Taxation Frederick University 2014
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 S1 S0 Price tax A P1 Deadweight loss B C P0 D E P1–t F Producer surplus Demand Q1 Q0 Quantity Consumer Surplus Before Tax: A + B + C Consumer Surplus After Tax: A Producer Surplus Before Tax: D + E + F Producer Surplus After Tax: F Deadweight Loss: C + E
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.
S1 S0 $70,000 60,000 tax 50,000 Price of luxury boats 40,000 Demand 30,000 20,000 510 10,000 200 400 600 Quantity of luxury boats Who Bears the Burden of a Tax? Supplier Pays Tax Consumer pays Supplier pays
S1 S0 $70,000 60,000 tax 50,000 Supplier pays Price of luxury boats 40,000 30,000 20,000 Demand 10,000 590 200 400 600 Quantity of luxury boats Who Bears the Burden of a Tax? Demand is inelastic Consumer pays
S0 $70,000 60,000 tax 50,000 Price of luxury boats 40,000 D1 D0 30,000 20,000 510 10,000 200 400 600 Quantity of luxury boats Who Bears the Burden of a Tax? Consumer Pays Tax Consumer pays Supplier pays
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.
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. • This activity is called rent seeking behavior – the effort to transfer surplus from one group to another.
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
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.
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