Chapter 6

Economic Impact of Taxation

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 Outline
• A Set of Important Taxation Concepts
• The Effects of a Tax
• Defining the income tax base: The Haig-
Simons comprehensive income definition
• Economic impacts of Direct Taxation: Theory
of Income Taxation, Tax on Business Income
and Wealth
• Economic impacts of Indirect Taxation: Taxes
on consumption and sales

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 A Set of Important Taxation Concepts:
Measuring the fairness of tax systems
• A marginal tax rate is the percentage that is paid in taxes on
the next dollar earned.
• An average tax rate is the percentage of total income is that
is paid in taxes.
• Most think a progressive tax system is fairest, in that it
respects the ability to pay.
– A progressive tax system is one in which effective average tax rates
rise with income.
– A proportional tax system is one in which effective average rates do
not change with income, so that everyone pays the same proportion
of their income in taxes.
– A regressive tax system is one in which effective average tax rates
fall with income.

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 Measuring the fairness of tax systems
Effective versus statutory rates
• Another important distinction is between statutory
and effective tax rates.
• Statutory tax rates are tax rates laid out in the legal
tax schedule.
• Effective tax rates are tax rates an individual actually
pays.
– The two diverge because
• There are many exemptions and deductions from taxable income,
which reduces the tax base.
• the burden of some taxes can be shifted.

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Measuring the fairness of tax systems
Vertical and horizontal equity

• Two distributional goals are frequently cited in

measuring tax fairness.
• Vertical equity is the principle that groups with more
resources should pay higher taxes than groups with
fewer resources.
• Horizontal equity is the principle that similar
individuals who make different economic choices
should be treated similarly by the tax system.
– In reality, horizontal inequities are hard to define, because
the person endogenously made a choice to earn more or
less.

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 The Effects of a Tax
• A tax is a wedge between the price buyers pay
and the price sellers receive.
• A tax raises the price buyers pay and lowers
the price sellers receive.
• A tax reduces the quantity bought & sold.
• These effects are the same whether the tax is
imposed on buyers or sellers, so we do not
make this distinction in this chapter.
 The Effects
P
of a Tax
With no tax,
eq’m price is PE and
quantity is QE . Size of tax = $T
Govt imposes a tax PB S
of $T per unit.
PE
The price buyers
pay is PB , PS D
the price sellers
receive is PS ,
and quantity is QT . Q
QT QE
 The Effects
P
of a Tax
The tax generates
revenue equal to Size of tax = $T
$ T x QT .
PB S

PE

PS D

Q
QT QE
 The Effects of a Tax
• Next, we use the tools of welfare economics to
measure the gains and losses from a tax.
• We will determine consumer surplus (CS),
producer surplus (PS), tax revenue, and total
surplus with and without the tax.
• Tax revenue is included in total surplus, because
tax revenue can be used to provide services
such as roads, police, public education, etc.
 The Effects
P
of a Tax
Without a tax,
CS = A + B + C
PS = D + E + F A
Tax revenue = 0 S
B C
Total surplus PE
D E
= CS + PS
=A+B+C D
F
+D+E+F

Q
QT QE
 The Effects
P
of a Tax
With the tax,
CS = A
PS = F
A
Tax revenue PB S
=B+D B C
Total surplus D E
=A+B PS D
+D+F F
The tax causes
total surplus to Q
fall by C + E QT QE
 The Effects
P
of a Tax
C + E is called the
deadweight loss
(DWL) of the tax, the A
PB S
fall in total surplus
B C
that
results from a D E
market distortion, PS D
such as a tax. F

Q
QT QE
 About the Deadweight
P
Loss
Because of the tax, the
units between
QT and QE are not
sold. S
PB
The value of these
units to buyers is
greater than the cost PS D
of producing them,
so the tax has
prevented some
mutually beneficial Q
QT QE
trades.
 About the Deadweight Loss
• A tax on a good reduces the welfare of buyers and
sellers. This welfare loss usually exceeds the revenue
the tax raises for the govt.
• The fall in total surplus (consumer surplus, producer
surplus, and tax revenue) is called the deadweight loss
(DWL) of the tax.
• A tax has a DWL because it causes consumers to buy
less and producers to sell less, thus shrinking the
market below the level that maximizes total surplus.
 What Determines the Size of the DWL?
• The govt needs tax revenue to finance roads, schools,
police, etc., so it must tax some goods and services.
• Which ones? One answer is that govt should tax the
goods or services with the smallest DWL.
• So when is the DWL small vs. large? Turns out it
depends on the elasticities of supply and demand.
• Recall: The price elasticity of demand (or supply)
measures how much quantity demanded
(or supplied) changes when the price changes.
 Defining the income tax base: The Haig-Simons
comprehensive income definition

• The Haig-Simons comprehensive income definition defines taxable

resources as the change in an individual’s power to consume during the
year.
• It is best viewed as a measure of ability to pay – regardless of the actual
choices in terms of consumption and savings.
• In reality, the U.S. tax system deviates from this definition in many
ways, for example, the exclusion of employer-provided health
insurance.
– In practice it is very difficult to implement the Haig-Simons income concept.
Problems include
• Adjusting for an individual’s ability to pay (property and casualty losses, medical expenses,
state and local taxes); the costs of earning income; and difficult to value items (imputed rent
on owner-occupied housing).

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 Externality/Public goods rationales for
deviating from Haig-Simons: Tax
expenditures
• Tax expenditures are government revenue losses
attributable to tax law provisions that allow special
exclusions, exemptions, or deductions from gross
income, or that provide a special credit, preferential
tax rate or deferral of liability.
• The government measures how much tax revenue is
lost by excluding health insurance from taxable
compensation, or allowing deductibility of charitable
contributions.

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 Tax deductions vs. tax credits

• Tax credits are more equitable than deductions.

– The value of deductions (such as for home mortgage
interest or charitable contributions) rises with a person’s
marginal tax rate, making them regressive.
– Credits are equally available for all incomes, so they are
progressive.
• In reality, a tax credit may not be very progressive if
those with low tax liabilities cannot have the excess
of the credit refunded.
– A tax credit is refundable if it is available to individuals
even if they pay few or no taxes.

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 Economic impacts of Direct
Taxation: Theory of Income
Taxation, Tax on Business Income
and Wealth

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 Income Tax
• Taxes on personal income the dominant source of revenue
for the federal government in the U.S.
- Accounted for 42% of federal revenue in 2011.
• All but seven states have a personal income tax.
• Before 1913, major source of revenue for federal
government was customs duty, or tariffs.
• 1913 constitutional amendment empowered Congress to
levy taxes on personal and business incomes.

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 Comprehensive Income
• Comprehensive income is the sum of a person’s
annual consumption expenditures and the increment
in that person’s net worth in a given year:
- I = C + ΔNW.
- Concept called the Haig-Simons definition of income.
• Net worth is the value of a person’s assets held at
any point in time less the value of a person’s
liabilities or debts.
• Capital gains are increases in the value of assets
over the accounting period.
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 Sources and Uses of Income

• Net capital gains = capital gains - capital

losses.
• Comprehensive income tax is levied on all
income irrespective of its use or source.

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Sources of Personal Income

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 Measurement Problems
• Means of measuring income must be developed before tax
can be implemented.
• Haig-Simons definition would require both realized and
unrealized capital gains be included in income.
− Mechanism needed to measure gains and losses in capital
assets being held.
− Difficult or impossible for some assets.
• Requires arbitrary judgment to determine which expenses
are costs of earning income and which are consumption or
increases in net worth.

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 Income-in-Kind
• Income in goods and services, not cash payments.
• Problem involved in administering income tax is
treatment of nonmonetary transactions
• Comprehensive income includes these services.
• Taxation of all types of income-in-kind is infeasible.
• When income-in-kind is non-taxable, employers are
encouraged to provide non-pecuniary returns (non-
wage satisfaction) in lieu of taxable benefits.

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 C h a p t e r 16

Economic impacts of Indirect Taxation:

TAXES ON CONSUMPTION AND SALES

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 Consumption as a Tax Base
• General tax on consumption equivalent to an income tax
that allows savings to be excluded from the tax bases.
• Annual comprehensive consumption is annual
comprehensive income minus annual savings.
• Dominant form of taxation of consumption in the U.S. is
retail sales tax.
- About 1/3 of aggregate state government revenues.
• Federal government taxes consumption mainly through use
of excise taxes.

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 The Expenditure Tax
• Comprehensive consumption tax, or
“expenditure tax”, would work like an income
tax that allows exclusion of retirement savings
from the tax base.
• All savings, without limit, no matter for what
purpose, would be excluded from income.
• No tax penalty for withdrawing funds from
savings.
• Tax paid only when funds are converted to cash
and spent.
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 Consumption, Saving & Capacity
• Can be argued that ability to pay is more appropriately
measured by person’s basic capacity to earn income.
• Based on horizontal equity, two people with equal potential
to earn income should pay same amount of taxes over their
lifetimes.
• Lifetime income includes endowment of capital so taxes
would depend one’s tendencies to defer consumption.
• One who saves nothing taxed entirely on basis of labor
income.
• One who saves pays taxes both on labor earnings and
income from accumulated capital.

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Comprehensive Consumption Tax Base
• Comprehensive consumption tax base excludes
any changes in net worth from the tax base.
• Only current expenditures are taxed under
consumption tax so measuring capital gains is
unnecessary.
• Anything that increases net worth excluded from
tax base including savings, purchase of income-
producing assets and stocks and bonds.

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 Incidence of Consumption Tax
• Because capital income excluded from taxation, tax
would be borne according to labor earnings.
• Portion borne by labor income could be shifted to
consumers if workers adjusted work hours in response
to tax.
• Consumption tax likely to be more regressive.
• Rate structure of an expenditure tax could be modified
to achieve a collectively chosen distribution of tax
burden.

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 Sales Taxes
• Few sales taxes are implemented to conform to
comprehensive consumption tax base.
- Levied mostly on tangible goods, excluding
professional services, haircuts, transportation, etc.
- Housing services are exempt.
- Many states exempt goods regarded as necessities such
as groceries and prescription drugs.
• Many consumption taxes levied on purchase of
automobiles and other durable goods.
- When purchased by businesses, marginal cost of
production and retail prices are increased.

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 Retail Sales Tax
• Ad valorem levy of a fixed percentage on dollar value of
retail purchases made by consumers.
• True tax levied only on consumption at its final stage and
collected from businesses that make retail sales.
• Usually added to retail price of goods and services.
• Broadening sales tax base instead of raising tax rates can
increase revenue.

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 Issues in State & Local Sales Taxation
• When taxes first introduced, services exempt from taxation
for administrative reasons.
• As services command more consumption, states in financial
crisis forced to consider taxing them.
• Aging population adversely affects states’ revenue when
services exempt as consumption more weighted towards
pharmaceuticals and medical products.
• Most states do not tax purchases by government agencies
and nonprofit organizations.
• E-commerce presents challenges in state sales taxation.

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 Excise Taxes
• Selective taxes levied on certain types of
consumption activities.
• Distorts choices among goods and services.
• Some are intended to discourage consumption
activities (taxes on liquor).
• Many consumption activities taxed are alleged
to generate negative externalities or are
considered luxury goods and services.

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 Incidence of Sales & Excise Taxes
• Criticism that they are regressive with respect to
income.
- Annual consumption expenditures, as percentage of annual
income, higher for low-income taxpayers than high-income
taxpayers.
• Has led many states to exempt certain items
such as food and prescription drugs.
• Distribution of tax burden between buyers and
sellers varies from state to state (in USA).

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 Turnover Taxes
• Effective rate conditioned by number of stages of
production.
• Extremely productive levy, producing high, stable yields at
low rates.
• Low rate believed to discourage tax evasion.
• Studies show tax to be somewhat progressive.
• Effective rates on many food items lower than those on
clothing and other manufactured goods.

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 Value-Added Tax (VAT)
• General tax on consumption levied on value added to
intermediate products by businesses at each stage of production.
• Value-added is difference between sales proceeds and purchases
of intermediate goods and services over a certain period:
Value Added = Total Transactions – Intermediate Transactions
= Final Sales = GDP
• Not currently used by U.S. federal government.
• General tax on value added equivalent to tax on national product.

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 Administration of VAT
• Invoice method taxes all transactions at a fixed
proportional rate so firms only maintain invoices on
sales and purchases for each tax payment period.
• Tax liability determined by applying rate to total
sales invoices and deducting VAT paid on previous
intermediate purchases.
• Consumers purchase goods with VAT included in
the price.
• Firms that make capital purchases allowed tax credit
for taxes paid on capital goods.
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 Administration of VAT
• VAT typically rebated on export sales.
- Goods of nations that use the tax more competitive in
international markets when they are exported to nations
where there is no national sales tax.
• Imported products subject to VAT, increasing
prices to domestic consumers.
• A criticism of VAT is that costs of administration
and compliance are high compared to other taxes.
- Estimated that administrative and compliance costs for
new VAT in U.S. could be $8 billion per year.

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Standard VAT Tax Rates, 2011

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Thank You!

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