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EC302: Microeconomic Analysis

Semester 2, 2019
Tutorial 6 Solution (Week 7)
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Question 1
List the sources of Public Finance in your own country. Which of these would you say are the
major sources of public finance?

• Taxation - income, capital, resource, goods, service

• Compulsory Social security deduction, which are most often accessed by government
borrowings
• Compulsory acquire access over resources
• Ownership of resources - Physical resources, like minerals, land or income that flows from
it
• Dividend income from government equity – SOE’s • Government borrowing from market
• Can print money or borrow from Reserve banks at zero interest rate. [Increases nominal
incomes and demand for goods. Can lead to inflation unless there are substantial
unemployed resources, implying real capital loss. Strong relationship between printing
money and inflation. ]
• Interest income on loans

Question 2
What does it mean to say that a tax system is ‘efficient’? When might the tax system fail to achieve
its goal of efficiency? Does taxation always drive resources away from their best use?

A tax system is efficient when it does not distort the efficient allocation of resources. A
deadweight loss (or excess burden) of taxation occurs when economic agents bear costs in
addition to the actual tax paid. This occurs when taxes change relative payments to factors
of production or the prices of goods and affect the quantity of goods supplied and consumed.
This does not occur, by definition, with a lump sum tax because behavior is not changed.
However, there are few (if any) acceptable lump sum taxes. Consequently, virtually all taxes
are distorting and involve some deadweight loss. However, taxes may reduce economic
distortions in imperfect or incomplete markets. In addition, a tax system may be described
as technically efficient if it raises a given amount of revenue at least administrative cost.
Question 3
What are attributes of a fair tax system? What are some alternative views of equity? Do the
different notions of equity involve some contradiction? If so, how is this dealt with?

A fair tax system is generally characterised by the ability to pay principle - individuals should
pay tax according to their ability to pay. Ability to pay is characterised in turn by the
principles of horizontal and vertical equity. Accordingly, these two equity principles are
widely considered to be the main attributes of a fair tax system. However, ability to pay may
be considered to depend on either ability to earn income or on actual income earned. It is
hard to tax an individual on their ability to earn income if they earn very little. On the other
hand, it is not fair to tax someone heavily who works very long hours for a low hourly rate.
The principle of fair deserts states that people should be fairly compensated for their efforts.
Moreover, in so far as taxation is designed to provide services, it may be argued that those
who benefit from at least some services should paid for them. Overall, fairness in taxation is
a complex topic.
Question 4
Discuss advantages and disadvantages of tax hypothecation.

Economists argue that all funds received by government should be treated in a similar way.
Locking up funds for specific expenditures (hypothecation) is potentially inconsistent with
determining the most efficient and equitable way to use resources. On the other hand,
politicians may argue that the public wants a greater say in the use of their payments to
government and that this is consistent with hypothecation. They may also find this assists
public fund raising. Tax hypothecation links expenditure to source of funds. Hypothecation
is quite common (social security taxation, fuel levies for roads, levies for fire-fighting
services). • The advantages are that: it is popular as tax payers see the purpose of the tax and
may be easier to raise revenue.
Question 5
Why is the statutory incidence of taxation often irrelevant when determining the actual effects of
taxation? What determines the economic incidence of a commodity tax?
The statutory incidence of taxation indicates who is legally responsible for paying a tax.
However, this entity may bear little, or even none, of the actual incidence of a tax. Consider,
for example, the real incidence of a commodity tax. When demand is inelastic, firms can pass
most of the cost on to consumers in the form of higher prices; when demand is elastic, firms
cannot raise the price because consumers can purchase other non-taxed goods. In a
competitive market, the real incidence depends on the relative elasticities of demand, supply,
and the competitive nature of the market.