Fiscal Policy – Taxation, Laffer Curve

Sem II, MEBE

Instruments of Fiscal Policy
 Taxation

 Public Expenditure

 Public borrowing

 Deficit financing
Adam Smith’s Canons of Taxation
• Canon of equity or justice
Taxes to be based on ability to pay

• Canon of Certainty
Clarity with regard to quantum, form and manner of payment

• Canon of convenience
Time and manner of payment to be convenient to taxpayer

• Canon of economy
Administrative cost of collection of tax to be minimum
Other Canons
• Canon of diversity
Sufficient number of taxes, both direct and indirect to maximise yield, stability
and equity
• Canon of elasticity
Tax collection should rise and fall according to rise and fall of national income
• Canon of productivity
Tax system should yield sufficient revenue to government
• Canon of simplicity
Tax system should be easily understood by citizens without being open to
various interpretations
• Canon of expediency
Tax system to be in line with economic and social policy of government
 Taxes – Classification on the basis of Tax
Rates

Progressive Tax

• Tax rate rises with an increase in taxable amount (tax base). A higher % rate of tax is imposed on those who have
higher incomes
• Based on ability to pay. Burden on lower income groups is much smaller
• This can stimulate demand and consumption as low income earners are likely to spend most of their income on
consumption
• Helps to redistribute income and wealth as marginal rate of tax adjusts progressively as income rises
• Reduces inequality in income distribution
• Has a disincentive effect by reducing willingness to work, save and invest
Proportional Tax

 Proportional tax has a flat rate which

remains unchanged even as taxable
amount changes
 Eg. sales tax, GST and other indirect
taxes
 If GST of a product is 10%, every
buyer who buys the product priced at
Rs.1000 would pay Rs.100 regardless
of personal income
 Has a less disincentive effect than a
progressive tax
  Regressive tax is one which takes a larger %
Regressive Tax of income from the low income earners as
compared to those with higher incomes
 The effective burden of tax is greater on
the poor than on the rich
 A high proportional tax on essential goods
like food items will be regressive as the
lower income groups spend a larger
proportion of their income on essential
goods.
 Consider two individuals A & B who each
purchase Rs.10000 worth of food a month
and pay a sales tax of Rs.1200 on these
items. A has an income of Rs. 12,000 and B
an income of Rs.20,000. The effective
burden of tax on A is 10% and that on B is
6%.
Laffer Curve
• Laffer Curve puts forward the idea that if tax rates are increased above a
certain level, tax revenues fall

• Higher tax rates reduces compliance and also discourage people from
working

• Cutting tax rates could lead to higher tax revenue collection

• There is an optimum rate of tax which can maximise total tax revenue

The idea was put forward by Arthur Laffer an American economist

Laffer Curve  As tax rates rise, tax revenue rises initially
 When tax rate rises from T1 to T2, Tax
revenue collected rises from R1 to R2.
 T3 is the tax rate that maximises tax
revenue, T3 is the optimal tax rate
if the objective is to maximise revenue
 If rates rise to T4, tax revenue starts to fall
Why would total tax revenue fall when rates
rise
 Disincentive Effect
• If tax rates are very high, there would be a reduced desire to work
harder and earn more as a very high proportion of additional income
earned would go as taxes. People would prefer to spend the time on
leisure than work
• Business firms would also have a reduced incentive to invest if business
taxes are very high
 Brain Drain or Emigration
• Highly skilled and high income earners would move to countries or
places where tax rates are lower
Why would total tax revenue fall when rates
rise
 Tax avoidance
• People would use loop holes in the tax system to pay less tax
• More incentive to get tax relief and make use of tax allowances

 Tax Evasion
Unlike tax avoidance which is legal, tax evasion is illegal. Very high tax
rates leads to non-declaration and concealment of income and wealth
to evade taxes
Laffer Curve - An Evaluation
The Laffer curve became important in the 1980s because it gave economic
justification to cutting tax. For politicians like Ronald Reagan it was an attractive
idea because
• Lower taxes were politically popular
• Increased tax revenues and lowered budget deficits
However, Laffer curve has not always been borne out by empirical evidence
• Several factors affect total tax revenue, hence it is difficult to measure the
impact of a tax cut
• Effects will differ depending on the level of business activity(booms &
depression)
• If the peak (optimal) rate identified is very high, it would be meaningless in
countries where the highest rate is less than that
Fiscal Policy & Economic Stabilization -
Contracyclical Fiscal Policy
 Business cycles cause economic instability
 In an expansionary phase when inflationary tendencies are present, a
contractionary fiscal policy which reduces expenditure and increase
tax is needed to curb aggregate demand and inflation
 In a contractionary phase, it is important that government
expenditure increases and tax decreases
 Economic stabilization can be achieved through
Automatic Stabilizers
Discretionary Fiscal Policy
Automatic Stabilizers
 Automatic stabilizers counteract the business cycles without any deliberate
government action

 There is automatic increase in tax revenue and decreases in expenditure in

an expansionary phase

 The opposite happens when the economy is in a recession

 It includes welfare payments, unemployment insurance and the income tax

system
How do Automatic Stabilizers work?
 Welfare Schemes & Unemployment Benefits
• In a recession, unemployment rate rises
• Unemployment insurance is automatically paid out offsetting some of the fall in
income
• Government expenditure on welfare scheme automatically rise in a recession
• In the prosperity phase, when unemployment is low, government expenditure
on welfare schemes automatically fall
 Progressive/ Proportional Tax
• When the economy expands, people are pushed into higher tax brackets,
slowing down spending.
• When the economy contracts, people fall into lower tax brackets, or have no
income liability, helping to maintain spending
Discretionary Fiscal policy
 Refers to deliberate changes in tax rates and expenditure policy by the
government to bring about stability in economy

 In response to an inflation, an increase in tax rates and widening of tax

base can curtail spending. This is accompanied by expenditure cuts and
attempts to secure a surplus budget. Fiscal deficit (which indicate
extent of government borrowings), will be reduced

 To counter a recession, a decrease in taxes and an increase in

expenditure will help to stimulate private spending
High Fiscal Deficit can be problematic

 When an economy is in a slowdown or recession, a high fiscal deficit can offset

negative impact of a slowdown in private demand

 If size of the deficit is not kept in control

 it could create inflation by raising interest and other input costs
 By driving up interest rates, it can also crowd out private investment