Econ7008 Economics of Tax Policy

Introduction to key concepts in

the economics of taxation
Professor Stephen Smith
UCL Department of Economics
"The art of taxation consists in so plucking
the goose as to obtain the largest possible
amount of feathers with the smallest possible
amount of hissing." (Colbert, 1665)
Jean-Baptiste Colbert was the controller
general of finance (from 1665) and
secretary of state for the navy (from
1668) under King Louis XIV of
France. He carried out the program of
economic reconstruction that helped
make France the dominant power in
Europe.

The portrait, by Claude Lefebvre, is in the

Château de Versailles.
Adam Smith's "canons of taxation"
• Equality
– Tax payments should be proportional to
income
• Certainty
– Tax liabilities should be clear and certain
• Convenience of payment
– Taxes should be collected at a time and in
a manner convenient for taxpayer
• Economy of collection
– Taxes should not be expensive to collect
and should not discourage business.

• Adam Smith (1723 -1790), author of “The Wealth of

Nations” and Professor of Moral Philosophy at
Glasgow University.
The economics of tax policy
• Modern economic analysis addresses two groups of questions

• The incidence of taxation

– ie where does the tax burden lie?

• The efficiency cost of raising tax revenues

– loosely, the “distortionary” effects of taxes

• Taxation as a political issue

– Tax policy is highly politicised (often major election issue)
– Taxation can signal values of society (approval / disapproval)
– Short-term political objectives may conflict with long-term rationality
– Unobtrusive taxation may be preferred ("stealth taxes")
Econ7008 Economics of Tax Policy: Outline

• Introduction to key concepts in the economics of taxation

– Economic incidence, efficiency, distributional incidence.

• The major taxes: economic issues

– Income tax, Corporation tax, Value-added tax.

• The optimal structure of commodity taxes

– Ramsey's analysis
– Commodity taxes and distributional equity
– Commodity taxes and the labour market.

• Special topics
– 1: Tax enforcement and compliance
– 2: Taxation of alcohol and tobacco
– 3: EU Tax harmonisation
Textbooks

• J E Stiglitz (2000), Economics of the Public Sector, Third

Edition, New York and London: Norton.

• J A Kay and M R King (1998) The British Tax System,

Fourth Edition, Oxford University Press.

• MP Devereux (ed) (1996) The Economics of Tax Policy,

Oxford University Press.

• B Salanié (2003) The Economics of Taxation. MIT Press.

Tax incidence
Formal incidence: Who is legally liable to
pay the tax? (Who do we collect the tax
from?)
Effective incidence: Who ultimately bears
the burden of the tax? (Whose living
standard falls as a result of the tax?)
Effective incidence may differ from formal
incidence because the imposition of a
tax can affect demand or supply in the
markets for goods or factors of
production, and hence can change
equilibrium prices. These changes in
prices can shift the burden of a tax
away from its formal incidence.
All taxes formally incident on business will
have their final incidence on customers,
owners (eg shareholders), or
employees.
Generally formal incidence is irrelevant in
determining the long run effective
incidence of a tax. (eg Employer and
employee NICs)
Effective incidence of a sales tax in a competitive
market (Partial equilibrium analysis)

A sales tax is typically collected

from retail businesses.
How far it can be shifted forward to
customers will depend on the
relative elasticities of supply and
demand for the taxed
commodity.
The more elastic is demand, the
less of effective incidence will
be on purchaser, and the more
on seller of the good.
The more elastic is supply, the
more effective incidence will be
borne by the purchaser, and the
less by the seller.
Sales tax incidence with imperfect
competition.

• With perfect competition, incidence of a sales tax

is governed by the relative elasticities of demand
and supply.
• With imperfect competition, the incidence of a
sales tax is more complicated, and also reflects:
– market structure (monopoly or oligopoly?)
– the shape of demand and supply curves
– the specification of the tax (specific or ad valorem?)
 Sales tax incidence with a monopoly seller
• Monopolist sets output where MR=MC,
and makes monopoly profits because
price (=avge revenue) > average cost.
• Diagrams illustrates some simple cases,
of a monopolist with a horizontal
marginal cost curve.
– A per-unit sales tax shifts the marginal
cost curve upwards by the full amount of
the sales tax.
– In the perfectly-competitive case, with a
horizontal supply function, the consumer
would bear all of the tax.
• With monopoly, the effect on the price to
consumers depends on the shape of the
demand curve:
– If the demand curve is linear, a tax of T
increases price by 0.5T
– With constant-elasticity demand curves,
price increases by more than T (ie the tax
is "over-shifted").
Incidence of a sales tax with oligopoly

• Incidence is still more complicated, and depends on the

nature of competition in the market.
• Producers interact strategically with each other.
• If producer A changes its price and/or output, what is the
effect on price and/or output chosen by other producers?

• For example
– One view of oligopoly behaviour is that if A raises its price to reflect
the tax, others may keep their prices unchanged, and steal A's
market share. This may deter any firm from raising its price, and
the tax is fully-incident on the firms.
– Other models of market behaviour have each firm expecting that
the others would match any price increase - so the full burden of
the tax would be shifted to consumers.
Deadweight loss

• Excess burden ( = "Deadweight loss")

– the additional cost of raising a given revenue through distortionary taxation
as compared with a poll tax yielding equal revenue.
– US studies suggest excess burden is approx 20 to 30 cents per dollar
raised in taxation

• Marginal excess burden

– The additional excess burden incurred in raising an additional pound in
revenue
– An efficient revenue system, raising a given tax revenue requirement at
least economic cost, would use each tax instrument up to the point where
the MEB from each tax is equalised
The deadweight loss from a sales tax on a single
commodity, in a simple indifference curve diagram

• Diagram shows a consumer’s

preferences between the taxed good
S and other goods.
• Imposition of the sales tax on S has
both income and substitution effects,
and leads to a new equilibrium at Et
• At Et the revenue collected from the
sales tax (measured in terms of other
goods given up) is the vertical
distance RS
• The welfare loss experienced by the
consumer is measured by RL (the
lump-sum tax payment that would
place the consumer on the same
indifference curve)
• The excess burden from the sales tax
on S is thus RL – RS
• Shown as DWL on the diagram
Properties of deadweight loss

• Illustrated by partial equilibrium

supply -and-demand diagrams,
assuming (for simplicity) infinite
supply elasticity (ie horizontal
supply curve)
• Top diagram illustrates how
deadweight loss rises with the
square of the tax rate
– DWL with tax at rate t = D
– Shaded area is 3x area D, so
total DWL with tax of 2t = 4D
• Bottom diagram illustrates how
deadweight loss is greater with
more-elastic demand
• For the same tax rate t, the
more price-elastic good has
higher DWL (additional DWL is
shaded area)
Distributional incidence of taxation
• vWhy is distributional incidence of interest?
– policy-makers may have objectives of equity or fairness
– pragmatic interest in distribution (eg politicians may want to know who will be the
"gainers" and "losers" from reform)

• A “proportional” tax
– a household's tax payments are a constant percentage of income
• A "progressive" tax:
– a household's tax payments increase as a percentage of income as incomes rise
• A "regressive" tax:
– a household's tax payments decrease as a percentage of income as incomes rise

• Distributional incidence can be assessed for single taxes, or for the tax system
as a whole
– but overall incidence is more important than that of individual taxes
– A regressive tax within the tax system can be offset by greater progressivity
elsewhere
Current vs lifetime income / redistribution
• What yardstick should we use to judge whether households are rich or poor?

• (a) Current income

– Households' incomes fluctuate over time. Low income in one period may
be only temporary.
– In a longer term perspective, a household with low current income may not
be poor.
– Moreover, by borrowing or dis-saving it may be able to maintain its
standard of living over the temporary drop in income.

• (b) Lifetime income

– If households can borrow and save, they can smooth their consumption
over temporary income fluctuations. Their lifetime income is the budget
constraint.
– Lifetime income would then be the right measure of those who are truly
poor, rather than just experiencing a temporary income loss.
– The state may be more concerned about helping the truly poor than the
temporarily poor.
Lifetime income - issues
• A practical problem for empirical work:
• Lifetime income is an expected value, and cannot be measured
objectively.
• Current consumption (spending) may be a good proxy for lifetime income if
households smooth consumption over income fluctuations.
– and unlike (b) this approach doesn't assume consumption smoothing when
this cannot take place (eg if credit constraints limit borrowing)
– but some spending data is lumpy (eg durables)
– ….implies non-durable spending may be the best indicator of living
standards

• What about households who cannot borrow enough to smooth their

consumption over periods of low income?
– We may still want to have some within-lifetime redistribution, for reasons of
efficiency
– ie to correct market failures which inhibit efficient smoothing by individuals.
• eg credit constraints
• absence of private insurance markets
• moral hazard (would we really let the improvident elderly starve?