Taxation: Theory

1. 1 Taxation: Theory Lecture 11a: Introduction: 2006-05-19 Hans L��f

2. 2 Chapters 17: Introduction to Taxation 18: Tax Incidence (Burden of taxes) EX 19: Taxation and Economic Efficiency EX 20: Optimal Taxation 21: Taxation of Capital EX 22. Personal Income Tax 23: The Corporation Income Tax EX 24: Reform of the Tax systems

3. 3 Idea of lectures 11 and 12 Basic understanding of Main theories on Taxation Theory. Select the most important topics for the course requirements Exam

4. 4 EXAM 1. CH 1 Public Sector in a Mixed Economy 2. CH 3-5 Fundamentals of welfare Economics. EX 1-9 + TB+LN 3. CH 6-9 Public Expenditure Theory TB+LN 4. CH 10-16. Expenditure programs TB+LN+Possible Questions 5. CH 17-25. Taxation Theory. TB+LN+Exercises+Outline+Key Concepts ------------------------------------------------------- Ex 2: Maj 29. No Term-Paper sem

5. 5 Outline 1. A good tax system: five attribites 2. Tax distortions 3. Horizontal versus Vertical equity 4. Pareto efficient tax structures 5. The Utilitarian versus the Rawlsian approach

6. 6 Basic 1. Contributions to support public services need to be compulsory because of the free rider problem: - Unless support for public goods is made compulsory no one will have initiative to contribute. 2. The government can force one group to give up its resources to another group and this �theft� is made legal by the political process. The power of taxation and the Boston Tea Party (unjust taxes were beeing levied on the colonies)

7. 7 Background * Taxation is as old as organized government; The bible says that one-tenth of the corps should be set aside for purposes of redistribution and for the support of the priesthood. * An individual who must give the government 30% of his earning is, effectively, working for the government 30% of the time.

8. 8 Two Main types In most countries, there is a broad variation of taxes. They can all be divided into two broad categories: Direct taxes on individuals and corportations and Indirect Taxes on a vareity of goods and services.

9. 9 Main Taxes 1 Income tax (wages and capital) US 45% 2 Payroll tax (a fixed % of wages) US 35% 3 VAT; Value added taxes (a fixed % of prices om goods and services) US 5% 4 Corporation income 5 Estate tax: US: 1 0-15% 5 Lump sum taxes (i.e. environmental) US 5% 6. Real Estate: US 2-3% --------------------------------------------------------------- Note: During recent dacades, most European countries have swithed to an increased reliance on value added taxes. USA relieas more hevily on individual income tax than do other advanced countries

10. 10 Economic aspects no 1 Income tax: Because the individual income tax is leived both on wages and capital income, it affects decision about labor supply, retirement education, saving and investment � which all have large inpact on economic growth and performance

11. 11 Principles of Taxation: From the economic point if view: Taxes are inevitable painful. From the individual point of view: Most people would like to see their own taxes reduces (but not necessary other peoples taxes) From the point of view of the government (a) To be reelected by the majority of the voters (b) To reach overall goals such as inceased welfare through high and stable growth rate and robust social security systems (c) To correct market failures

12. 12 Five desirable characteristics of any tax system 1. Efficiency 2. Simplicity 3. Flexibility 4. Responsibility 5. Fairness

13. 13 1. Economic efficiency The tax system should not interfere with efficient allocation of resources. That is, the tax system should not be distortionary. And, if possible, it should be used to enhance economic efficiency.

14. 14 Economic efficiency Recall that in the absence of market failures, the economy would automatically allocate resources efficiently. Information conveyed by market prices would lead to production, exchange and product mix efficiency. No one could be better off without making anyone worse off. However, most taxes change relative prices. As a result, the price signals are distorted � and the allocation of resources is altered.

15. 15 Economics Impacts of Taxation * Behavioral effects (education, work, saving, consumption) * Financial effects (dividends, capital gains-increases in the price of an asset and interest- asre most treated differently) * Organizational effects (the tax system may encourage or discourage banks relative to other financial institutions or arrangements) * General equlibrium effects (A tax on interest may reduce the supply of saving, and eventually, the stock of capital: This in turn may reduce the productivity of workers and their wages) * Announcement effects and capitalization ( impact effect; announcement concerning the future tax treatment of an asset can have an immidate impact on the value of the asset i.e house price)

16. 16 Economics Impacts of Taxation Distortionary and nondistortionary taxation (Non-distortionary: Taxes means that the government is taking money away from an individual meaning that his income is reduced. A tax is nondistotionary if and only if the individual do not/can no react at all in order to alter his tax liability when the tax is imposed. Economicst call taxes that are nondistiotionary LUMP-SUM TAXES Since individuals and firms cannot avoid them, lump sum taxes do not lead to changes in behavior or to reallocation of resources Definition: A tax of a fixed amount that has to be paid by everyone regardless of the level of his or her income

17. 17 Economics Impacts of Taxation Any tax on commodities is distortionary: an individual can change his tax liability simply by reducing his purchases of the commodity Any tax on income is also distortionary: an individual can reduce his tax liability simply by working less or by saving less.

18. 18 Economics Impacts of Taxation Taxation can sometimes be used in a positive way, to correct som market failure. Corrective taxes: Raises income and improve the efficiency of resource allocation. Dangers of global warming associated with the build up of greenhouse gases (such as carbon dioxide) in the atmospere due to high energy uses.

19. 19 2. Adminsitrative simplicity The tax system ought to be easy and relatively inexpensive to adminster. That is, the tax system should have low costs of of administration and compliance.

20. 20 3. Flexibility A tax system ought to be able to respond easily (or automatcally) to changes in economic circumstances AUTOMATIC STABILIZATION: As the economy goes into recession a reduction in tax revenues may be extremely desiarable to provide needed stimulus for the economy Progressive taxes: When income drop (recession) the tax is proportionally more reduced. When income increases (boom) the tax is proportionally more increased.

21. 21 4, Polictical Responsibility The tax systemet should be transparent, that is, it should be clear who is benefiting and who is paying or it should be designed so that individuals can ascertain what they are paying, and evauluate how accurately the system reflects their prreferences. Jean-Baptiste Colbert, a finance minster to Louis XIV � The art of taxation consits in so plucking the goose as to obtain the larges amount of feathers with the least possible amount of hissing (=screaming)

22. 22 5. Fairness The tax system should be, and should be seen to be, fair, treating those in similar circumstances similarly, and imposing higher taxes on those who can better bear the burden of taxation. But how we define precisely what is andis snot fair?

23. 23 Horizontal and Vertical Equity Horizontal: Individuals who are the same in all relevant aspects are trated the same. (A poor and a rich twin) Vertical: Some people are in a position to pay higher than others, in they should do it. (A poor and a rich tvin)

24. 24 Sum up Pareto Efficient Systems Tax structures that, given the tools and information available to the government, no one can be better off without making someone else worse off.

25. 25 Value Judgment The advantage of this approach is that it separates efficiency considerations from value judgments. Almost all would agree that if a tax structure could be found in which some one would be better of and no else worse off/ or everyone was better of, should be adopted. But no such tax system exists! Instead the main question is if the gains to some groups are sufficiently large to justify losses to some others. The answer depends on value judgements.