Theme 8 – taxation and tax theory

Horizontal Equity: The Ideal Tax Base OPTIONAL - Robert Haig 1921 and Herbert Simons 1938 proposed a method of thinking about optimal tax base that relied on three principles: 1 People

Theme 8 – Taxation and Tax

Theory

Public Economics

Public Revenues

• In general, public revenue may be considered to

include any revenue flowing to the public

budgets Among those public budgets there may

be budgets of governments, lower regional

administration units (districts and municipalities), parafiscal funds and also budgets of health

insurance funds The most substantial item on

the revenue side of public budgets are taxes It

further contains non-tax public revenue (interest

revenue, fees and fines, and revenue from selling

and renting out state or municipal property)

Other definition… A tax is …

• a financial, mandatory, nonequivalent, non-specific charge or

other levy imposed on a taxpayer by a state

• The tax is implemented by law.

• The failure to pay taxes is punishable by law

• The taxes can be paid regularly or occasionally based on certain

conditions stipulated by the tax legislation.

The three criteria necessary to be a tax are

•the payment is required (by the law)

– free rider theorem of public goods

•imposed by a government

•not tied directly to the benefit received by the taxpayer.

• Definition of service/benefit is broad & imprecise

• Examples: TV licences, parking tickets

The Main Issues of Tax Theory

There are two main issues related to tax theory:

- Normative: How to design taxes to promote social

welfare

in terms of the public interest in efficiency and equity

- Positive: The economic effects of the various taxes that

governments use

- What effects do taxes have on people’s desires

to consume, save, supply their labor, or on firms’

desire to invest?

- Who bears the burden of various taxes?

- Public officials need to be able to answer these

questions to design taxes that promote social welfare

(4) Promotion of economic efficiency

(5) Promotion of end-results equity

Tax Principles

(1) Ease of Collection and

(2) Ease of Compliance

- To successfully implement a tax policy, it is

necessary to incur the costs associated with

administering and enforcing it

- Given that society must incur these costs, it

wants to get the most possible revenue at the

least possible cost

- Requires that individuals be able to calculate tax

bills fairly easily and that it be difficult for

individuals to hide information on taxable assets

Ease of collection (direct

adminis cost)

• CIT, VAT – 2% of total tax revenue

• Payroll Tax – 1 %

• Bad results for… (why? Due to very low tax rates)

– PIT – self employed persons – 30 %

– Road tax – 5 %

– Heritage tax (now abolished) - !169 %

Ease of compliance (indirect

adminis cost) in Czech

Republic

• CIT, VAT – 5% of total tax revenue

• Payroll Tax – 1 %

• PIT – self employed persons – 30 %

• Road tax – 20 % (very low tax rates)

(3) Flexibility

- Tax policy is a primary tool of macroeconomic policy

(i.e economic stabilization)

- To be able to respond quickly to address potential

difficulties in the economy, tax authorities must be able to change tax liabilities easily and quickly and those

changes must quickly be felt throughout the economy

Tax Principles

Tax Principles

(3) Flexibility (II)

Tax Principles

(4) Economic Efficiency

- Individuals must face same prices for economy to reach

Pareto-optimal outcome

- Broad-based taxes are distorting (i.e drive wedge

between price paid by consumer and prices kept by

firms) so they violate this property

- The goal then is to design a tax that introduces the least

distortion and keeps society as close to the optimal outcome as possible

Pareto-(5) End-Results Equity

- Tax policy is designed to work with redistribution

programs to achieve this goal

Six Main Taxes (1)

(1) A personal income tax

- Tax on income received by individuals

- Typically collected from firms who withhold pay

- Tax liability calculated once a year and refund or extra

payment made depending on whether enough was withheld

Six Main Taxes (2)

- Tax on value of items of wealth – usually residential,

commercial and industrial properties

- Levied on owner of property

- Value assessed periodically by tax authorities

(6) A value-added tax

- Tax on value added of firms (which is the difference

The Six Main Taxes (3)

Use of the six main taxes

- Governments in Europe also use personal and corporate

income taxes, payroll taxes (to support social security

payments) and property taxes

- They levy a value-added tax on businesses

- Recently, advocates have argued for a personal

consumption tax rather than a personal income tax

→ Biggest difference is that it would allow individuals

to

subtract saving from income before calculating tax

The Ability-to-Pay Principle

- Dates from Adam Smith and John Stuart Mill in late

1700s and early 1800s

- Holds that people must be willing to sacrifice for the

public good

- Gave rise to view of taxes as necessary evil

- Key question: How to determine what people should

sacrifice?

- Two potential approaches based on ability to pay

- Horizontal Equity: Two people deemed equal in

every relevant economic dimension should pay same tax

- Vertical Equity: It is permissible to tax unequals

unequally

The Ability-to-Pay Principle continued

- Both principles raise important and difficult questions

- In what sense are people to be deemed to be equal or

unequal?

- How unequally can unequal be taxed?

- The issue of horizontal equity is the quest for the ideal

tax base (i.e the item to be taxed)

- People with identical tax bases will pay identical tax bill

- The issue of vertical equity is the quest for the ideal tax

structure, as defined by chosen tax rates and

deductions

- Differences in chosen tax rates and deductions make it

so that different people pay different tax bills

Horizontal Equity: The Ideal Tax Base

(OPTIONAL)

- Robert Haig (1921) and Herbert Simons (1938) proposed a

method of thinking about optimal tax base that relied on three

principles:

(1) People ultimately bear the burden of taxation

(2) People sacrifice utility when they bear the burden of taxation

Horizontal equity: Two people with equal utility before tax should have equal utility after tax

Vertical equity: If person has more utility than another before tax they should also have more after tax

(3) The ideal tax base is the best surrogate measure of utility

- Because utility cannot be measured, society must rely on

something else, which should be best surrogate

Horizontal Equity: The Ideal Tax Base

Continued (OPTIONAL)

Haig–Simons income

- Argues that the best surrogate for utility is the increase in

purchasing power during the year

Y HS = consumption + change in net worth = C + ∆NW

- Concludes that people with the same Y HS should be

considered equals and should pay the same tax because they

will sacrifice the same utility

- Once Y HS is accepted as ideal tax base it implies that the

optimal tax structure is the broadest possible personal

income tax

→ This requirement is never met in practice

Horizontal Equity: The Ideal Tax Base

Continued (OPTIONAL)

Sources of Income Uses of income

- Personal income and capital

gains (portion of capital gains

usually excluded from tax base)

- Earned and unearned income

(receipt of transfer payments

usually excluded from tax base)

- Different sources of earned

income (interest earned on

savings and fringe benefits

- Form of capital gains (accrued capital gains usually excluded, realized usually included)

- Under the Haig–Simons definition of income, there are a number of

distinctions that should not matter (but usually do)

- Factors that should be treated the same, but usually are not

Horizontal Equity: The Ideal Tax Base

Continued (OPTIONAL)

- These differences usually exist because policymakers often

use tax policy to try to promote social ends which might run

counter to the concept of horizontal equity

- Business expenses should be excluded because they

subtract from purchasing power out of income

- Calculation of Y HS must be indexed to inflation because

increasing prices reduces purchasing power

- Conclusion: Combined, these facts suggest that the ideal tax

base is (Y HS - business expenses), indexed for inflation

Horizontal Equity: The

Ideal Tax Base

Continued (OPTIONAL)

Haig-Simons income and utility

- Is this a good surrogate measure

of utility? Almost certainly not!

- Whether income is good measure

of utility depends on whether

people are identical

- People receive utility from

income and leisure

- Income comes from work and leisure comes from not working

- If every person has same preference for income and leisure

and same opportunities (i.e same wage) they will choose

same point and have same utility

Horizontal Equity: The

Ideal Tax Base Continued

(OPTIONAL)

- But people do not have identical tastes

and opportunities

- Suppose people earn different wages

- Person with higher wage can receive

higher utility with same income by taking more utility (i.e can earn same income with fewer hours work)

- Suppose people have different tastes

- Person with stronger preference for

consumption works more and earns more income but both are on second indifference curve which represents

Horizontal Equity: The Ideal Tax Base

Continued (OPTIONAL)

Consumption as the ideal tax base

- Recognizes that consumption is not a perfect surrogate

measure of utility but is likely better than income

- Consumption most directly generates utility

- Consumption changes over time are more directly tied to

utility changes over time than are income changes over time

- Implication is that to meet the concept of horizontal equity,

two people with equal lifetime consumption before tax should

have equal lifetime consumption after tax

Horizontal Equity: The Ideal Tax Base

Continued (OPTIONAL)

- This suggests that tax should be annual tax on consumption

rather than annual tax on income

- Two people with same lifetime income might have very

different lifetime consumption due to differences in annual consumption/savings decisions

- Note that it would be possible to design an annual income tax

that would be equivalent to an annual consumption tax

- Would require allowing people to subtract saving from

income, which would actually make it a consumption tax

Horizontal Equity:

The Ideal Tax Base (OBLIGATORY)

Musgrave’s view of horizontal equity

- Argues that questioning whether income or consumption tax

is better is the wrong question

- Instead, believes that horizontal equity should only consider

whether taxes discriminated against people in inappropriate

ways

- Either income or consumption tax is appropriate surrogate for

utility so long as people are not treated differently based on gender, race, religion, etc

- Society should just accept one type of tax and then worry

more about the specific tax structure (i.e vertical equity)

Vertical Equity

- This is the quest for distributive justice, which generates

heated debate without a satisfactory conclusion

- Key question: Should tax structure be progressive,

proportional, or regressive

- Let Y hHS and T h be individual h’s income and tax burdens

→ If T h / Y hHS increases as Y hHS increases, tax is progressive

→ If T h / Y hHS is constant as Y hHS increases, tax is proportional

→ If T h / Y hHS decreases as Y hHS increases, tax is regressive

- Societies tend to have a strong preference for proportional or

Progressive, Proportional, and

Progressive, Proportional, and

Regressive Taxes

Income and Consumption over

Life Cycle

Measuring of Consequences of Taxation to Income Distribution I.

Lorenz Curve

Measuring of Consequences of

Taxation to Income Distribution III.

Tax Incidence

• Two main concepts of how a tax is distributed:

– Statutory incidence – who is legally responsible for

tax

– Economic incidence – the true change in the

distribution of income induced by tax.

– These two concepts differ because of tax shifting.

Tax Incidence: General Remarks

• Only people can bear taxes

– Business paying their fair share simply shifts the tax

burden to different people

– Can study people whose total income consists of

different proportions of labor earnings, capital

income, and so on.

– Sometimes appropriate to study incidence of a tax

across regions.

Tax Incidence: General Remarks

• Both Sources and Uses of Income should be considered

– Tax affects consumers, workers in industry, and

owners

– Economists often ignore the sources side

Tax Incidence: General Remarks

• Incidence depends on how prices are determined

– Industry structure matters

– Short- versus long-run responses

Tax Incidence: General Remarks

• Incidence depends on disposition of tax

revenue

– Balanced budget incidence computes the combined

effects of levying taxes and government spending

financed by those taxes.

– Differential tax incidence compares the incidence of

one tax to another, ignoring how the money is spent

• Often the comparison tax is a lump sum tax – a tax

Tax Incidence: General Remarks

• Tax progressiveness can be measured in a number of ways

– A tax is often classified as:

• Progressive

• Regressive

• Proportional

– Proportional taxes are straightforward: ratio of taxes

to income is constant regardless of income level.

Tax Incidence: General Remarks

• Can define progressive (and regressive) taxes in a number of

ways.

• Can compute in terms of

– Average tax rate (ratio of total taxes total income) or

– Marginal tax rate (tax rate on last dollar of income)

Tax Incidence: General Remarks

(optional)

T 1 − T 0

• Measuring how progressive a tax system is

present additional difficulties Consider two

simple definitions.

– The first one says that the greater the increase in

average tax rates as income rises, the more progressive

is the system.

Tax Incidence: General Remarks

(optional)

T T T

– The second one says a tax system is more progressive

if its elasticity of tax revenues with respect to income is higher.

– Recall that an elasticity is defined in terms of percent

change in one variable with respect to percent change in another one:

Tax Incidence: General Remarks

(optional)

• These two measures, both of which make intuitive sense, may

lead to different answers.

• Example: increasing all taxpayer’s liability by 20%

Partial Equilibrium Models

• Partial equilibrium models only examine the market in which the

tax is imposed, and ignores other markets.

• Most appropriate when the taxed commodity is small relative to

the economy as a whole.

Partial Equilibrium Models:

Per-unit taxes

• Unit taxes are levied as a fixed amount per unit of commodity

sold

– Excise tax on cigarettes, for example, is 2.37 CZK

per piece; sparkling wine 2340.- CZK per 1 hl.

• Assume perfect competition Then the initial equilibrium is

determined as (Q 0 , P 0 ) in Figure 1.

Partial Equilibrium Models:

Per-unit taxes

• Next, impose a per-unit tax of $u in this market.

– Key insight: In the presence of a tax, the price paid

by consumers and price received by producers differ.

– Before, the supply-and-demand system was used to

determine a single price; now there is a separate

price for each.