Taxation

Frederick University

2009

Taxation and Government For government to provide goods and services

such as national defense, social security, national parks, etc. it must have money.

The Government raises money several ways including user fees and taxes.

User Fees are fees paid by those that use the good or service: it is a price.

Taxes may be paid by everyone or only those that use a good or service: who pays depends on the type of tax.

What is the Role of Government?

The level of taxes is determined by the amount of government services and goods provided.

The Government’s roles include:

Providing a stable set of institutions, laws and rules. Promoting effective and workable competition. Correcting for externalities. Creating an environment that fosters economic stability

and growth. Providing public goods. Adjusting for undesirable market results.

How Much Should Government Tax?

The government must raise revenues equal to the cost of providing the amount of goods and services that its citizens demand.

Types of Taxes

There are many types of taxes: Personal Income taxes Corporate Income taxes Excise Taxes Value Added Taxes (VAT) Property Taxes Social Security Taxes

Types of Taxes

Direct taxes (income taxes, property taxes)

Indirect taxes (VAT, excise taxes)

The Costs of Taxation

The costs of taxation include: The direct cost of the revenue paid to

government The loss of consumer and producer

surplus caused by the tax The cost of administering the tax

codes.

The Costs of Taxation

When government institutes taxes, there is a loss of consumer and producer surplus that is not gained by government.

This is known as deadweight loss.

The Costs of Taxation Graphically the deadweight loss is

shown on a supply-demand curve as the welfare loss triangle.

The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.

Consumer Surplus Before Tax: A + B + CConsumer Surplus After Tax: AProducer Surplus Before Tax: D + E + FProducer Surplus After Tax: FDeadweight Loss: C + E

S1

P1–t

Quantity

Price

P0

Q0

P1

Q1

Producer surplus

S0

Demand

Consumer surplus

Deadweight loss

tax

A

B C

D E

F

The Costs of Taxation

There are other costs of taxation. Resources must be devoted by the

government to administer the tax codes and by citizens and businesses to comply with it.

The Costs of Taxation

Payroll accounting has become so onerous, businesses large and small often pay payroll-accounting firms to keep up with changing municipal and state payroll rules and actually issue paychecks for their clients’ employees.

The Benefits of Taxation

The benefits of taxation are the goods and services that government provides

Some of these benefits are part of the basic institutional structure of a market economy that allows it to work efficiently.

- the basic legal system is an example.

The Benefits of Taxation

Still other benefits take on the qualities of a public good – national defense, for example.

The Benefits of Taxation

Other benefits are provided for reasons of equity or because they provide positive externalities.

The Benefits of Taxation

The policy debate about the benefits of taxation generally focuses on goods that could be supplied by the market but are publicly supplied. Education and health care are

examples.

The Benefits of Taxation

Measuring the benefits of these goods is difficult since they are not provided in a market setting.

Principles of Taxation

Benefits received Ability to pay

Principles of Taxation

The benefit principle states that the individuals who receive the benefit of the good or service should pay the tax necessary to supply the good.

Examples are gasoline taxes and airport taxes, both paid by travelers.

Principles of Taxation The ability-to-pay principle states

that individuals who are most able to bear the burden of the tax should pay the tax. Those who have higher incomes can afford to pay a greater proportion of their income in taxes, regardless of the benefits

The best example of this is a progressive tax, such as the income tax in Cyprus.

Difficulty of Applying the Principles of Taxation

The principles of taxation are difficult to apply because, among other reasons, the two principles often conflict.

Difficulty of Applying the Principles of Taxation

In funding health care, for example, the poor should pay because they benefit the most, while under the ability-to-pay principle, the rich should pay.

Difficulty of Applying the Principles of Taxation

The elasticity concept helps us to understand the tradeoffs as well as who is likely to bear the burden of a tax.

Burden Depends on Relative Elasticity

Elasticity is a measure of how easy it is for the supplier and consumer to change their behavior and substitute other goods.

Consequently, the more one group (consumers or suppliers) is able or

willing to change its behavior relative to the other group the more likely it is

to avoid the tax burden.

Burden Depends on Relative Elasticity

The person who physically pays the tax is not necessarily the person who bears the burden of the tax.

The burden of the tax is rarely shared equally since the elasticities are rarely equal.

Burden Depends on Relative Elasticity

The relative burden of the tax dictates that the more relatively inelastic the behavior of one’s group (supply or demand), the larger the tax burden one will bear.

Burden Depends on Relative Elasticity

If demand is more inelastic than supply, consumers will pay the higher share. If supply is more inelastic than demand, suppliers will pay the higher share.

Burden Depends on Relative Elasticity

Who pays a tax is not necessarily who bears the burden.

The person who actually pays the tax does not matter, and the person who bears the burden can differ from the person who pays.

Difficulty of Applying the Principles of Taxation

Since the free market system is very efficient, Governments with free market economies desire to change the behavior of suppliers and buyers as little as possible.

Hence, Governments should tax inelastic goods or services.

In the language of consumer and producer surplus, if the government seeks to minimize welfare loss, it should tax goods with inelastic supplies and demands.

Who Bears the Burden of a Tax?

Supplier Pays Tax

Pric

e of

luxu

ry b

oats $70,000

60,000

50,000

40,000

30,000

20,000

10,000

Quantity of luxury boats 600200 400

S1

Demand

S0

510

taxConsumer pays

Supplier pays

Who Bears the Burden of a Tax?

590

Pric

e of

luxu

ry b

oats $70,000

60,000

50,000

40,000

30,000

20,000

10,000

Quantity of luxury boats 600200 400

S1S0

Demand is inelastic

Demand

taxConsumer pays

Supplier pays

Who Bears the Burden of a Tax?

Consumer Pays Tax

Pric

e of

luxu

ry b

oats $70,000

60,000

50,000

40,000

30,000

20,000

10,000

Quantity of luxury boats 600200 400

D0

S0

510

tax

Consumer pays

Supplier pays

D1

Tax Incidence and Current Policy Debates

The analysis of tax incidence is helpful when discussing current policy debates.

Social Security Taxes

Social Security taxes are payroll taxes for a government-run retirement program.

Both employer and employee contribute a percentage of before-tax wages to the Social Security fund.

Social Security Taxes

On average, labor supply tends to be less elastic than labor demand, so the Social Security tax burden is primarily on employees.

Value Added Tax

VAT is paid by retailers on the basis of their sales revenue.

Demand is inelastic so consumers bear the greater burden of the tax.

Government Intervention as Implicit Taxation

Government intervention can be seen as a combination tax and subsidy.

The Difference Between Taxes and Price Controls

The effects of taxation and price controls are similar.

They are different in that price ceilings create shortages and taxes do not.

Shortages also create black markets. Both taxes and price controls create

deadweight loss.

This activity is called rent seeking behavior – the effort to transfer surplus from one group to another.

Rent Seeking, Politics, and Elasticities

An enormous amount of time and money is spent in the political arena to increase one’s surplus at the expense of another group.

What is theaverage tax rate?

Total tax due divided by total taxable income

What is themarginal tax rate?

The change in taxes due divided by the change in taxable income

What is aprogressive tax?

A tax that charges a higher percentage of income as income rises

What is aregressive tax?

A tax that charges a lower percentage of income as income rises

What is aproportional tax?

A tax that charges the same percentage of income, regardless of the size of income

What is a flat rate tax?

Same as a proportional tax

46

VAT, excise, and flat-rate taxes are examples of a regressive tax because each results in a greater burden on the poor than the rich.

47

Progressive income taxes follow the ability-to-pay principle because there is a direct relationship between the average tax rate and income size.

Which principle dominates in Cyprus?

The ability-to-pay principle dominates the benefits-received principle