economic burden of the tax?

Both statutory and econ. burden is on the seller.

Statutory vs Economic Incidence (Tax Burden)

The Effect of a Sales Tax on a Market

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?

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.)

The Excess BurdenThis inefficiency is called

“An Excess Burden”“A Deadweight Loss”

The Excess BurdenThis inefficiency is called

“An Excess Burden”“A Deadweight Loss”

A poll tax (or any non-price related tax) will not have these costs.

The Excess BurdenMarginal Excess Burden := The excess burden of

an extra RM raised in taxes.(This is generally higher than the average burden,

as should tax least distorting commodities first.)

The Excess BurdenMarginal Excess Burden := The excess burden of

an extra RM 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.

The Excess BurdenMarginal Excess Burden := The excess burden of

an extra RM 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.

The Excess BurdenMarginal 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.

Tax Incidence

Tax Incidence

Shifting of Taxes

• Forward Shifting is the transfer of the burden of a tax from the seller, who is legally obligated to pay it, to a buyer. 

• Backward Shifting is the transfer of the burden of a tax from the buyer, who is legally obligated to pay it, to a seller.

General Equilibrium Analysis and Shifting

• When one good is taxed and another good is not taxed, the impact of the tax is not confined to the taxed good.

• Because a tax on one good lowers the profit that can be made to firms producing it, they may shift their productive resources to the other good so as to maximize their after-tax rate-of-return in both markets.

• This has the effect of equalizing the after-tax rate-of-return.

Multimarket Analysis of Excess Burden

Multi-market Analysis Incidence

Questions:

Who pays the taxes on

(1)Cigarettes(2)Alcohol(3)Petrol(4)Labour?

4. Taxation and Equity

IF policy maker care about equity they will care about the winners and losers associated with tax changes.

RecallA 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

constant as income rises.

Government Taxes and Expenditures and the Distribution

of Income • The Tax Incidence is who bears the burden of a tax. 

• The Expenditure Incidence is who receives the benefits of a government program.

• The Budget Incidence is the net analysis of a program’s tax and expenditure incidence.

• The Differential Tax Incidence is the change in the tax incidence that results from substituting one equal yield tax for another.

The Lorenz Curve

• The Lorenz Curve maps the cumulative percentage of households against their cumulative percentage of income.

LORENZ CURVE

The Gini Coefficient

• The Gini Coefficient is the ratio of the area between the Lorenz curve and the perfect equality line (Area A in the previous slide) to the area under the perfect equality line (Areas A and B).