Econ 225 - Economics of Taxation: Course Objectives

P.O.
Box 1100-20300, TEL: +254-(0) 20 2696596;
NYAHURURU, Cell: +254 713-552761/ (0)736-299961
KENYA ECON 225 – ECONOMICS OF TAXATION

econs@laikipia.ac.ke; www.laikipia.ac.ke
COURSE OBJECTIVES
By the end of the course the learner should be able to:

- Describe the various sources of public revenues
- Explain the canons of taxation
- Explain the approaches to each of the canons in the design of tax policy
- Explain issues for tax reforms in developing countries
- Explain the approaches to optimal public finance in federal systems
- Explain the burden of public debt
REFERENCES
Artkinson, A.B and J.E, Stiglitz (1980): Lectures in Public Economics. New York, McGraw-
Hill
Barley, S.J. (2002). Public Sector Economics Theory and Practice. 2 nd edition. New York
Palgrave
Hillman, A.L (2009). Public Finance and Public policy- Responsibilities and limitations of
Government. Cambridge. Cambridge University Press
Howard, M (2001). Public Sector Economics for Developing Countries. Kingston 7.
University of West Indies Press
Musgrave and Musgrave (1989): Public Finance in Theory and Practice. 5thed. New York,
McGraw-Hill
Rosen H (2005): Public finance. 7th ed. McGraw-Hill
Stiglitz, J.E (2000): Economics of the Public Sector. 3rded. New York, Norton
Page 1 of 90
TABLE OF CONTENT
Contents
TOPIC ONE: INTRODUCTION ................................................................................................................. 5
1.1: TOPIC OBJECTIVES ..................................................................................................................... 5
1.2 PUBLIC REVENUE ........................................................................................................................ 5
1.3: REASONS FOR TAXATION ........................................................................................................ 7
1.4: CANONS OF TAXATION ............................................................................................................ 7
TOPIC TWO: CATEGORIES OF TAXES ........................................................................................................ 10
2.1: TOPIC OBJECTIVES ................................................................................................................... 10
2.2: THE CIRCULAR FLOW MODEL AND TAX IMPACT POINTS ............................................ 10
2.3: OTHER CATEGORIES OF TAXES ........................................................................................... 12
TOPIC THREE: APPROACHES TO TAX EQUITY ........................................................................................... 14
3.2: THE BENEFIT PRINCIPLE ........................................................................................................ 14
3.3: THE ABILITY-TO-PAY PRINCIPLE ......................................................................................... 16
3.4: TAX PROGRESSIVENESS ......................................................................................................... 19
TOPIC FOUR: TAXABLE CAPACITY AND TAX EFFORT ................................................................................ 23
4.2 TAXABLE CAPACITY ................................................................................................................ 23
4.3 TAX EFFORT ................................................................................................................................ 26
TOPIC FIVE: TAX BURDEN ......................................................................................................................... 29
5.2: TAX LIABILITY, TAX BURDEN AND EXCESS BURDENOF TAX ..................................... 29
5.3: MEASURING EXCESS BURDEN OF TAX .............................................................................. 30
TOPIC SIX: TAX INCIDENCE AND TAX SHIFTING........................................................................................ 33
6.2: DEFINITIONS .............................................................................................................................. 33
6.3 TAX INCIDENCE ANALYSIS .................................................................................................... 34
6.4: FACTORS INFLUENCING THE EXTENT OF TAX SHIFTING ............................................. 36
TOPIC SEVEN: EFFECTS OF TAXATION ON ECONOMIC BEHAVIOUR ........................................................ 42
7.2: INTRODUCTION ........................................................................................................................ 42
7.3: EFFECT OF INCOME TAX ON LABOUR SUPPLY ................................................................ 42
Page 2 of 90
7.4: EFFECTS OF TAXATION ON SAVING ................................................................................... 45
7.5: TAX RATES AND TAX REVENUES ........................................................................................ 50
TOPIC EIGHT: OPTIMAL TAXATION .......................................................................................................... 53
8.2 OPTIMAL TAX ............................................................................................................................. 53
8.3: OPTIMAL INCOME TAXATION ....................................................................................................... 55
8.4: OPTIMAL COMMODITY TAXATION ..................................................................................... 56
.............................................................................................................................................................. 57
TOPIC NINE: TAX EVASION AND TAX AVOIDANCE ................................................................................... 60
9.2: DEFINITIONS .............................................................................................................................. 60
9.3: CONSEQUENCES OF TAX EVASION ..................................................................................... 60
9.4: CAUSES OF TAX EVASION AND AVOIDANCE ................................................................... 61
TOPIC TEN: TAX REFORM ......................................................................................................................... 65
10.1: TOPIC OBJECTIVES ................................................................................................................. 65
10.2: MOTIVATIONS FOR REFORMS ............................................................................................ 65
10.3: EVALUATION OF TAX REFORM PROPOSALS .................................................................. 65
10.4: ISSUES THAT MOTIVATE TAX REFORMS IN DEVELOPING COUNTRIES .................. 65
10.5: ECONOMIC PROBLEMS OF DEVELOPING COUNTRIES AND TAX REFORM ........ 67
10.6: CASE EXAMPLES OF TAX REFORM PROBLEMS ............................................................. 69
TOPIC ELEVEN: FISCAL FEDERALISM ........................................................................................................ 72
11.2: DEFINITIONS ............................................................................................................................ 72
11.3: OPTIMAL FEDERALISM ......................................................................................................... 73
11.4: TAX ASSIGNMENT .................................................................................................................. 76
11.5: TAX COMPETITION ................................................................................................................ 77
TOPIC TWELVE: PUBLIC DEBT................................................................................................................... 79
12.2: PUBLIC DEBT AND BUDGET DEFICITS .............................................................................. 79
12.3: SOURCES AND TYPES OF GOVERNMENT OBLIGATIONS/DEBT ................................. 80
12.4: EFFECTS OF GOVERNMENT BORROWING ON THE ECONOMY .................................. 81
12.5: THEORIES ON THE BURDEN OF THE DEBT ...................................................................... 81
12.5.1 Lerner’s View .......................................................................................................................... 82
12.5.2: An Overlapping Generations Model .......................................................................................... 82
Page 3 of 90
Table 12.1: Overlapping Generations Model ...................................................................................... 83
The Period 2001 - 2021 .......................................................................................................................... 83
12.5.3 Neoclassical Model.................................................................................................................. 84
12.6: CONSEQUENCES OF PUBLIC DEBT .................................................................................... 85
12.7: DEBT SITUATION IN DEVELOPING COUNTRIES ............................................................. 86
12.8: DEBT REDEMPTION ............................................................................................................... 87
12.9: TO TAX OR TO BORROW ....................................................................................................... 88
12.9.2 Intergenerational equity ............................................................................................................... 88
12.9.3 Efficiency considerations ............................................................................................................. 88
12.9.4: Macroeconomic considerations .................................................................................................. 89
12.9.5 Moral and political considerations .............................................................................................. 89
Page 4 of 90
TOPIC ONE: INTRODUCTION
1.1: TOPIC OBJECTIVES
By the end of this topic learner should be able to:

• Define public revenue
• Explain the various sources of public revenue
• Explain the objectives of taxation
• Describe the characteristics of a good tax system
1.2 PUBLIC REVENUE

1.2.1 Definition
Public revenue is the means for public expenditure. The necessity of raising public revenue arises
from the necessity of the government to incur public expenditure.
Public revenues includes all the income and receipts, irrespective of their sources and nature,
obtained during any given period of time and includes loans that are subject to future payment. It
includes only those sources of revenue that are not subject to repayment.
Government activity requires the reallocation of resources from private to government use. The
individuals must be induced to surrender their right to command resources for their own private
use. The government authorities then obtain those rights for the purpose of providing goods and
services. The method of raising revenue affects the political equilibrium (quantity and mix of public
goods); market equilibrium and efficiency; and distribution of income.
1.2.2 Sources of Public Revenue
Taxes are the most common source of government revenues. However, there are other sources of
revenues like Fees, Price, Special Assessment, Fines & Penalties, Gift, and Profit from government
enterprises etc.
(i) Taxes
These are compulsory charges or payment levied or imposed by a public authority (central or local
government) on an individual or corporation. A tax payer does not receive a definite and direct
quid pro quo (direct return) from the public authority.
The definition of tax implies that a tax is a compulsory payment to the public authority. It is paid
by a person on whom it is levied whether he derives any benefit from it or not. A person who pays
taxes to the state cannot claim that because he/she pays taxes, a specific service in return should be
provided to him. For instance, the individual cannot demand that a police officer should be posted
at his residence to protect his property at night. The government spends money which it derives
from taxes in maintaining law and order in the country and like other individuals he/she benefits
from it.
(ii) Fees (user charges):

A fee is a payment made by the citizens of a country to the State in return for obtaining a definite
service. Fee, unlike tax, is not compulsory contribution but involve voluntary transactions. It is
only paid by those persons who enjoy the special benefit of the services rendered by the State.
Page 5 of 90
The amount of the fee is generally less than the cost of rendering the service. For instance, student's
fee is not equal to the cost of service rendered to him/her. Some part of the total cost is covered by
fees and some by taxes. The fees are prices determined through the political process rather than
market interaction.
(iii) Price
Price, like fee, is also a payment made by a person in return for obtaining a definite service. The
difference between a fee and price is that public purpose is more prominent in fee than it is in price.
Price is a voluntary payment with a quid pro quo. It is received in payment for the goods and
services sold by the government, e.g. bills for electricity and water provision. Other examples are
when government sells timber from its forest, iron, coal, copper salt, gold etc., from its mines, and
the charges of fare on state buses (e.g. railway commuter bus in Nairobi) or from railways
(commuter trains and Standard Gauge Railway).
The total revenue which the government receives from such services of business character is called
price in economics.
(iv) Special assessments
Special assessment is a compulsory contribution made by the owner of a property for some benefit
conferred to his property by the public authority. It is levied in proportion to the special benefits
derived to defray the cost of a specific Improvement to property undertaken in the public interest
thus is a compulsory payment for improvement.
For instance, when the government provides water, electricity, drainage, paves streets, lays out
parks, etc. in a particular locality of the city, the value of all the property situated in that locality
will go up. The government has every right to share a part of this unearned increment by taxing the
owners of the property who have, benefited from the improvement. Special assessment is more or
less in proportion to the benefits enjoyed by the owners of immovable properties, for example,
charges on house owners due to the government providing good transport to the area
(v) Fines and penalties
Fines and penalties are payments made for the contravention of law. They are imposed to curb
certain offences. The purpose is to deter people from breaking the law.
(vi) Donations and Gifts
These are voluntary contributions made by individuals, private organisations, and foreign
governments e.g. during disaster(s) or calamities.
(vii) Privatisation
This refers to the transfer of publicly owned assets into the ownership of the private sector.
(viii) Borrowing
This is where individuals and organisations lend funds to the government and in return they receive
a bond or other note of government indebtedness that embodies the promise to repay the loan with
interest in future.
(ix) Printing of paper money: the government creates money and assigns it legal tender
qualities
Page 6 of 90
1.3: REASONS FOR TAXATION
The state uses taxation as the main source of revenue to fund its activities for collective satisfaction
of all the citizens wants. However, taxation policy can be a useful instrument for the realization of
other objectives. These include
- Overcoming the inefficiencies of the market system in the allocation of economic activities
and resources.
- Redistributing income and wealth in a just or equitable manner.
- Smoothing out cyclical fluctuations in the economy and ensuring a high level of
employment and price stability.
- Providing social welfare services including maintaining peace and security
- Protection of domestic commodities from foreign competition.
- Improvement of social welfare by discouraging the consumption of harmful commodities
such as cigarettes.
- Discouraging certain economic activities by heavy taxation and encouraging others through
tax exemption.
- Boosting employment level by starting new projects using the revenue collected from
various taxes
1.4: CANONS OF TAXATION

These canons are considered as the essential requirements of a good tax system. They are also
referred to as principles of taxation.
(i) Equity (Equality)
The canon of equity states that a tax is that which is based on the principle of equity. That is, taxes
need to be fair such that each payer contributes her fair share to the cost of government. The tax
must be levied according to the taxpaying capacity of the individuals. This is considered to be a
very important canon of taxation. By equality we do not mean that people should pay equal amount
by way of taxes to the government. By equality is meant equality of sacrifice. The principle points
to progressive taxation requiring that the rate or percentage of taxation should increase with the
increase in income and decrease with the decrease in income.
(ii) Certainty
The Canon of certainty implies that there should be certainty with regard to the amount which
taxpayer is called upon to pay during the financial year. If the taxpayer is definite and certain about
the amount of the tax and its time of payment, he can adjust his income to his expenditure. The
state also benefits because it will be able to know roughly in advance the total amount which it is
going to obtain and the time when it will be at its disposal. If there is an element of arbitrariness in
a tax, it will then encourage misuse of power and corruption Thus the time of payment, the manner
of payment, the quantity to be paid all ought to be clear and plain to the contributor and to every
other person
(iii) Convenience
"Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient
for the contributor to pay it". For instance, if the tax on agricultural land is collected in installments
Page 7 of 90
after the crop is harvested, it will be very convenient for the agriculturists to pay it. Similarly,
property tax, house tax, income tax, etc., should be realized at a time when the taxpayer is expected
to receive income. The manner of payment of tax should also be convenient. If the tax is payable
by cheques, the contributor will be saved from much inconvenience.
(iv) Economy
The canon of economy implies that the expenses of collection of taxes should not be excessive.
They should be kept as little as possible, consistent with administration efficiency. If the
government appoints highly salaried, staff and absorbs major portion of the yield, the tax will be
considered uneconomical. Tax will also to regarded as uneconomical if it checks the growth of
capital or causes it to emigrate to other countries. Thus administration and compliance costs should
be as minimum as possible.
(v) Productivity/fiscal adequacy

The canon of productivity indicates that a tax when levied should produce sufficient revenue to the
government. If a few taxes imposed yield sufficient fund for the state, then they should be preferred
over a large number of small taxes which produce less revenue and are expensive in collection.
(vi) Elasticity (Buoyancy)

The principle requires that tax revenue should have an inherent tendency to increase along with an
increase in national income, even if the rates and coverage of taxes are not revised.
(vii) Flexibility
It should be possible for the authorities, without undue delay to revise the tax structure, both in
terms of coverage and rates, to suit the changing requirements of the economy and the treasury.
(viii) Simplicity
The tax system should not be too complicated so as to bring difficulties to administer and
understand and breed problems of differences in interpretation and legal disputes. Every tax should
be simple, easy and understandable to a common man. Its procedure must be simple in nature so
that tax payer is able to understand and calculate it.
(ix) Diversity
Tax revenue should come from different sources so as to minimize the problems encountered by
changes from one source such as tax evasion. The government should collect revenue from its
citizens by levying direct and indirect taxes. Variety in taxation is desirable from the point of view
of equity, yield and stability
(x) Expediency
Tax should be based on certain principles so that it may not need justification from the government.
New taxes should not be imposed unless there is a sufficient basis for it. A tax should not be a
subject of any criticism - tax payer should have no doubt about its desirability.
(xi) Co-ordination must exist between different taxes levied by various tax authorities.
(xii) Efficiency (neutrality)

A tax should not interfere with the attainment of optimum allocation and getting of maximum
satisfaction. The system should avoid excess burden which leads to loss of welfare of over and
above the revenue raised, due to misallocation of resources.
Page 8 of 90
1.5 SUMMARY
Public revenues include all the income and receipts to the government during a given period
of time. The state can raise revenues from taxes, fined and penalties, fees, user charges,
charging prices on outputs, borrowing, privatization, special assessments or printing of paper
money
Other than the need to raise revenue, the government can use its tax policy to achieve other
economic objectives including overcoming market inefficiency, redistribution of income and
wealth, smoothing cyclical fluctuations, protection of domestic firms and improvement of
social welfare.
A good tax system should have the characteristics of certainty, convenience, economy,
buoyancy, fiscal adequacy, flexibility, diversity, equity, efficiency and simplicity.
Page 9 of 90
TOPIC TWO: CATEGORIES OF TAXES

- Use the circular flow model of an economy to show impact points for taxes
- Name the types of taxes given their points of impact in the economic system
- Distinguish between direct and indirect taxes, personal and in rem taxes
- Explain tax progressivity
2.2: THE CIRCULAR FLOW MODEL AND TAX IMPACT POINTS

Figure 2.1 presents a simplified circular flow of income and expenditures, together with the major
points of which taxes are inserted.
Households
1 Consumption
Dividends Household
Wages Retained saving
8 10 earnings Business
9
Factor saving
Capital
Markets Market
2
6 7 Investment
Profit
Payroll
Market for Market
5
Consumer for Capital
Depreciation
Goods Goods
Gross 3
Factor payments receipt
Firms 4
Figure 2.1: Points of Tax Impact in the Circular Flow model
From Figure 2.1 the following can be noted;

(i) Taxes can be levied in the factor or product markets
(ii) Any particular transaction may be taxed at either the household (buyer) or the firm (seller) side
of the market.
(iii)Any particular household or firm may be taxed at either the sources (income) or the uses
(expenditure) side of its account.
Combining the buyer – seller and sources – uses distinctions, the taxes can be arranged as in Table
2.1 and Table 2.2
Page 10 of 90
Table 2.1: Various categories of taxes
Uses Sources
Households Expenditure tax (2) -Income tax(1)
-Employee payroll tax (8)
Firms Profit tax (7) Retail sales tax(3)
Employee payroll tax (6)
(Numbers in the brackets refer to impact points shown in Figure 2.1)
Table 2.2: Impact Points and types of Taxes
Point Type of tax Source (base)

1 Income tax Household incomes
2 Expenditure tax (VAT) Expenditures by consumers on final goods and service
3 Sales tax Retail sales’ receipts of the firms.
4 Corporate income tax Income of the firms originating from markets for
consumer and capital goods.
5 Income tax Business receipt net of depreciation.
6 Payroll tax Employer contribution
8 Payroll tax Employee contribution
7 Corporate profit tax. Corporate profits
9 Withholding tax. From retained earnings: - part of profit not distributed to
shareholders aimed for expansion purpose.
NOTE
Depreciation is an operating expense and is tax free.
Taxes on Holding and Transfer of Wealth: Taxes may be imposed on the holding of wealth or
stocks, rather than on transactions or flows generated in current production. An example is the
property tax. If interpreted as a tax on capital income, it might be incorporated in Figure 2.1, but
other wealth taxes, such as those imposed on the transfer of wealth by inheritance or gift, cannot
be so included.
Equivalence of Taxes: There are pairs of taxes which may look different but which are in fact
equivalent. Thus in a competitive market, it makes no difference on which side of the counter the
tax is imposed.
- In the product market, a tax of 10% on the seller imposed on the net price of, say, $100, raises
gross price to $110 and gives precisely the same result (i.e. revenue, gross price, and output)
as a purchase tax upon the buyer imposed at the same rate on the net price. This holds whether
we deal with a selective tax or with a tax on the sale or purchase of all consumer goods.
- In the factor market a tax on the employer imposed on his or her payroll at 10% gives the same
result (equal revenue) as a 10% tax imposed on the income of the wage earner.
- A general tax on factor purchases is equivalent to a general tax on factor sales, i.e. income tax.
- In an economy without saving, there would be a further equivalent between a general tax on
factor purchases, a general tax on factor income, a general tax on product purchases, and a
general tax on product sales. This chain of equivalence among taxes does not apply, however,
once we allow for savings, since a tax on factor sales (income tax) now ceases to be equivalent
to one on product purchases.
Page 11 of 90
2.3: OTHER CATEGORIES OF TAXES
2.3.1 Personal and In-Rem Taxes
Personal taxes are taxes paid according to taxpayer’s personal ability to pay. In Rem taxes (taxes
on “all things”), on the other hand, are taxes imposed on activities or objects such as purchases,
sales, or the holding of property, independently of the characteristics of the owner. In Rem taxes
may be imposed on either the household or the firm side. But personal taxes, by their very nature,
must be imposed on the household side of the transaction.
Thus, if proceeds from the sale of factors of production are to be taxed in a personal fashion, the
tax must be imposed on households as a personal income tax. Similarly, if consumption is to be
taxed in a personal fashion, the tax must be placed on the household in the form of a personal
expenditure tax. A sales tax imposed on firms is not responsive to the particular consumer, but
gives the same treatment to all households who undertake the taxed transaction.
In Rem taxes do not consider the ability to pay or equity. They are based on the benefits as measured
by the amount consumed. Irrespective of whether or not the consumer ability to pay is low, if his
consumption is high he will pay more. They are in this sense considered to be regressive. As such,
personal taxes tend to be generally superior in equity since they are assessed on the household side.
2.3.2 Direct and Indirect taxes
Direct taxes are taxes which are imposed initially on the individual or household that is meant to
bear the burden (e.g. income tax) while, Indirect taxes are the taxes which are imposed at some
other point in the system but are meant to be shifted to whoever is supposed to be the final bearer
of the burden (e.g. sales taxes, excise duty).
The distinction between direct and indirect taxes does not always coincide with that between
personal and In Rem taxes. Thus the employee contribution to the payroll tax may be considered
direct, yet it is not a personal tax since no allowance is made for the owner’s ability to pay.
Similarly, the property tax on owner – occupied residences is direct, but it is an In Rem tax rather
than a personal tax.
An indirect tax is imposed on one person, but is paid either partly or whole by another person.
Indirect tax affects the income at the time when the consumer goes to buy goods.
Page 12 of 90
2.4: SUMMARY
• Any particular market transaction may be taxed at either the household (buyer) or the firm
(seller) side of the market.
• Any particular household or firm may be taxed at either the sources (income) or the uses
(expenditure) side of its account. Such taxes are equivalent since the circular flow model
depicts balance of accounts (total uses = total sources). Thus a tax on total gross receipts of
firms would be equivalent to a tax on the total uses of its proceeds or cost payments plus
profits.
• Taxes on the basis of the impact points can be classified as income tax, expenditure tax, sales
tax, corporate income tax, payroll tax, corporate profit tax, or withholding tax
• Taxes may also be classified as personal or in rem; direct or indirect taxes
• Personal taxes are taxes paid according to taxpayer’s personal ability to pay. In Rem taxes
(taxes on “all things”), on the other hand, are taxes imposed on activities or objects such as
purchases, sales, or the holding of property, which are independent of the characteristics of the
owner. In Rem taxes may be imposed on either the household or the firm side while personal
taxes, by their very nature, must be imposed on the household side of the transaction.
• Direct taxes are imposed initially on the individual or household that is meant to bear the
burden (e.g. income tax) while, Indirect taxes are imposed initially at some point in the system
but are meant to be shifted to whoever is supposed to be the final bearer of the burden (e.g.
sales taxes, excise duty).
Page 13 of 90
TOPIC THREE: APPROACHES TO TAX EQUITY

By the end of this topic the learner should be able to:
• Explain the two approaches to tax equity
• Describe how each principle influences tax policy design
• Give examples of taxes based on each principle
• Explain the challenges in tax policy design under each approach
3.2: THE BENEFIT PRINCIPLE

3.2.1 The principle
The principle argues that taxes be paid in accordance with the benefits received from government
expenditures. According to this principle, the truly equitable tax system will differ depending on
the expenditure structure. The principle is not only one of tax policy but also that of tax-expenditure
policy.
How can the Principle be applied?
Under a strict regime of benefit taxation, each taxpayer would be taxed in line with his /her demand
for public services. Since preferences differ across individuals, no general tax formula can be
applied to all people. Each tax payer would be taxed in line with his or her evaluation.
The typical mix of private goods purchased is known to vary with income level of the consumer
household and similar patterns may be expected to prevail for social goods. However, for the latter
what is important is how much various consumers are willing to pay for the same amount. If the
social good is a normal good, consumer valuation is expected to rise with income.
Illustration
Suppose taxpayers have the same structure of tastes (pattern of indifference curves) so that persons
with the same incomes value the same amount equally. Suppose that people with say KES 10,000
value a given level of public service at KES 1000. If 1000 units of the good are supplied, they
would be willing to pay KES 1 per unit. With the assumption of diminishing marginal utility of
income, people with higher incomes, e.g. KES 20, 000, will be willing to pay higher unit price (Tax
Price). With the doubling of income, the tax price may double to KES 2, or may less or more than
double.
The appropriate formula will therefore depend on the preference patterns for individuals (response
of tax price to increase in income), which in turn depends on the income and price elasticity of
demand for social/public goods.
Elasticity of tax price with respect to income is given as follows:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑎𝑥 𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐼𝑛𝑐𝑜𝑚𝑒 (𝐸𝑦 )
𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑇𝑎𝑥 𝑃𝑟𝑖𝑐𝑒 (𝐸𝑝,𝑦 ) = =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑃𝑟𝑖𝑐𝑒 (𝐸𝑝 )
∆𝑇𝑎𝑥 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 ∆𝑃 𝑌

𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑇𝑎𝑥 𝑃𝑟𝑖𝑐𝑒 (𝐸𝑝,𝑦 ) = × , 𝑖. 𝑒. , 𝐸𝑝,𝑦 = ×
∆ 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑎𝑥 𝑝𝑟𝑖𝑐𝑒 ∆𝑌 𝑃
Page 14 of 90
If income elasticity is high, the appropriate tax prices will rise rapidly with income, but if price
elasticity is high, the increase in will be dampened.
Three different situations can arise based on income elasticity of tax price.
(i) If elasticity of tax price equals 1, both Ey and Ep change at the same percentage rate and
the ratio of tax to income (tax rate) remains constant at all income levels. The tax is
therefore proportional.
(ii) If elasticity of tax price is greater than 1, Ey exceed Ep and the percentage of income paid
in taxes or the average tax rate increase as income rises. Thus the tax is progressive.
(iii) If elasticity of tax price is less than 1, Ey falls short of Ep and the percentage of income
paid in taxes or the average tax rate reduces as income rises. The tax is thus regressive.
Therefore, the required tax rate structure will be proportional, progressive, or regressive depending
on whether the income elasticity equals, exceeds of falls short of price elasticity.
NB: The rationale for or against progressive taxation may be discussed in terms for benefit taxation
as well as in the usual ability to pay context
3.2.2 Conditions under which Benefit Tax Criteria is Feasible

The benefit tax criteria is feasible under two conditions
(i) Where public goods are in the nature of private goods i.e. wholly rival. In this case benefits
can be imputed to a particular user who can be asked to pay, e.g. issuance of licenses,
financing of municipal transportation, provision of airport facilities, etc.
(ii) Taxes in lieu of charges. In some situations, it may be desirable to impose direct charges but
this can be too costly. A tax on a complementary product can thus be levied (used) in lieu of
charges. Examples include petroleum tax (meant for road maintenance and repair), property
tax (in form of charging special assessments) for costs of improvements which service the
particular location, and social security charges (employee payroll taxes) if benefit payments
stand in direct relation to the contributions.
3.2.3 Challenges in Implementing the Benefit Principle
1. For the benefit principle to be operational, expenditure benefits for a particular tax payer must
be known or easy to determine. It is often very difficult to measure benefits to the individuals
because.
- Benefits derived are interdependent. The benefit that any individual enjoys does not depend
only upon his own consumption of public services but also on that of other community
members.
- There are many benefits that cannot be ascribed to any particular individual or group i.e.
externalities
- People suffer from a lack of complete knowledge. A service might be important but not
widely known
- Taxpayers may show lesser demand for public services hence no equilibrium solution can
be achieved
- Where problems of economic growth and stabilization are experienced, benefit approach is
not able to guide the government because the benefits accruing to the economy as a whole
cannot be apportioned amongst individual members of the society
- Secondary, tertiary and late beneficiaries are not considered because the tax would be only
be confined to the points of first impact
Page 15 of 90
- Enjoyment of public good by one person does not deprive others from its use hence the
marginal cost is zero. It is not possible to establish a correspondence between its cost to the
supplier and the benefit to its users.
2. The benefit taxation can only be equitable if it is assumed that a proper state of distribution of
income and wealth exists. This is a serious shortcoming since in practice there is no separation
between taxes used to finance public service and taxes used to redistribute income.
3. Designing the tax structure on the basis of this principle would be on the assumption that
income received by a member is directly connected only with the benefits received from the
state, but this cannot be quantified.
4. The relevant price and income elasticities are not known or readily derived from market
observation as in the case of private goods. Moreover, the elasticities differ among various
types of public services. It is not obvious which elasticity will be larger and by how much
especially if the entire budget is considered.
5. Most basic functions of a government e.g. addressing the needs of the poor are ruled out.
6. Revenues based on benefits received do not match the government’s expenditure because state
budget is determined through a political process and individuals do not go by their own interest
only.
3.3: THE ABILITY-TO-PAY PRINCIPLE

3.3.1 The Principle
The principle requires that people contribute to the cost of government in line with their ability to
pay. Thus tax should be imposed according to what one can afford to pay. The tax burden is
distributed among individuals according to their taxable capacities. Taxation in this sense is
independent of expenditure determination. The approach allows government to carry out its
redistribution function since the tax burden is independent of benefits individuals receive.
3.3.2 Horizontal and Vertical Equity
There are two concepts of equity under the ability to pay principle: Horizontal and Vertical equity
(a) Horizontal tax equity: deals with the tax treatment of people who are similarly situated. Those
who are in the same position (have the same amount of income) should pay the same amount
in taxes
(b) Vertical equity: deals with the tax treatment of people who are differently situated (different
amounts of income). Individuals with higher incomes should thus pay more in taxes.
The two concepts of equity apply the basic principle of equality under the law. That is, people
should be treated equally in taxation. Equality here implies that people are made to experience
equal burdens.
3.3.3 Ability to Pay and Vertical Equity
Vertical equity views progressive taxation as an instrument of redistribution. It is based on the
assumption that the marginal utility of income tends to decline as an individual’s income and
wealth increases. This means that an extra shilling yields less utility to a rich person than to a poor
person as shown by the total utility graph in figure 3.1.
Page 16 of 90
Utility TU
Income
Figure 3.1: Diminishing Marginal Utility of Income
3.3.4 Equal Sacrifice Rules

Taxpayers are considered as treated equally if their tax payments involve an equal sacrifice or equal
loss of welfare. The loss of welfare in turn is related to the loss of income. If the level of welfare
as a function of income (marginal utility of income schedule) is the same for all taxpayers, the
equal sacrifice rule calls for people with equal income (ability to pay) to contribute equal amounts
of tax, and those with different incomes to pay different amounts.
But how should these amounts differ?

How the amounts paid in tax by people with different ability to pay will depend on the shape of the
utility function and by what rule the equality of sacrifice is defined. There are three interpretations
of equal sacrifice. They include; equal absolute, equal proportional or equal marginal sacrifice
(i) Equal Absolute Sacrifice
This requires that the same loss of total utility be imposed on all taxpayers. Different taxpayers are
made to sacrifice the same amount of utility by way of taxes so that the difference between the
aggregate utility from income before tax and the utility of income after tax is the same for every
tax payer. With declining marginal utility schedule, tax liability rises with income as shown in
Figure 3.2.
Total utility
Total utility
U
U
0 Y2' Y2 Y1' Y1 Income (Y)
Figure 3.2: Equal Absolute sacrifice for individuals with different levels of income
Page 17 of 90
Figure 3.2 is drawn on the assumption that the individuals 1 and 2 have the same preferences hence
have the same total utility function. Individual 1 is rich with a pre-tax income OY1 while individual
2 is poor with a pre-tax income OY2. Tax reduces individual 1’s income to 0Y1' and individual 2’s
income to 0Y2' but they both suffer the same loss of utility given by U . The choice of the tax
structure in this case depends on the rate of decline of the marginal utility of income.
(ii) Equal Proportional Sacrifice

This requires that tax be imposed in such a way that each tax payer loses the same fraction of his
or her total utility. That is, taxation should lead to the same proportional loss of utility for all tax
payers. The fraction of total utility lost because of the tax is the same
This is illustrated in Figure 3.3 where tax reduces individual 1’s income to OY’1 and individual 2’s
income to OY’2, in such a way that AF/AY1 = BE/BY2. The choice of the rate structure depends
on the marginal utility of income schedule.
Total utility TU
A
F
B
0 Y2' Y2 Y1' Y1 Income (Y)
Figure 3.3: Equal proportional sacrifice for individuals with different levels of income
(iii) Equal marginal sacrifice
In this case the tax on each individual is levied in such a way that the post-tax marginal utility of
income is equalised for all individuals. That is, progressive tax has to be imposed which equalises
the post-tax incomes. Both individuals post tax income is equal to 0Y2' as in Figure 3.4. The rule
ensures that the required Tax revenue is raised with minimum total sacrifice to society.
Page 18 of 90
Total utility
TU
U1
U 2
0 Y1' = Y2' Y2 Y1 Income (Y)
Figure 3.4: Equal marginal sacrifice with taxation
NOTE
The equal sacrifice rules have different implications for low income and high income individuals.
The marginal rule is worst for high income households but is best for the low income households.
High income households are better under the absolute than under proportional rule
3.3.4. Challenges in designing tax policy based on ability- to- pay principle
a) Deciding on the three possible interpretations of equality of sacrifice to adopt.
b) Problems of measuring utility
c) It is not certain whether marginal utility of income declines as income rises nor is it clear
whether income is the main determinant of utility.
d) The principle calls for interpersonal comparisons of utility that depends upon cardinal utility
measurement.
e) Index of ability to pay: In seeking to achieve the objective of equality, the government has to
decide whether: income, wealth or spending power is the appropriate index of ability to pay.
Income based taxes serve the objective of equality to sacrifice when income is broadly defined
from all the sources such as work, gifts, inheritance and life time savings etc.
Wealth based taxes are advocated as a way of achieving a more equitable distribution patterns
because it tends to be unevenly distributed than income. But they are unlikely to yield adequate
revenues because there would be difficulties in valuing assets to assess tax liability and in
adjusting asset values for inflation. Similarly there would be difficulties in defining the tax-
paying units as wealth may be held in joint names.
3.4: TAX PROGRESSIVENESS

The tax can be proportional, progressive, or regressive.
Page 19 of 90
Proportional describes a tax system under which an individual’s average tax rate (the ratio of taxes
paid to income) is the same at each income level. Thus the ratio of taxes paid to income is constant
regardless of income level.
In the progressive system, the individual’s average tax rate increases with income
If the average tax rate falls as income increases, then the tax is regressive.
Total tax paid Proportional
Progressive Regressive
Lump-sum tax
0 Income (Y)
Figure 3.5: Types of tax rate structure
Lump sum taxation is a situation where an individual tax liability does not depend on income or
behaviour. An example of a lump sum tax is a head tax of $500, which is independent of earnings
NOTE:
In the above definitions, progressiveness of a tax is not in terms of the marginal tax rate. The
marginal tax rate measures the proportion of the last unit of income taxed by the government (the
change in taxes paid with respect to a change in income).
Consider the example of the income tax structure in Table 3.1 showing the amount of tax paid, the
average tax rate and the marginal tax rate for each of the several income levels.
Table 3.1: Tax Liabilities under a hypothetical tax system
Income ($) Tax Liability Average Tax Rate Marginal Tax Rate
2,000 -200 -0.10
3,000 0 0 0.2
5,000 400 0.08 0.2
10,000 1,400 0.14 0.2

30,000 5,400 0.18 0.2
From Table 3.1, the average tax rate increases with income, however the marginal tax rate is
constant at 0.2 because for each additional dollar earned, the individual pays an additional 20 cents
regardless of the income level.
Page 20 of 90
Two approaches to measuring progressiveness of a tax system
(a) The greater the increase in average tax rates as income increases, the more progressive
the system.
Algebraically, if we let T0 and T1 be the true tax liabilities at income levels l0 and l1
respectively (l1 is greater than l0). The measurement of progressiveness v1, is:
𝑇1 𝑇0
−
𝐼1 𝐼0
𝜈1 = (1)
𝐼1 −𝐼0
Once the analyst computes the values of T1 and T0 and substitutes into Equation (1), the tax
system with the higher value of v1 is said to be more progressive.
(b) A tax system is more progressive than another if its elasticity of tax revenues with respect
to income (i.e. the percentage change in tax revenues divided by percentage change in
income) is higher.
Here the expression to be evaluated is v2, defined as

(𝑇1 −𝑇0 ) (𝐼1 −𝐼0 )
𝜈2 = ÷ (2)
𝑇0 𝐼0
Illustration
Consider a proposal in which everyone’s tax liability is to be increased by 20 percent of the amount
of tax he/she currently pays.
This proposal would increase the tax liability of a person who formerly paid T0 to 1.2 x T0, and the
liability that was formerly T1 to 1.2 x T1.
The finance minister says that the proposal will make the tax system more progressive, while a
member of the opposition says it has no effect on progressiveness whatsoever.
Who is right? It depends on the progressivity measure.
Substituting the expressions 1.2 x T0 and 1.2 x T1 for T0 and T1 respectively, in equation (1), v1
increases by 20 percent. The proposal thus increases progressiveness.
On the other hand, if the same substitution is done in equation (2), the value of v 2 is unchanged.
(Both the numerator and denominator are multiplied by 1.2, which cancels out the effect.)
Thus even very intuitively appealing measures of progressiveness can give different answers.
Two people would disagree about the progressiveness of a tax system and each would be right
depending on their individual definition of tax progressiveness.
Page 21 of 90
3.5: SUMMARY
Tax equity in taxation can be achieved on the basis of the benefit principle or ability to pay principle
Under the benefit principle, taxes are paid in accordance with the benefits received from government
expenditures. Ability to pay principle on the other hand requires that taxes be imposed according
to what one can afford to pay
The benefit taxation is feasible where goods provided by the public sector are in the nature of private
goods and where taxes could be levied on complementary products in lieu of changes on pure public
goods.
The use of benefit principle has very limited use in the case of pure public goods because of
difficulties in isolating and measuring the benefits of public service to an individual. It rules out the
basic functions of a government like helping the needy and assumes that distribution of income is
proper. The fact that state budget is determined through a political process and individuals do not
go by their own interest only creates a problem where tax revenues based on benefits received do
not match the government’s expenditure
The ability to pay principle reflects fairness in the distribution of the tax burden where people are
equally treated to achieve horizontal and vertical equity. The index of ability to pay could be income
or wealth.
To achieve vertical equity, equal absolute sacrifice, equal proportional sacrifice and equal marginal
sacrifice rules could be used
The tax can be proportional, progressive, or regressive depending on how the average tax rate varies
with income. It is Proportional if an individual’s average tax rate is the same at each income level;
progressive if an individual’s average tax rate increases with income, and regressive if average tax
rate falls as income increases.
Tax progressiveness can be measured on the basis of changes in the average tax rate as income
increases or on the basis of income elasticity of tax revenue.
Page 22 of 90
TOPIC FOUR: TAXABLE CAPACITY AND TAX EFFORT

• Define taxable capacity
• Distinguish between absolute and relative taxable capacity
• Describe the procedures for measuring taxable capacity and tax effort for country
• Explain the factors that influence taxable capacity and tax effort of a country
4.2 TAXABLE CAPACITY

4.2.1 Introduction
High taxation lead to increase in revenue of the state but it reduces the purchasing power of the
people and adversely affects their ability and willingness work, save and invest. Taxable capacity
fixes the limit beyond which the government cannot tax the people. If the government taxes people
beyond this limit it will fail in its tax effort; i.e. productive efforts and efficiency of production will
begin to suffer. The finance minister of every country must therefore keep the taxable capacity of
the people in mind whenever he/she is imposing new taxes or increasing the rates of existing taxes
so as to avoid
- widespread discontent among the people who will oppose government’s tax measures
vehemently if their taxable capacity is overstepped
- unnecessarily denying the government its due share of revenue from taxes by imposing
taxation at a level much lower than the taxable capacity of the community
4.2.2 Definition and Measurement of taxable Capacity

Taxable capacity is defined as “the ability of people to pay taxes without adversely affecting or
worsening their standard of living and efficiency”.
Taxable capacity is usually used in two senses

- Absolute taxable capacity
- Relative taxable capacity
(i) Absolute Taxable Capacity

This indicates the amount of money or proportion of national income that can be taken away, by
the government, from people in the form of taxes without producing the unfavourable effects. In
other words, it represents the maximum amount of tax revenue that can be collected from the
individuals of a particular country during a particular period.
The definition of absolute taxable capacity has been interpreted by economists in different ways
(i) The total production minus the amount required for maintaining the population at
subsistence level”.
Limitations of the interpretation

- It is not possible to measure the subsistence level of a community
- If the entire amount i.e. total production minus subsistence consumption is taken away by
the state from the citizens as taxes, their living standards are bound to be adversely affected.
Page 23 of 90
Their efficiency will decline and the production of goods and services will fall resulting in
serious reduction in the future productive capacity and the absolute taxable capacity of the
society.
(ii) To address such limitations another definition has been given: absolute taxable capacity is
represented by the difference between total production and total consumption. According
to the definition, there are two limits to the taxable capacity of people which are determined
by check to total production and check to the total revenue yield as a result of imposition
of higher rates of taxation.
If higher rates of taxation results in lower production in the country and does not bring in
additional revenue to the government, then it should be presumed that the taxable capacity
of the country has been overreached.
(iii) Another interpretation to absolute taxable capacity is “the limit of squeezability” That is,
the total surplus of production over the minimum consumption required to produce that
volume of production, the standard of living remaining unchanged.
Limitation
- This definition considers community’s standard of living as something static for all time to
come. This cannot be the case because the main objective of economic growth in a country
is to bring about a rapid rise in the standard of living of the people.
NOTE
These definitions explain the absolute taxable capacity of a country. However, the determination
of a country’s absolute taxable capacity is almost impossible. The definitions are vague and
ambiguous and lack practical importance.
- every tax has the unpleasant effects of reducing income of tax payers hence it makes little
sense if we say that absolute taxable capacity is the limit up to which a community can be
taxed without producing unpleasant effects. It is not possible to single out any particular
unpleasant effect as indicating the limit of taxable capacity. Capacity to pay without
suffering is thus zero.
- If on the other hand taxes are paid without regard to suffering, the only practical limit to
taxable capacity is the total income of tax payers. Practical limit to taxable capacity therefore
lies somewhere in the middle. The problem is that it cannot be correctly identified.
(ii) Relative taxable capacity
federation, can contribute in the form of taxes in order to meet some common expenditure. That is,
it is the capacity of the community to contribute to some common expenditure in relation to the
capacities of other communities.
If one community is contributing more than its due share, then its taxable capacity will have been
exceeded. It is possible to determine in advance the proportion in which two or more communities
should contribute in order to meet some common expenditure.
In accordance with their respective “abilities to pay” - The richer community shall be called upon
to bear a greater share of such common expenditure. If the common expenditure increases due to
certain reasons, the contribution of the richer section of the community shall rise at a rate faster
Page 24 of 90
than that of the poorer section. For example, in sharing the total expenditures of the United Nations
Organisations, the richer countries contribute a larger proportion of the total expenditures.
NOTE
There is no logical connection between the relative and absolute taxable capacity. A community
may be contributing toward a common expenditure in excess of its relative taxable capacity, but its
absolute taxable capacity has not been reached. Similarly, a country might have been taxed in
excess of its absolute taxable capacity while its relative taxable capacity towards meeting a
common expenditure is not exceeded.
It is true that we cannot measure the absolute taxable capacity of a country with any degree of
accuracy. However, just like other concepts in economics that cannot be measured with accuracy
but play important roles in the formulation of economic laws and principles, we cannot deny the
existence of absolute taxable capacity and its importance in public finance.
4.2.3 Factors Determining Taxable Capacity

The taxable capacity of a country depends on several factors. Some of the important factors which
determine the taxable capacity of people are as follows;
(i) Wealth: - the greater the wealth of a country, ceteris paribus, greater will be its taxable
capacity and vice versa.
(ii) Distribution of wealth: - the wealth of a nation may be so distributed that a large proportion
of the country’s total population reaches the income or wealth limit which is taxed. This is
the case when the distribution of income or wealth in a country is more equal. In such a
case, for direct taxes, the taxable capacity will be much lower. But if there are only few rich
people who are subject to all kinds of taxation, and others remain poor, the taxable capacity
of the country will be high. Thus the greater the inequality of income, higher shall be the
taxable capacity. The reason for this being that the government under such conditions can
get an adequate income by imposing taxation on the richer sections of the community.
(iii) Size of population: - other things being equal, the greater the size of population, lower will
be the taxable capacity of a country. This is because expenditure on consumption increases
as a result of the increase in population. However, if the productive capacity of the country
increases in the same proportion in which its population increases the taxable capacity will
be unaffected.
(iv) Stage of economic development: - the taxable capacity of developed countries is greater
than that of the less developed countries.
(v) Nature of the tax system: -if the tax system of a country is wide in its scope, the taxable
capacity would be high. If the tax system satisfies the canon of economy and convenience,
the taxable capacity would be high. if the tax system produces adverse effects on the
economy the taxable capacity of the country will be low
(vi) Price level: - the surplus or excess of income over expenditure forms the taxable capacity
of a country. This surplus will be low if prices are high. low prices will therefore enhance
the taxable capacity of the people in a country
(vii) Stability of income: - the national income of developed countries is generally stable I n that
there are no violent fluctuations in their national incomes. However, in the less developed
countries, there is instability in national income because a large proportion of the population
derives its livelihood from agriculture which is highly dependent on weather. This is one
of the reasons why the taxable capacity of developed economies is higher than that of
developing economies.
Page 25 of 90
(viii) Psychology of tax payers: - During war time, people are prepared to make greater sacrifices
for the country. The sense of democracy, citizenship and responsibility toward the working
of the government, are those factors that if present in taxpayers, increases the taxable
capacity of people and vice versa.
(ix) Political conditions: - when some natural calamities like epidemics, floods, famine, etc.
occur in any part of a country, people generally become willing to pay more taxes.
(x) Standard of living of people: - when the standard of living of people in a country is low,
greater surplus is available for taxation purposes.
(xi) Kinds of taxes levied and manner of raising taxes: - whether the taxes are imposed on
income or property, or on the production of certain goods or on consumption of income,
makes a great deal of difference on the revenue raising capacity of the government. Further,
how much resources the government can get through taxation will also depend on the
manner in which taxes are imposed. Government can get more revenue with progressive
taxation than when taxes are proportional or regressive.
(xii) Nature of government expenditure: - When good and productive use of money is made, it
increases the wealth of the country and consequently the taxable capacity of the people. It
is not only the effect of public expenditure on production of wealth that matters, but also
the effect of the public expenditure on the mental reaction of the people. The gove5rnment
can favourably change the outlook and reaction of the public to tax levies. It can also change
the wants of people and make them prefer a low standard of life than the one to which they
are accustomed and by so doing it can raise the taxable capacity of the people.
4.3 TAX EFFORT
4.3.1 Tax Effort and Tax shares
Tax effort is an index measure of how well a country is doing in terms of tax collection, relative to
what could be reasonably expected given its economic potential. It is a ratio that, by construction,
is always positive.
Tax effort for a country is calculated by dividing the actual tax share by an estimate of how much
tax the country should be able to collect given the structural characteristics of its economy.
Studies identify the general level of economic development of a country, its openness to trade and
the relative importance of agriculture in domestic production, as the key characteristics bearing on
a developing country’s ability to collect taxes, and thus its tax share. Empirically, these
characteristics are captured respectively by per capita income, the ratio of trade to GDP, and the
share of agriculture to GDP.
In earlier work, the principle determinants of the tax share in GDP (or GNP) are presumed to
include the sectoral composition of value added, the overall level of industrial development, and
the importance of international trade in the economy. The sectoral composition of value added is
likely to be an important influence on the tax share because some sectors of the economy are more
amenable to taxation and generate different taxable surpluses.
(i) For developing countries, the share of agriculture in the economy may be an important
determinant of taxable capacity because small farmers are notoriously difficult to tax and
subsistence agriculture (which is generally associated with a large share of agriculture in
the economy) does not generate large taxable surpluses. Further, many countries are
unwilling to tax main foods that are used for subsistence. To some extent, however, a large
share of agriculture may reflect an export industry in certain crops, which might be more
Page 26 of 90
amenable to taxation. However, in countries where agriculture is highly productive as an
industry, the share of agriculture in the economy is relatively small.
(ii) The mining share may be important as mining can generate large taxable surpluses. In most
countries, there are usually only a few large firms engaged in mining, which facilitates tax
administration. However, in most cases foreign investment in mining and oil extraction is
common and countries often give significant tax concessions to the foreign investors. This
limits the potential revenue collections from this source (though they may collect
substantial revenues in the form of transfers to the budget, as in Nigeria).
(iii) The share of manufacturing may also be important as manufacturing enterprises are
typically easier to tax than agriculture since business owners typically keep better books
and records and manufacturing can generate large taxable surpluses if production is
efficient. Unfortunately, it is difficult to separate demand and supply-side factors.
Agricultural societies generally demand higher levels. Thus, it may be inappropriate to
interpret the composition of GDP variables as reflecting only supply-side factors
(iv) Per capita income is typically considered the best proxy for the overall level of
development. This factor may have explanatory power beyond sectoral share, though these
factors are usually linked to each other, since the share of services and industry increases
with the level of development and income. One problem with using nominal magnitudes in
a cross country analysis is that they must be converted into a common currency, such as the
U.S dollar. If exchange rates do not reflect purchasing power parities, the comparison based
on a common currency may be skewed, though if there is some systematic skewing across
the countries then this may not bias the results. One possibility, however, is to convert the
nominal magnitudes into a common currency using purchasing power corrected exchange
rates.
(v) The share of international trade in the economy is a measure of openness. Certain features
of the international trade make it more amenable to taxation than domestic activities. In
developing countries, the international trade sector is typically the most monetized sector
of the economy. Entrance and exit to the country takes place in specified locations. Thus
import or export shares could be important determinant of tax share
NOTE
Country comparisons based on tax effort are considered superior to those relying on tax shares
because they take into account the way in which each country exploits its tax potential. A high tax
effort ratio, above one, indicates that the country is collecting more taxes than predicted by the
structural characteristics of its economy. A low tax effort ratio, below one, indicates that the
country is collecting less tax than predicted. A tax effort about one means that tax collection is as
expected from structural characteristics.
4.3.2 Methods of estimating tax effort
a) We can do a regression for a sample of countries, the tax to GDP ratio on explanatory variables
that serve as proxies for possible tax bases and other factors that might affect a country’s
ability to raise tax revenues. The predicted tax ratio from such a regression is considered a
measure of “taxable capacity”. The regression coefficients are interpreted as average effective
rates on those bases. The ratio of actual to predicted tax ratios is then computed and used as
an index of “tax effort.”
b) Another alternative is to calculate average effective tax rates of a sample of countries and to
apply them to a standard set of tax bases for those countries. This measures the tax that would
be collected if a country applied a standard tax rate to a standard tax bases. The ratio of the
actual yield to a standard tax yield is used as an alternative index of “tax effort.”
Page 27 of 90
There are conceptual similarities and differences between these two general approaches.
- In both cases, tax effort is defined as a ratio of tax revenues to some measure of taxable
capacity.
- They also assume that the tax bases and the explanatory variables reflect only differences in
taxable capacity and not tax effort. This is unfortunately a rather strong assumption.
- It is perhaps implausible that tax bases and other economic characteristics do not also reflect
the demand for public spending (hence public revenues) so that the measure is not simply
one of tax capacity
- One advantage of the regression approach is that in principle it controls the measure of
taxable capacity for factors other than tax bases, while the average tax system approach does
not.
4.4: SUMMARY
Taxable capacity defines the extent to which people can be taxed without the worsening of
standards of living
It measures the proportion of total income that can be taken as tax without producing
unfavourable effects
Relative taxable capacity defines the proportion of a common budget that a given state can
contribute in form of taxes
Tax effort an index measure of how well a country is doing in terms of tax collection relative
to what could be reasonable expected given its economic potential.
The tax share is expected to increase with GDP and the share of foreign trade; it decreases with
the share of agriculture. Low-income, predominantly rural, land-locked countries tend to have
a lower tax share than upper-middle income, coastal and significantly industrialized countries.
The larger the agricultural share in an economy the lower the tax share is likely to be due to
the difficulty of taxing agriculture directly and the relatively low level of monetization in the
agricultural sector. However, a large industrial sector implies a higher tax share since this
sector is typically well-organized, highly monetized and relatively easy to tax in comparison
to the agricultural sector.
It is calculated by dividing the tax share by an estimate of how much tax the country should be
able to collect given the structural characteristics of its economy.
Page 28 of 90
TOPIC FIVE: TAX BURDEN

• Distinguish between Tax Burden and Tax Liability
• Define excess burden of taxation
• Describe two approaches the measurement of excess burden of taxation
• Relate the excess burden of taxation to price elasticity of demand
5.2: TAX LIABILITY, TAX BURDEN AND EXCESS BURDENOF TAX

The economic concern on the “burden of taxation” is that taxes that deter economic activity create
an “excess burden” or dead weight loss. The more general meaning of the term burden of taxation
ignores the many benefits derived from public services financed by the tax revenues.
Tax burden refers to the total loss of welfare due to taxation. Tax liability on the other hand refers
to actual sum of money a taxpayer is required to pay or the proportion of one’s income paid in
taxes.
It is often assumed that tax burden equal total tax liability to an individual. However, this may not
always be the case. There are cases where tax burden can be more than tax liabilities. Where tax
burden exceeds tax liability there is excess burden.
Illustration1
Suppose a tax is imposed on radio sets (value added taxes) in order to raise one million shillings.
The sum total of tax collections from various consumers still equals one million shillings, but the
burden imposed on the private sector will be larger. This is so because the tax interferes with
consumer choices.
Some people who had planned to buy the radios may avoid buying them because of the tax payable.
Therefore, they pay no taxes but the budget choice is less satisfactory than it was before. These
taxpayers therefore suffer burdens which are not reflected in total revenue. Others may reduce their
purchases and pay a tax on the reduced amount. In both cases above the consumer’s expenditure
pattern has been distorted by the tax. Each taxpayer suffers a burden which is greater than that
which would have applied if they had paid the same amount as a flat charge.
Illustration 2
Another reason why tax revenue and total burden may differ is observed when the imposition of
tax leads to a change in factor inputs and hence in total output. Suppose the same revenue as in the
previous example is collected under a progressive income tax. The result is that workers may work
more or less because the tax is imposed. If they work less, their earnings fall. If this decline in
earnings is counted as part of the burden, the total burden once more exceeds tax revenue. Because
the same tax revenue is collected but additional loss of welfare is borne by those whose income
decrease.
Illustration 3
Excess burden over liability in taxation can also be considered from the employment point of view.
Changes in output may result, not because of adjustments in factor inputs in response to changes
Page 29 of 90
in after – tax factor rewards, but because of resulting changes in the level of aggregate demand and
unemployment.
NOTE
The overall burden suffered by the private sector tends to exceed the amount of revenue obtained.
The amount by which the tax burden exceeds tax liability is called “excess burden of tax.” The
excess burden of a tax is the loss of welfare above and beyond the tax revenues collected. It is also
referred to as welfare cost or deadweight loss due to taxation.
Excess burden arises from distortions caused by imposition of a tax
5.3: MEASURING EXCESS BURDEN OF TAX

There are two approaches to measuring the excess burden of taxation
- The Indifference curve approach
- The compensated demand approach
5.3.1 Indifference curve approach

The excess burden of a tax is illustrated in the graph below using the concepts of budget line and
indifference curve.
In Figure 5.1, good X is measured on the horizontal axis while good Y is measured on the vertical
axis. The consumer is assumed to consume both commodities.
Y A
Tax Revenue
G
H Equivalent Variations
E2 M
C2
N E3 E1
C3 i
ii
F I D
0 B2 B3 B1 X
Fig.X5.1: Measuring excess burden using Indifference curves approach
The pre-tax budget line is AD with consumer equilibrium at E1.
The imposition of a percentage tax tx on commodity X increases the price of X to (1+ tx) Px and
results in a tilt in budget line from AD to AF with equilibrium at E2 on the indifference curve ii
indicating a loss in welfare or a decrease in utility.
The tax bill is equal to GE2.
Page 30 of 90
An alternative way of measuring the reduction in utility is equivalent variation – the amount of
income that needs to be taken away from the consumer (before the tax was levied on X) to induce
her to move from i to ii.
The equivalent variation measures the loss inflicted by the tax as the size of the reduction in income
that would cause the same decrease in utility as the tax. This equivalent variation is equal to
ME3=GN.
The amount by which the loss in welfare (measured by the equivalent variation) exceeds the taxes
collected (i.e. the excess burden) is distance E2N.
5.3.2 The compensated demand approach

The excess burden can also be measured using compensated demand curve (derived from the above
analysis) as follows. In Figure 5.2 D represent the demand for commodity X; and S b and Sa
represent the before and after tax supply of commodity X respectively.
The graph is drawn under the assumption that the social marginal cost of commodity X is constant
at Px
At Px, the consumer’s surplus is aih. At (1+ tx)Px, the consumers’ surplus reduces to agf.
The difference between the pre-tax and post-tax consumer’s surpluses consists of the revenue gfhd,
which goes to the government and the part fdi which is lost.
Price a Tax Revenue
Excess Tax Burden
(1+tx)Px g f Sa
Px h d i Sb
q2 q1 Qty of X
Fig. 5.2: Measuring excess burden using Compensated demand curve
The area fdi is the welfare cost or deadweight loss of a tax. It is equal to the area of the triangle fdi
which is algebraically given by one-half of the product of its base and height given by:
1
× (𝑔 − ℎ) × (𝑞2 − 𝑞1 )
2
NOTE:
In the compensated demand approach the assumption is that the value of public sector output is
equal to the tax revenue. Thus the area fdi is taken as the measure of the deadweight loss. However,
in practice
1. The deadweight loss of welfare will be reduced if the tax is used to finance services that yield
substantial positive externalities, and if the public services are complementary to private sector
Page 31 of 90
outputs. If this is true then the public sector outputs will be valued more than their tax costs and
the area fdi for excess burden can be reduced or possibly be eliminated so that excess benefits
or gain in welfare results
2. If however, tax revenues were to be used to finance public services yielding little or no positive
externalities and the production of which are at excessively higher costs (inefficiency in
production) or provision in quantities greater than citizens’ wish to consume (inefficiency in
consumption), then the area fdi would underestimate the excess burden of taxation
5.4: SUMMARY
Excess burden of taxation measure the deadweight (efficiency) loss associated with a tax. It
shows the loss in welfare over and above the tax revenues raised from taxation.
Excess burden of tax can be measured from the compensated demand approach or the
indifference curve approach.
In the compensated demand approach the excess burden is given by the difference between total
loss in consumer and producer surpluses and total tax revenues raised while it is given by the
difference between the equivalent variation and tax liability in the indifference approach.
Page 32 of 90
TOPIC SIX: TAX INCIDENCE AND TAX SHIFTING

• Define tax incidence
• Describe the various forms of tax shifting
• Distinguish between partial and general equilibrium approaches to tax incidence
analysis
• Use partial equilibrium approach to analyse incidence of tax
• Explain the factors that influence the extent of tax shifting
6.2: DEFINITIONS
Tax Incidence
Tax incidence indicates who actually bears the burden of the tax. While a firm may be legally liable
to pay customs and excise duties on its products, it may attempt to recover tax increases by shifting
the burden to other agents that transact with it. This can be in the form of any of the following:
- Raising product prices (forward shifting)
- Reducing the prices paid for its inputs of land, labour and capital (backward shifting)
- Reducing dividends paid to its shareholders (lateral shifting)
- Or by some combination of all the three responses
Concepts of Incidence
The statutory /formal incidence of a tax indicates who is legally responsible for the tax i.e. whom
the initial impact of the tax falls or where legal liability of the tax falls. Knowledge of statutory
incidence tells us essentially nothing about who really pays the tax.
The economic /effective incidence of a tax is the change in the distribution of private real income
induced by a tax. That is, it refers to the final resting place of a tax after all individuals and firms
have adjusted their behaviour in respect of work, spending, saving and investment. This is
important because individuals or firms will attempt to shift the tax backward to suppliers and
forward to consumers.
Absolute tax incidence examines the effects of a tax on the whole economy or on individual
households, when there is no change in other taxes or government expenditure. Absolute incidence
is of most interest for macroeconomic models in which tax levels are changed to achieve the
stabilization goal.
Taxes will reduce the level of disposable income both at macro and micro level. At macro level,
an increase in taxes leads to a decrease in aggregate demand. If the public policy is to stabilize the
economy by increasing taxes without changing government expenditures, the course that the
economy will take will depend on distributional effect of the tax itself. An increase in tax depending
on state of the economy can lead to unemployment, a reduction in prices or can lead to a shift in
resources from one use to another use, so that each tax action has its own effect and distribution
implication.
Page 33 of 90
Differential tax incidence: examines how incidence differs when one tax is replaced with another,
holding the government budget constant. Because differential incidence looks at changes in taxes,
a reference point is needed. The hypothetical “other tax” used as the base of comparison is often
assumed to be a lump sum tax (a tax for which the individual’s liability does not depend upon
behaviour). For example, a 10 percent income tax is not a lump sum tax because it depends on
how much the individual earns. But a head tax of $550 independent of earnings is a lump sum.
Budget Incidence: Budget incidence may originate from changes in government expenditure or
changes in taxes. Government expenditure may be on transfer payment, salaries to civil servants,
capital expenditures for development, purchases of goods and services, and debt repayment and
servicing. Incidence of government expenditure can be explained in various ways:
- Under normal circumstances, Increase in government expenditure leads to increase in
disposable real income and further increase in employment in the country. This is under
normal circumstances. But, if not planned well, increase in government expenditure may lead
to increased aggregate demand over aggregate supply, hence leading to inflation.
- On the other hand, increase in taxes has the opposite effect. Its immediate effect is a reduction
in real disposable income, increased unemployment, or reduced inflation.
NB: Taxation and government spending take place simultaneously. Those taxes reduce earnings of
the private sector and in particular they reduce disposable income. As a result of this, benefits from
public goods will increase while benefits from private sectors will decline.
These effects constitute budget incidence of a tax.
6.3 TAX INCIDENCE ANALYSIS

6.3.1 Introduction
There are two principal approaches to tax incidence analysis; partial Equilibrium Approach and the
general Equilibrium approach. The partial equilibrium models look only at the market in which the
tax is imposed and ignores the ramifications in other markets. The approach is only appropriate
when the market for the taxed commodity is relatively small compared to the economy as a whole.
The analysis uses supply and demand model of perfect competition.
Taxes on goods can be administered as unit taxes or advalorem taxes:

- Where tax is collected on each unit of output produced or sold it is called a unit tax.
- Where it is quoted as a percentage of selling price it is called an advalorem tax.
Illustration
A tax quoted as shs.20 per Kilogram, is a unit tax.
A tax quoted as 5% of manufacturer’s price or 10% of wholesale price, depending on where it is
collected is an advalorem tax.
NOTE
Irrespective of their kind, taxes will disrupt the equilibrium existing between demand and supply
in the market.
6.3.2 Effect of imposing a unit tax
Page 34 of 90
An increase in tax of a given commodity increases the price and reduces the demand for the product
depending on price elasticity of demand of the product.
Price S’
a S
F G
B H A
K L
0 E Qe Quantity
Figure 6.1: Effect of a unit tax
When a unit tax is imposed, its effect is to shift the supply curve upwards from S to S1. Unit tax is
viewed here as additional to cost. S is the supply schedule prior to tax and S 1 is the supply schedule
after imposition of a unit tax “a.” The demand schedule is given by D.
- Quantity demanded declines from OQe to OE.
- OB is Price before tax and OF is Price after tax.
- Total tax rate is KF.
- BF is tax rate payable by consumer per unit sold.
- KB is tax rate paid by seller of the product.
- Total amount of tax revenue collected from both seller and consumer is represented by area
KFGL.
- Consumer pays the amounts of tax represented by area BFGH.
- Producer pays the amount of tax represented by area KBHL.
6.3.3 Effect of imposing an advalorem tax

When it comes to advalorem tax, the case is different. Tax is a function of the price per unit sold,
since tax is expressed as per cent of selling price.
Unlike in unit tax where the supply curve shifts when tax is introduced, in the case of advalorem
tax it is the demand curve which shifts downwards.
Tax amount collected is still represented by the difference between the price paid by consumer and
net price received by seller. Also note that when advalorem tax is imposed, although the demand
curve shifts downwards, the shift is not uniform because the amount of tax per unit falls as the
quantity sold increases.
Page 35 of 90
Price D
S
G
F
D1
H A
B
K J
L
S D1 D
Quality
O E Qe
Figure 6.2: Effect of an advalorem tax
In Figure 6.2, DD is the market demand schedule and SS is the supply schedule. Equilibrium output
before tax equals OQe, and price equals OB.
AJ
When an advalorem tax at rate t = is imposed, the net demand schedule shifts to D1 D1
AQe
Output falls to OE, and the gross price rises to OF, and the net price falls to OK. Total tax revenue
is represented by area KFGL. Consumer pays the amount of tax represented by area BFGH.
Producer pays the amount of tax represented by area KBHL.
There are two ways of quoting advalorem tax from the diagram;
GL
(i) Net advalorem tax rate if quoted as t =
EL
GL
(ii) Gross advalorem tax rate if quoted t =
EG
6.4: FACTORS INFLUENCING THE EXTENT OF TAX SHIFTING

6.4.1: The relative elasticities of demand and supply
Immediate effect of imposing tax on commodity is to raise its price. But the resulting changes in
price magnitude by which the price will rise or fall will depend on elasticity of demand and supply.
(i) When both demand and supply schedule are elastic, an increase in tax leads to a less than
proportionate increase in price.
Page 36 of 90
P S2
S1
G
F
H A
B
K
L
D
Q
O E C
Figure 6.3: Tax incidence with elastic demand and elastic supply curves
From Figure 6.3 we note that total tax liability equals total tax collected from both producer and
consumer and is represented by area KLGF. Tax burden to the consumer is given by area BHGF,
with tax rate burden BF. The supplier’s tax burden is given by area KLHB with tax rate to supplier
given by BK.
The burden to the consumer reflect the additional amount which they must pay in order to get new
quantity OE, compared with what they would pay in order to get whole larger quality OC. To the
consumer, tax effect is increased prices from OB to OF and reduced demand from OC to OE. The
burden to supplier is reflected in reduced supply and reduced net price. Supply falls from OC to
OE. Net price falls from OB to OK. This leads to less net revenue from the sale of product.
This explanation suggests a very important rule that the burden of tax is divided between the buyer
and the seller as ratio of elasticity of supply to elasticity of demand in the relevant range of demand
and supply schedule.
Consider the Figure 6.3, when demand curve and supply curve are rotated around point A, then it
is clear that the buyer’s share in the tax burden increases as the demand curves becomes less elastic
and supply curve becomes more elastic. In other words, the consumers share in the tax burden
increases as demand schedule steepens or becomes more inelastic and the supply schedule flattens
or becomes more elastic.
Therefore
Bb Es
=
Bs Ed
Where Bb and Bs represent the buyer’s and seller’s shares in the tax burden
Es is price elasticity of supply and Ed, the price elasticity of demand
Proof
Q P0
Elasticity of demand, Ed over the relevant price range OF is given as: Ed = 
P Q0
P0 is the original price = OB and change in Price is defined by OF – OB = BF

Page 37 of 90
Q0 is the initial demand = OC and change in demand is defined by OC − OE = EC
EC OB
Therefore; Ed = 
BF OC
Q P
Similarly to obtain elasticity of supply by Es = 
P Q
Change in Price is BK from the initial price (P 0) given by OB, and change in Q is EC from the
initial OC. Therefore;
EC OB
Es = 
BK OC
The elasticity of supply is based on net price (OK) to the seller after the tax (FK) as compared to
original price (OB) before tax. From the expressions for Es and Ed, the ratio of elasticity of SS to
DD will be
EC OB

Es BK OC BF
= =
Ed EC OB BK

BF OC
BF is tax rate payable by consumer and BK is tax rate payable by supplier.
We can also interpret BF and BK as follows: BF is buyer’s share in tax burden and BK is seller’s
share in tax burden.
Es BF Buyers share of tax burden Elasticity of sup ply
Therefore, = → =
Ed BK Sellers share of tax Burden Elasticity of dmend
Different cases
1. Where demand is perfectly inelastic while supply is elastic the whole tax burden is transferred
(shifted) to consumer
Price D S + tax
S
P1
P0
0
Quantity
Figure 6.4: Tax incidence with perfectly inelastic demand
Figure 6.4 shows that change in price does not lead to any Quantity demanded. The Consumer
Pay all tax burden as shown by shaded region.
Page 38 of 90
2. Where the supply schedule is perfectly inelastic and demand curve is downwards slopping, an
increase in tax results to a decrease in the price received by sellers. This is because the buyers
continue to by the same quantity at the previous prices. The whole tax burden is borne by the
supplier.
Price S
P0
P1
D0
D1
0 Q Quantity
Figure 6.5: Tax incidence with perfectly inelastic supply curves
3. Where there is perfectly elastic demand and an elastic supply, the effect will be as shown in
Figure 6.6. The price paid for a unit of the good remains P0 as before. The consumers continue
to buy the same quantity. Sellers bear the whole tax burden
Price S + tax
P0 D
P1
0 Q Quantity
Figure 6.6: Tax incidence with perfectly elastic demand
4. When supply is perfectly elastic while demand is downward sloping the entire tax burden falls
on the consumer. They must continue to receive the same price for the same quantity. The entire
tax is shifted to buyers
Page 39 of 90
Price
P0 S
D0
0 Q Quantity
Figure 6.7: Tax incidence with perfectly elastic supply curve
NOTE
The illustrations given show that the more elastic the supply curve relative to the demand curve,
the greater the burden to the consumer and the more elastic the demand curve, the greater the
burden to the seller.
5.4.2 Other Factors Influencing the Effective Incidence of Tax
(i) Type of tax e.g. in the case of a sales tax, the sellers quite often adopt the practice of
quoting the sale price as seen and once the bargain has been settled, add the sales tax in
the bill. Such a practice tends to break the resistance of the buyers and it becomes easier
to shift the incidence of the tax on to them.
(ii) Large usage of advertising and publicity. With large usage of advertisement, some prices
comes to be fixed and acceptable as normal, tax or no tax. It is not easy to shift the tax
here by means of a price vice. However a possibility may exist to shift the tax by
deteriorating the quality or reducing the size of the taxed object. Restaurant quite often
adopt the policy of reducing the sizes of various eatables as a substitute for raising prices.
(iii) Level of competition; sometimes the market may be controlled by a small group of sellers
and by convention, it may be difficult to change the price unless everyone does so. For
example, newspapers having the same price in a city. In this case, it will be easier for all
of them to raise the price and if any one of them do not want to do so, it would be better
to reduce the number of pages or reduce the quantity.
(iv) The shifting of tax depends to a great extent upon the tax rate. If the tax is quite small and
the market is competitive, the sellers may choose to absorb the tax in order to maintain
the good will of the buyers.
(v) It will be more difficult to shift the tax to the buyer in the case of a commodity tax which
has close and effective substitutes. The consumers will then have an easy mean of shifting
their demand if the price of their taxed goods is raised. It means that the elasticity of
demand for these goods will be high and so the tax will have to be borne by the sellers.
However, if the substitutes are also taxed, then the shifting of the tax incidence will depend
Page 40 of 90
upon the general pattern of the demand elasticities for this group of commodities as a
whole vis-à-vis the pattern of their supply elasticity.
(vi) Geographical coverage of a tax in the case of goods taxation, has a great influence in
determining the incidence of the tax in the taxed area. Since the untaxed goods will be
available in the neighbouring area, there will be great resistance of the buyers to bear the
tax incidence. The price of the good will therefore rise to an extent much smaller than
would be the case if geographical area of the coverage was complete. In order to
discourage buying of the taxed commodity in the neighbouring untaxed areas and bringing
them in, the authorities often impose a use tax on the taxed goods if it is brought in from
the untaxed area.
(vii) The degree of market power of the buyers and sellers: A discriminating monopolist may
identify those groups of customers with relatively inelastic demand and pass most of the
tax burden to them unlike an individual firm in perfect competition
(viii) The coverage of the tax base: If indirect taxes are applied selectively to a narrow range of
goods and services consumers will tend to substitute untaxed goods and services for those
taxed. In contrast, value added tax with its extensive coverage limits the scope for
substitution by consumers of untaxed goods and services. The effective incidence of a
value added tax is mainly on consumers which reflect its wide tax base.
6.5: SUMMARY
Tax incidence indicates who actually bears the burden of tax

While statutory incidence tells who is required by law to pay tax, it does not essentially
indicate who really pays the tax. The change in distribution of private real income induced
by a tax gives the final resting place of the tax after all individuals and firms have adjusted
their behavior.
Partial equilibrium analysis demonstrates that the distribution of the tax burden will depend
on the relative elasticity of demand and supply at equilibrium
Buyers bear a greater burden of the tax the more elastic supply curve is while sellers bear a
greater burden the more elastic the demand curve is.
The extent of tax shifting is also influenced by type of tax, level of advertising, level of
competition, tax rate, geographical coverage of the tax, and the degree of market power of
buyers and sellers.
Page 41 of 90
TOPIC SEVEN: EFFECTS OF TAXATION ON ECONOMIC BEHAVIOUR

- Distinguish between incentive and disincentive effect of a tax
- Explain the theoretical basis of analysing effect of a tax on labour supply and Saving
- Explain the relationship between tax rates and tax revenues
7.2: INTRODUCTION
In our analysis s far it is has been assumed that gross domestic product is independent of taxation.
In other words, it is assumed that the only effect is a redistribution of the pattern of production and
consumption between market and tax-financed outputs. The distributional effects represent a
movement along both the production possibilities frontier and its associated contract curve.
However, if high levels of taxation create disincentive-to-work effects then gross domestic product
will be lower as a result of taxation. In such a case the deadweight loss of welfare would severely
understate the total welfare loss because the economy moves inside its production possibility
frontier as factors of production are dissuaded from work. The same outcome would result if
taxation of companies created a disincentive-to-invest effect
7.3: EFFECT OF INCOME TAX ON LABOUR SUPPLY

Income tax affects take-home pay (i.e. post-tax wages).
Consider the example of a backward-bending supply curve of labour shown in Figure 7.1 If an
increase in income tax reduced wages from w2 to w3, then hours worked would fall from h3 to h2
(creating a disincentive-to-work effect). But, if the supply curve is backward bending and an
increase in income tax reduces wages from w1 to w2, the hours worked would increase from h1 to
h3 (creating an incentive-to-work effect).
w1
w2
w3
0 h1 h2 h3 Hours worked
Fig 7.1 Backward bending Labour supply curve
Page 42 of 90
Figure 7.1 shows that income tax will affect the decision to work, which in turn affects output.
However, it is not self-evident whether those effects will be positive or negative.
If work effort is reduced the economy moves within its production possibility frontier. Hence any
such disincentive-to-work effect is important in that it reduces economic growth and therefore the
capacity of the economy to improve living standards generally and to provide benefits for low-
income and the economically disadvantaged groups.
The incentive or disincentive effect of taxation is the net outcome of two effects:
1. The substitution effect. This refers to the substitution of leisure for work or vice versa. The
opportunity cost of leisure is the income forgone by not working. This is the ‘price’ of leisure.
Hence an increase in income tax (leading to a fall in the post-tax wage rate) reduces the cost
of leisure and increases demand for it (i.e. hours worked fall). The reverse occurs when post-
tax wages rise. The substitution effect depends on the price of leisure measured by changes in
the marginal post-tax wage rate, i.e. the extra take-home pay arising from an extra hour’s work
(e.g. overtime). In turn, the marginal wage rate depends on the marginal rate of income tax,
i.e. the extra tax paid divided by the extra income earned.
2. The income effect. Leisure is assumed to be a commodity with a high income elasticity of
demand. Hence the income effect increases the demand for leisure as incomes rise, and
increases work effort as income falls. The income effect depends on the average rate of income
tax (i.e. total income tax paid divided by total earned income).
The net impact of a change in income tax on hours worked depends on the relative sizes of the
income and substitution effects.
1. If the income effect is greater than the substitution effect, an increase in income tax will
increase hours worked and reduce leisure time (i.e. h1 to h3).
2. If the income effect is less than the substitution effect then an increase in income tax will
reduce hours worked and increase leisure time (i.e. h3 to h2).
3. If the income and substitution effects are of exactly the same size, then hours worked will
remain constant.
Separation and measurement of income and substitution effects

In Figure 7.2, I1 and I2 are indifference curves in which the trade-off is between income earned by
working (on the vertical axis) and leisure (on the horizontal axis). Thus the price of leisure is the
income forgone by not working.
Page 43 of 90
Income
B
I1
M I2
e1
C e3
e2 N
0 L1 L2 L3 A Leisure
Fig 7.2: Income and substitution effects of income tax
Lines BA, CA and MN are budget lines showing the maximum combinations of income and leisure
that can be achieved within a given budget. For example, beginning with budget line BA,
maximum income is 0B if no leisure is taken, whilst maximum leisure is 0A if hours employed are
zero. The line BA shows all maximum possible combinations of income and leisure, given the
wage rate.
Assuming that the objective is to maximize welfare, individuals try to locate on the highest possible
indifference curve, I1 being preferred to I2.
The particular combination of work and leisure chosen on I1 is determined by the point of tangency
with the budget line, where the marginal rate of substitution (MRS) of work for leisure required to
maintain a constant level of welfare, equals the marginal rate of transformation (MRT) of work
into leisure. MRS is measured by the slope of the indifference curve. MRT is measured by the
slope of the budget line, which itself measures the ratio of the prices of work and leisure.
Equilibrium exists when MRS equals MRT. Thus the original equilibrium point is e1.
An increase in income tax reduces maximum post-tax income but has no effect on maximum
leisure. Hence the line BA pivots on point A to CA. The rate of income tax is BC divided by 0B.
With the tax, the highest attainable indifference curve is now I2 and the equilibrium shifts from e1
to e2.
Leisure increases from L1 to L2 meaning that hours worked fall. In this case the substitution effect
is greater than the income effect. This is equivalent to the shifting from h3 to h2.
In Figure 7.2, separation and estimation of the income and substitution effects is achieved by
restoring the income to what it was before imposition of the income tax. This is achieved by giving
the individual a lump-sum payment that shifts CA to MN (parallel to CA) which is tangential to
the original indifference curve I1. This restores welfare back to its pre-tax position. But the slope
of MN is now less than that of BA because the relative prices of work and leisure have been
changed as a result of the tax. Hence a new point of tangency occurs at e3.
The shift from e1 to e2 is the net effect of the income tax and depends on the relative sizes of the
income and substitution effects. The movement from e1 to e3 is the substitution effect and is due to
the change in the relative prices of work and leisure. The shift from e3 to e2 is the income effect.
Page 44 of 90
The income effect of a lower post-tax wage reduces leisure and increases work effort, the
movement from e3 to e2 reducing leisure from L3 to L2. The substitution effect of a lower post-tax
wage decreases work and increases leisure, the movement from e1 to e3 increasing leisure from L1
to L3.
In Figure 7.2, the net effect of the income tax is decrease in work effort shown by the shift from e1
to e2 because the substitution effect is greater than the income effect. However, if the income effect
is greater than the substitution effect then e2 will lie to the left of e1, showing that the extra tax
reduces leisure and increases work effort.
NOTE
This theory does not prove that income tax (or increases in it) creates disincentives to work. Whilst
e2 must be to the left of e3, the position of e2 relative to e1 is indeterminate since it depends on
which effect, between the income effect or substitution effect, is bigger.
On the basis of this theory, a poll tax is to be preferred to an income tax on efficiency grounds
because it does not change the relative prices of goods or services (including labour). That is, poll
tax does not destroy the pre-tax marginal equality of MRS = MRT. An income tax destroys the
marginal equality because it is a selective tax on income.
7.4: EFFECTS OF TAXATION ON SAVING

According to the life-cycle model, individuals’ consumption and saving decisions during a given
year are the result of a planning process that considers their lifetime economic circumstances. The
amount one saves each year depends not only on his/her income that year but also on the income
that he/she expects in the future and the income received in the past.
Consider Sarah, who expects to live two periods: “now” (period 0) and the “future” (period 1).
Sarah has an income of I0 dollars now and knows that her income will be I1 dollars in the future.
Think of “now” as “working years,” when I0 is labour earnings and the “future as retirement years,
when I1 is fixed pension income.
Sarah’s problem is to decide how much to consume in each period. When Sarah decides how much
to consume, she simultaneously decides how much to save or borrow. If her consumption this
period exceeds her current income, she must borrow. If her consumption is less than current
income, she saves.
The possible combinations of present consumption (c0) and future consumption (c1) available to
Sarah (her inter-temporal budget constraint) will be characterized by two points
- One option available to Sarah is to consume all her income just as it comes in – to consume
I0 in the present and I1 in the future. This bundle is called the endowment point. Thus the
inter-temporal budget constraint must pass through the endowment point.
- Provided that the individual can borrow and lend at an interest rate of r, the constraint is a
straight line whose slope in absolute value is (1 + r).
Page 45 of 90
Future consumption (c1)
c *1 E1
11 A
Endowment point
slope = 1 + r
saving

0 c 0* I0 N Present consumption (c0)
Figure 7.3: Utility maximizing choice for present and future consumption
Sarah’s budget constraint is MN in Figure 7.3. It runs through the endowment point, A.
To determine the choice along MN, we introduce Sarah’s preferences between future and present
consumption, which are represented by conventionally convex shaped indifference curves. Under
the reasonable assumption that more consumption is preferred to less consumption, curves farther
to the northeast represent higher levels of utility.
Subject to budget constraint MN, Sarah maximizes utility at point E1, where she consumes c 0* in
the present and c1* in the future. With this information, it is easy to find how much Sarah saves.
Because present income, I0, exceeds present consumption, c 0* , then by definition the difference (I0
- c 0* ) is saving.
NOTE
The result in figure 7.3 does not prove that it is always rational to save. If the highest feasible
indifference curve had been tangent to the budget line below point A, present consumption would
have exceeded I0, and Sarah would have borrowed.
Now consider how much the amount of saving changes when a proportional tax on interest income
is introduced. He effect on savings will depend on whether payments of interest by borrowers are
deductible from taxable income or not.
7.4.1: Deductible Interest Payments and Taxable Interest Receipts
Figure 7.4 reproduces the before-tax constraint MN from Figure 7.3 in the situation where interest
is subject to a proportional tax at rate t, and interest payments by borrowers are deductible.
Page 46 of 90
- The after-tax constraint must also pass through the endowment point (I0, I1)), because interest
tax or no interest tax, Sarah always has the option of neither borrowing nor lending.
- The tax reduces the rate of interest received by savers from r to (1 – t) r. Therefore, the
opportunity cost of consuming a dollar in the present is now only [1 + (1 – t)r] dollars in the
future.
- At the same time, for each dollar of interest Sarah pays, she can deduct $1 from taxable income.
This is worth $t to him in lower taxes. Hence the effective rate that has to be paid for borrowing
is (1 – t)r. Therefore, the cost of increasing current consumption by one dollar, in terms of
future consumption, is only [1 + (1 – t)r] dollars. Together, these facts imply that the after-tax
budget line has a slope (in absolute value) of
[1 + (1 – t)r].
The budget line that passes through (I0, I1) and has a slope of [1 + (1 – t)r] is PQ in Figure 7.4. As
long as the tax rate is positive, it is flatter than the pre tax budget line MN.
With indifference curves drawn as before, the new optimum point is at E’, where present
consumption is c 0t , and future consumption is c1t . Saving is given by the difference between resent
consumption and present income, distance ( I 0 −c 0t ). Note that c 0t I 0 is less than c 0*I 0 , the before-
tax amount that was saved. The interest tax thus lowers saving by distance c 0*c 01 .
c *1 E1
P
c 1' E1
11
slope = [1 + (1 − t )r ]
slope = 1 + r

saving
0 c 0* c0' I0 M Q
Present consumption (c0)
Fig. 7.4: Interest receipts taxed and interest payments deductible: Savings decreases
Page 47 of 90
Saving does not always fall. For a counterexample, consider Figure 7.5. The before- and after-tax
budget lines are identical to their counterparts in Figure 7.4, as is the before-tax equilibrium at point
E1.
~
The new tangency occurs at point E , to the left of E1. Consumption in the present is c~0 , and in
the future, c~ . In this case, a tax on interest actually increases saving from c *I to c~ *I .
1 0 0 0 0
Thus, taxing interest can either increase or decrease saving depending on the individual’s
preferences,
c *1 E1
P
~
c 1' E
’
11
slope = [1 + (1 − t )r ]
slope = 1 + r
saving

  
0 c0' c 0* I0 M Q
Fig. 7.5: Interest receipts taxed and interest payments deductible: Saving increases
The ambiguity of the effect of interest tax on savings arises because of the conflict between two
different effects.
- On one hand, taxing reduces the opportunity cost of present consumption, which tends to
increase c0 and lower saving. This is the substitution effect, which comes about because the
tax changes the price of c0 in terms of c1.
- On the other hand, the fact that interest is being taxed makes it harder for a lender to achieve
any future consumption goal. This is the income effect, which arises because the tax lowers
real income. If present consumption is a normal good, a decrease in income lowers c 0, and
hence increases saving.
Just as in the case of labour supply, whether the substitution or income effect dominates cannot be
known on the basis of theory alone.
Can a rational person actually increase her saving in response to an increased tax on interest?
Page 48 of 90
Consider the extreme case of a “target saver,” whose only goal is to have a given amount of
consumption in the future – no more and no less. (Perhaps she wants to save just enough to pay
her children’s future college tuition). If the tax rate goes up, then the only way for her to reach
her target is to increase saving, and vice versa. Thus, for the target saver, saving and the after-tax
interest rate move in opposite directions.
7.4.2: Non-deductible Interest Payments and Taxable Interest Receipts
Figure 7.6 reproduces the before-tax budget constraint MN from figure 7.4. in a situation where
the interest is taxed at rate t, but borrowers cannot deduct interest payments from taxable income.
As was true for Case 1, the after-tax budget constraint must include the endowment point (I0, I1).
P slope = [1 + (1 − t )r ]
11 A
slope = 1 + r
0 I0 M Q
Fig. 7.6: Interest receipts taxed and interest payments non deductible
Starting at the endowment point, A, suppose Sarah decides to save $1, that is, move $1 to the left
of point A. Because interest is taxed, this allows him to increase his consumption next period by
[1 + (1 – t)r] dollars. To the left of point A, then, the opportunity cost of increasing present
consumption by $1 is [1 + (1 – t)r] dollars of future consumption. Therefore, the absolute value
of the slope of the budget constraint to the left of point A is [1 + (1 – t)r]. This coincides with
segment PA of the after-tax budget constraint in figure 7.6.
Suppose instead that starting at the endowment point, Sarah decides to borrow $1, that is, move $1
to the right of point A. Because interest is nondeductible, the tax system does not affect the cost
of borrowing. Thus, the cost to Sarah of borrowing the $1 now is (1 + r) dollars of future
consumption, just as it was before the interest tax. Hence, to the right of point A the opportunity
cost of increasing present consumption by a dollar is (1 + r) dollars.
This coincides with segment AM of the before-tax budget constraint MN.
Page 49 of 90
Putting all this together, then we see that when interest receipts are taxable but interest payments
are non-deductible, the intertemporal budget constraint has a kink at the endowment point. To the
left of the endowment point, the absolute value of the slope is [1 + (1 – t)r]; to the right, it is (1 +
r).
What is the impact on saving?
If Sarah was a borrower before the tax was imposed, she is not affected. That is, if she maximized
utility along segment AM before the tax was imposed, she also does so after.
On the other hand, if Sarah was a saver before the tax, her choice between present and future
consumption must change, because points on segment NA are no longer available to her.
However, just as in the discussion surrounding the cases of 7.4 and 7.5, we cannot predict whether
Sarah will save more or less. It depends on the relative strengths of the income and substitution
effects.
7.5: TAX RATES AND TAX REVENUES

In section 7.3, our concern was with how labour supply would be affected by a given tax regime.
We observed that with a proportional tax, labour supply will fall or increase depending on which
between the income effect and substitution effect is greater. In the event that the substitution effect
is greater, labour supply falls with increase in taxes. This is equivalent to saying that given the
wage rate, labour supply increases with net wages.
In this section we will explore how tax collections to the government vary with the tax rate.
Consider the supply curve of labour SL depicted in figure 7.7 which shows the optimal amount of
work for each after-tax wage, other things being the same.
Wage
SL
w a j k c
(1 -t1)w b d
(1-t2)w e f
(1-tA)w
(1-t3)w h i
L3 LA L2 L1 L0 Hours of work per week
Figure 7.7 Income and labour supply with tax

Figure 7.7 is drawn on the assumption that hours of work increase with the net wage (the
substitution effect dominates). The same argument could be repeated using a labour supply curve
for which the income effect is dominant.
Page 50 of 90
It can be observed from the figure that with no tax, before-tax wage w is associated with L0 hours
of work and no revenue is collected. But if a proportional tax at rate t1 is imposed, the net wage is
(1 – t1)w, and labour supply is L1 hours. Tax collections are equal to the tax per hour worked (ab)
times the number of hours worked (ac), or area of the rectangle, abdc. With similar reasoning if
the tax rate were raised to t2, tax revenues would be eakf. Whether the increase in tax rate from t1
to t2 increases revenues collected requires a comparision of the areas abcd and eakf. In the figure,
area of eakf exceeds abdc indicating that a higher tax rate leads to greater revenue collections.
Do government revenues always increase when the tax rate goes up?
The answer is No. Consider a case where the tax rate is t3, and revenues collected given by the
area haji which is less than the revenues at the lower rate t2. This shows that although the tax
collected per hour is very high at t3, the number of hours worked falls so much that the product of
the tax rate and hours is fairly low. As the tax rate approaches 100 percent, people stop working
altogether and tax revenues fall to zero.
All the preceding arguments are summarised by Figure 7.8 (the Laffer curve) which plots tax rate
on the horizontal axis against tax revenue on the vertical axis.
Tax revenue
R*
t1 t2 tA t3 t4 Tax rate
Figure 7.8: Laffer curve. Relationship between tax revenues and tax rates
At very low tax rates, revenue collections are low. As tax rates increase, revenues increase reaching
a maximum at tax rate tA. For rates exceeding tA, revenues begin to fall, eventually diminishing to
zero.
NB: The laffer curve illustrates that it would be absurd for a government to impose tax rates
exceeding tA, because tax rates would be reduced without the government losing any revenues
Page 51 of 90
7.6: SUMMARY
Personal income taxes affect economic decisions on labour supply, savings, and portfolio
choice among others
Taxes on earnings can increase, decrease or leave unchanged the hours worked, level of savings.
The overall effect will depend on the relative sizes of income and substitution effects of the tax.
Whether personal taxation will increase, reduce or leave unchanged the economic decisions is
therefore an empirical question.
In the analysis of labour supply effects, substitution effect is due to reduction of the opportunity
cost of leisure when taxation lowers the take home wage. Leisure becomes relative cheap and
individual will have more of it and work less. Income effect is when taxes cause reduction in
real incomes and people have to work more to offset the decline
In the analysis of effects of personal income tax on savings distinction is made between the
situation where for borrowers the interest paid on loans tax deductible and the situation where
they are not deductible. Tax is levied on interest earnings for the savers.
Substitution effect in savings case is the reduction in savings (increase in present consumption)
due to the lower opportunity cost of present consumption. Income effect is due to the decrease
in total lifetime resources which tends to reduce preset consumption
Analysis of the relationship between tax rates and tax revenues shows for a given economy,
there will be an optimal tax rate. If rates are lower, the government unnecessarily foregoes
revenues. If rates are higher than optimal, it is possible to reduce rates without necessarily
reducing revenues
Page 52 of 90
TOPIC EIGHT: OPTIMAL TAXATION

• Explain optimal taxation
• Explain the rules for optimal commodity and income taxation
8.2 OPTIMAL TAX
Optimal taxes also referred to as allocatively efficient taxes will have no impact on the allocation
of resources other than those impacts specifically intended to overcome market failure. Thus such
taxes do not lead to inefficient use or reallocation of resources from optimal uses. Optimal taxation
should therefore be interpreted as taxation that does not alter the relative prices of outputs and
inputs. Such taxes will only appropriate the economic rent earned by a factor.
Economic rent is defined as:
- The excess earned by a factor of production over the sum necessary to induce it to do its work
(the Ricardian definition) or
- The excess earnings over the amount necessary to keep a factor in its present occupation (the
Paretian definition).
The Ricardian definition applies to natural resources such as coal, oil and gas, which have no
alternative use if left in the ground.
Illustration
Consider two separate oil deposits whose product is sold under perfectly competitive conditions
and whose factor supply is perfectly elastic, but whose costs differ as depicted in Figure 8.1.
Deposit 1 is represented by MC1 and AC1 and Deposit 2 by MC2 and AC2. The least-cost rate of
output is the same for both deposits at q1, but costs are assumed to be higher for deposit 2 because
of geological or locational factors.
Price MC2
Cost AC2
MC1
P2 P2=MR2=AR2
U
C1 V AC1
P1 P1=MR1=AR1
0 q1 q2 Quantity
Figure 8.1: Economically Optimal Taxes on Natural Resources
Page 53 of 90
If price is set at p1, only deposit 1 will be exploited, its rate of output being q1. However, if price
rises to p2 then deposit 2 will produce q1 and deposit 1 will now produce q2 (where its MC = MR)
and the total supply will now be q1 + q2.
If price is p2, deposit 1 earns an economic rent equal to the area P2UVC1. This economic rent is due
to the unique nature of the deposit and is distinct from monopoly profits since it is consistent with
perfect competition in the market for the product. In theory this may be taxed without affecting
price or output as long as MR and MC are unchanged. Hence, taxation of economic rent has no
allocative effects.
An ideal tax would therefore only appropriate P2UVC1. The marginal deposit (deposit 2) earns no
economic rent when price is p2 should be free of taxation
What is the relevance of Paretian Definition?
In practice oil resources can only be exploited using other factors of production (labour, capital and
entrepreneurship). These resources have alternative employments. The government must therefore
determine the minimum rate of return required to attract factors into oil production. This minimum
rate is referred to as transfer earnings because it determines whether factors transfer from one use
to another. Economic rent is all earnings above the transfer earnings, which may be taxed without
affecting allocative efficiency. Such a tax will not induce resources to move out of oil production
NOTE
Economic rents will be higher in the short run than in the long run because capital is fixed in the
former. However, taxation of short-run ‘quasi-rents’ would deter further exploration for (and
development of) further oil deposits. Hence an allocatively efficient tax only appropriates long-
run (or true) economic rents, not short-run quasi-rents.
If producers have some control over oil prices then marginal fields will earn monopolistic rent (i.e.
monopoly profits). In principle, taxation of monopolistic rent will also leave output unchanged. In
Figure 8.2, monopolistic rent is equal to the area P1RST and its removal by an optimal tax would
leave output unchanged at q1.
Price
Cost
MC
P1 R AC
T S
MR AR
0 q1 Output
Figure 8.2: Taxation of monopolistic rent
Page 54 of 90
8.3: OPTIMAL INCOME TAXATION
An income tax may cause allocative inefficiency because it changes the relative prices of work and
leisure. If it causes a net reduction in work effort then the economy moves within its production
possibility frontier and welfare is correspondingly reduced.
The question of optimal income taxation is how to design income tax in such a way that such
welfare losses are minimised.
Consider Figure 8.3 which depicts the effects of a poll tax (a fixed lump-sum per head) and that of
income tax where the two different taxes raise the same tax revenue to the government.
Income from work

B
I1
Z I2
e1
C I3
e2
e3
0 L2 L1 L3 Y A Leisure
Figure 8.3: Comparing a poll tax and an income tax in efficiency terms
In Figure 8.3, the pre-tax budget line is BA.
Imposition of a poll tax of BZ creates budget line ZY. The maximum post-tax income is 0Z and
the maximum leisure is 0Y. YA is the amount of time spent earning sufficient income to pay the
poll tax. The budget line shifts parallel to BA to its new position at ZY because the poll tax does
not affect the relative prices of work and leisure. It passes through e3 because it raises the same
amount of revenue as the income tax.
The poll tax reduces income by less than the income tax (which creates CA as before) because it
has a wider tax base, being payable by those who were previously not working but who now have
to work in order to pay it.
The poll tax equilibrium is e2, resulting in less leisure (i.e. more work) at L2 than the income tax
equilibrium e3 with more leisure L3 (less work).
This result is because the marginal rate of tax for a poll tax is zero (i.e. payment is not related to
income). Hence the poll tax has no substitution but only an income effect (measured by the shift
from e1 to e2) that increases work effort.
The income tax on the other hand creates a substitution effect precisely because payment of it is
related to income (i.e. marginal tax rate is positive). The substitution effect partially offsets the
Page 55 of 90
income effect. Therefore the net result is that the poll tax will increase work effort by more than
the income tax.
In the figure 8.3, the substitution effect of the income tax more than offsets the income effect so
that L3 lies to the right of L1. There is a net disincentive-to-work effect created by the income tax
compared with the incentive to work created by the poll tax. This example also shows that relative
to a poll tax, an income tax creates an excess burden (dead weight / efficiency loss) because it
results in the individual being on a lower indifference curve (I3 rather than I2).
NOTE
A poll tax is allocatively efficient because it does not change the relative prices of goods or services,
including labour. In other words, a poll tax does not destroy the pre-tax marginal equality of MRS
= MRT. An income tax on the other hand destroys that marginal equality because it is a selective
tax on income.
However, since income tax is related to income, it is more acceptable on equity grounds than a poll
tax. A poll tax is severely regressive: the lower the income, the higher the proportion of income for
which it accounts. Equity rules normally favour progressive taxation (i.e. where the proportion
taken by tax rises with income), or at least proportional taxation (i.e. where the proportion of
income taken by taxation stays the same at all income levels but where the rich still pay more tax
than the poor in absolute terms). Hence, whilst allocatively efficient, a poll tax is usually deemed
so inequitable that it is not politically acceptable as the sole or dominant form of taxation. It may,
however, be acceptable as a small part of a larger tax system.
8.4: OPTIMAL COMMODITY TAXATION

The problem in optimal commodity taxation is:
Given a level of government revenue to be raised, which must be financed solely by taxes upon
commodities, how should these taxes be set so as to minimize the cost to society of raising the
required revenue?
If a social welfare function is adopted to represent the states preferences, the problem of optimal
commodity taxation can be rephrased as that of choosing the commodity tax rates to maximize
social welfare subject to the revenue constraint.
The solutions to this problem have been given by:
a) Ramsey rule (Ramsey, 1927)

b) The inverse elasticities rule (Baumol and Bradford, 1970)
c) The Corlett-Hague Rule (1953)
8.4.1 The Ramsey Rule (1927)
The Ramsey rule says that to minimize total excess burden, tax rates should be set so that the
percentage reduction in the quantity demanded of each commodity is the same.
Consider two goods, X and Y, how should the tax rates tx and ty be set to minimize overall
excess burden?
To minimize the overall excess burden, the marginal excess burden of the last unit of revenue
collected from each good must be the same. If this condition does not hold, it would be possible to
Page 56 of 90
lower overall excess burden by raising the rate on the commodity with the a smaller marginal
excess burden while lowering the rate on commodity with the larger marginal excess burden.
Suppose for a good X a tax tx is levied so that the price increases from Po to Po + tx. The
taxation lowers the quantity of X from Xo to X1. The excess burden associated with the tax
is given by the area abc
Price
P0 + (tx+1 ) g f
P0 + tx h i b
P0 j e a c
Dx
0 X2 X1 X0
Suppose the government increases tax rate on X by 1 so that the price becomes
Po + (tx + 1) and the quantity demanded falls further to X2, the excess burden will increase by the
trapezoidal area fbae.
1
Thus the marginal excess burden = x[(t x + (t x + 1)] = x
2
Associated with the increase in the tax rate, there is change in tax revenue given by
Area gfih – Area ibae = X 1 − X
The marginal excess burden per unit of tax revenue collected is given as:
x
X 1 − X
Similarly the marginal excess burden per unit of tax revenue collected for good Y is given by
y
Y1 − Y
For efficient taxation

x y x x
=  =
X 1 − X Y1 − Y X Y
Page 57 of 90
Thus the percentage reduction in demand must be equal for all commodities
Efficient taxation should therefore induce proportional changes in quantities demanded and not
proportional changes in prices because excess burden is a consequence of distortions in quantities.
The rule applies for related and non-related goods
8.4.2 Inverse Elasticities rule

The Inverse elasticities rule is derived by placing further restrictions on the economy used to derive
the Ramsey rule. It is assumed that there are no cross-price effects between the taxed goods so that
the demand for each good is dependent only upon its own price and the wage rate.
The rule states that for goods that are not related in consumption, for efficiency, the proportional
rates of tax should be inversely related to the price elasticity of demand of the good on which they
are levied.
The rule is derived by reinterpreting the Ramsey rule to explore the relationship of the rule and
elasticity of demand.
Suppose  x is the compensated elasticity of demand for good X, t x the ad valorem tax rate on X,
t x x will be the percentage change in price of X times the percentage change in quantity demanded
when price increases by one per cent. Similarly, t y y will be the percentage change in price of Y
times the percentage change in quantity demanded when price increases by one per cent.
Efficient taxation requires that: t x x = t y y
tx  y
Hence =
ty y
According to the rule, tax rates do not require to be set at same rates for efficiency. Since efficient
tax distorts decisions as little as possible, the potential for distortions is greater the more elastic the
demand for the commodity. Efficiency requires therefore that higher tax rates be levied on
commodities with relatively inelastic demands
The inverse elasticity rule implies that necessities, which by definition have low elasticities of
demand, should be highly taxed.
8.4.3 The Corlett-Hague Rule:
Corlett and Hague (1953) proved the implication of the Ramsey rule: that when there are two
commodities, efficient taxation requires taxing the commodity that is complementary to leisure at
a relatively high rate. To understand this result intuitively, recall that if it were possible to tax
leisure, a “first-best” result would be obtainable where revenues could be raised with no excess
burden.
Although the tax authorities cannot tax leisure, they can tax goods that tend to be consumed jointly
with leisure, indirectly lowering the demand for leisure. If for example, computer games are taxed
Page 58 of 90
at a very high rate, people buy fewer of them and spend less time at leisure. In effect, then, high
taxes on complements to leisure provide an indirect way to get at leisure, and hence, move closer
to the perfectly efficient outcome that would be possible if leisure were taxable.
8.5: SUMMARY
Optimal taxation is one in which there is no effect on the allocation of resources other than those
intended to overcome market failure. Thus, optimal taxes do not alter the relative prices of
inputs and outputs. Economically efficient taxes will only appropriate rent.
Theoretically, poll taxes are considered to be economically efficient than income taxes. This is
because income taxation produces substitution effect while poll tax does not. The substitution
effect of income tax results when tax makes leisure relatively cheaper and hence increases
leisure and reduces work.
For commodity taxes, optimal taxation require that taxes on commodities be set such that the
proportional reduction in quantity demanded is equal for all commodities.
Higher tax rates should be set for goods with relatively inelastic demand and goods
complementary to leisure should be taxed at higher rates.
Page 59 of 90
TOPIC NINE: TAX EVASION AND TAX AVOIDANCE

- Define tax evasion and tax avoidance
- Describe various ways of committing tax fraud
- Explain the causes of tax evasion
- Explain the positive and normative approaches that avert tax evasion
9.2: DEFINITIONS
An implicit assumption in the analysis of taxation is that firms and consumers honestly report their
taxable activities. This assumption is patently unacceptable when confronted with reality. Tax
evasion, which refers to the intentional failure to declare taxable economic activity, is pervasive in
many economies.
Tax Evasion: is purposeful failure to pay legally due taxes, through cheating or fraud. Failure to
report sales or receipt of income to the tax authorities for tax purposes, or failure to pay the
amount due as tax, amounts to tax evasion.
There are several ways of committing tax fraud that include:
(i) Keeping two sets of books to record business transactions. One records the actual business and
the other is shown to the tax authorities. Some evaders use two cash registers.
(ii) Moonlight for cash. Working an extra job is perfectly legal. However, the income received on
such jobs is often paid in cash rather than by cheque. Hence, no legal record exists, and the
income is not reported to the tax authorities.
(iii)Barter. When one receives payment in kind instead of money, it is legally a taxable transaction
but such income is seldom reported.
(iv) Deal in cash. Paying for goods and services with cash and cheques makes it very difficult for
the tax authority to trace transactions.
(v) Under-invoicing of imports.
(vi) Under-reporting of income especially where income is earned and paid in cash to hide
transactions or exchanged in a barter way – receiving payment in kind instead of money.
(vii) Smuggling
(viii) Money Laundering
Tax Avoidance: is changing one’s behaviour or arranging one’s affairs in such a way as to reduce
one’s legal tax liability. Tax avoidance may include taking advantage of legal ‘loopholes’ in the
form of deductions or exclusions which arise either as a result of errors or less than tight drafting
of the legal legislation, or as a deliberate policy to encourage a certain activity. Tax avoidance is,
thus, legal.
Selling less of a product as a result of imposition of a tax is a good example of tax avoidance.
9.3: CONSEQUENCES OF TAX EVASION

- Less revenue: for provision of public goods; deficits and its consequences
- Heavy burden on those who comply leading to unequal income distribution
- Unfair competition
- More cost to tax authority
- Renders redistribution plan ineffective.
- Understating taxable capacities for countries
Page 60 of 90
- Promote inefficiency allocation of resources
9.4: CAUSES OF TAX EVASION AND AVOIDANCE

9.4.1 Tax Evasion Model
The studies on tax evasion conclude that undeclared economic activity, and hence tax evasion is a
significant part of total economic activity in many economies, which justifies the study of the
causes and consequences of tax evasion. If tax evasion constitutes a significant part of the activities
within the economy, then a theory of evasion is of potential use in designing structures that
minimize evasion at least cost and ensuring that policies are optimal given that evasion occurs.
The Simple Tax Evasion Model is the positive theory of tax evasion. It is assumed in the model
that:
(i) An individual cares only about maximizing his expected income. He has a given amount of
earnings and is trying to choose R, the amount of income to hide from tax authorities.
(ii) The marginal income tax rate is t, which also represents the marginal benefit to the individual
of hiding a unit of income (e.g. a dollar) from tax authorities. In other words, when the marginal
income tax rate is t, the marginal benefit (MB) of each unit of income shielded from taxation
is also t.
(iii) The tax authority does not know the taxpayer’s true income, but randomly audits his returns.
The probability that the individual taxpayer will be audited is p.
(iv) If he is caught cheating, the individual will pay a penalty which increases with R, at an
increasing rate.
Assuming that the individual knows the value of p and the penalty schedule, he makes his decision
by comparing the marginal cost (MC) and marginal benefit (MB) of cheating. The expected MC is
the amount by which the penalty goes up for each dollar of cheating.
This is given by the marginal penalty x the probability of detection Therefore MC = p x marginal
penalty. This is clearly shown in Figure 9.1 where the amount of income not reported is measured
on the horizontal axis, and income from cheating (in dollars) on the vertical. The marginal benefit
(MB) for each dollar not reported is t, (the amount of tax saved).
The “optimal” amount of cheating is where the two schedules cross (at R*) determined where MB
= t = MC at which point the individual’s income is maximized.
A no cheating scenario would correspond to R* = 0 in which case, MC’ > MB throughout.
Page 61 of 90
Income from cheating MC = p x marginal penalty
MB = t
0 R* (R= Dollars of under-reporting)
Figure 9.1: Optimal tax evasion
The model implies that:
• Cheating increases when marginal tax rates go up, mainly because a higher value of t
increases the MB of evasion, shifting the MB schedule upwards so that the intersection with
MC occurs at a higher value of R*.
• Cheating also increases when either the probability of detection (p)goes down holding the
marginal penalty constant, or when the marginal penalty goes down holding the probability
of detection constant, or when both the probability of detection and the marginal penalty go
down thus making the marginal cost of cheating low.
On the basis of arguments above, it is clear that cheating can be reduced by either or all of the
following:
- Reduction of the marginal income tax rates

- Increase in the probability of detection (more random audits)
- Increase in the marginal penalty.
Limitations of the model
Simple tax evasion model (positive theory of tax evasion) yields useful insights, but it ignores some
potentially important considerations. These are:
a) Psychic costs of cheating: Tax evasion may make people feel guilty. One way to model this
phenomenon is by adding psychic costs to the marginal cost schedule. For very honest people,
the psychic costs are so high they would not cheat even if the expected marginal penalty were
zero.
b) Risk Aversion: To the extent that individuals are risk averse, their decisions to engage in what
is essentially a gamble may be modified to include risk.
Page 62 of 90
c) Work choices: The model assumes the only decision is how much income to report. The type
of job and the amount of before-tax income are taken as given. In reality, the tax system may
affect hours of work and job choices. For example, high marginal tax rates might induce people
to choose occupations that provide substantial opportunities for evading taxation, e.g.
participation in the so-called underground economy which include economic activities that are
legal but easy to hide from the tax authorities (home repairs) as well as work that is criminal
per se (prostitution, selling drugs).
d) Changing probabilities of audit: the probability of an audit is independent of both the amount
evaded and the size of income reported. However, audit probabilities may depend on
occupation and the size of reported income.
9.4.2 Normative analysis of Tax Evasion.
Most public discussions of the underground economy assume that it is a bad thing and that policy
should be designed to reduce its size. But under certain conditions, the existence of an
underground economy raises social welfare. For example, if the supply of labour is more elastic
to the underground economy than to the regular economy, optimal tax theory suggests that the
former be taxed at a relatively low rate (application of the inverse elasticity rule).
Alternatively, suppose that participants in the underground economy tend to be poorer than those
in the regular economy. To the extent that the society has egalitarian income redistribution
objectives, leaving the underground economy intact might be desirable.
Tax Amnesty
During a tax amnesty, people can pay delinquent taxes without facing criminal charges for their
previous tax evasion. Assessing the likely impact on tax collections of a tax amnesty is difficult.
- In many cases, state tax amnesties have been accompanied by the state’s announced intention
to increase its enforcement efforts. The success of many tax amnesty programmes, then, may
be due partly to better enforcement.
- A further problem in evaluating tax amnesty programs lies in their long-term effects on tax
compliance. When tax amnesties are declared repeatedly, people may come to believe that
they will occur in the future as well, lowering the expected costs of future tax evasion. An
amnesty program that brings with it an expectation of future amnesties may actually increase
tax evasion.
9.4.3: Causes of Tax Evasion in Developing Countries

The following will lead to increased tax evasion
High tax rate: spend more money on advice, performing more complex manoeuvres and taking
greater risk
Insufficient penalties: are inadequate to deter people from underreporting income
Imprecise laws that are not clear leaving loopholes to be manipulated by the potential evaders and
avoiders
Inequity: leads to increased desire to avoid or evade tax and the activity would be socially
acceptable.
Page 63 of 90
Probability of being detected: If it is low then tax evasion would be high.
Income level: if it is low, people tend not to report it.
Poor tax usage, Corruption and mismanagement of collected funds tend to act as a disincentive for
paying taxes.
Complicated tax system: If the tax system is not simple to understand to a large section of the
population many will not pay taxes. Administering the taxes to ensure compliance will also be
difficult and costly
9.5: SUMMARY
Tax Evasion is the purposeful failure to pay legally due taxes, through cheating or fraud.
Failure to report sales or receipt of income to the tax authorities for tax purposes while tax
Avoidance is the changing one’s behaviour or arranging one’s affairs in such a way as to
reduce one’s legal tax liability
Tax evasion and avoidance are not desirable because they lead to less revenue, leave a heavy
burden on those who comply leading to unequal income distribution, unfair competition,
inefficiency in resource allocation, and raises the cost to tax authority
Keeping two sets of books to record business transactions, Moonlighting for cash, exchanging
physical goods for goods (Barter) Making all payments in cash, Under-invoicing of imports,
Under-reporting of income, Smuggling and Money Laundering
are some of the ways in which people commit tax fraud.
The tax evasion model is a positive analysis of tax evasion. The model reveals that cheating on
the taxable activity increases when marginal tax rates go up, if the probability of detection (p)
goes down with marginal penalty fixed, or when the marginal penalty goes down with
probability of detection constant, or when both the probability of detection and the marginal
penalty go down.
Tax evasion and avoidance may also be due to imprecise laws that leave loopholes that are
exploited and inequity in the tax system
Cheating to the tax authority can therefore be reduced by Reduction of the marginal income tax
rates, increasing probability of detection by conduction more random audits and Increase in the
marginal penalty.
Page 64 of 90
TOPIC TEN: TAX REFORM
By the end of this topic the learner should be able to:

- Explain the factors used to evaluate tax reform proposals
- Compare how various issues motivate tax reform debates between developing and
developed economies
- Explain the how special economic problems of developing countries influence their
tax reforms
10.2: MOTIVATIONS FOR REFORMS
The government’s tax system often undergoes changes from time to time in a bid to address
changing needs of the economic system. The pressure to change the tax system may originate from
government need for extra revenue, management of macroeconomic policy, the need to favour one
type of activity rather than another, implementation of aspects of social policy in terms of income
distribution and lobby groups including special interest groups, political parties and government
departments
10.3: EVALUATION OF TAX REFORM PROPOSALS

Tax reform proposals should be evaluated in order to ascertain their soundness and overall effects
on the economy as well as on the entire tax system on the basis of the following factors
a) The cost or yield to the tax authority and the distribution of gainers and losers among different
categories of taxpayers.
b) Their economic effects and any behaviour changes it’s likely to induce
c) Consistency with the general thrust of the government tax policy, and its broader economic,
financial and social policies
d) The implications for other parts of the tax system including the social security system
e) The likely effect on the perceived fairness and general acceptability of the tax system
f) Their effects in increasing or reducing the complexity of the tax system
g) The administrative implications including effects on public expenditure and the use of public
service manpower
h) The compliance burden on employees, businesses, and other tax payers
i) Views expressed by members of parliament, representative bodies, or individual tax payers
j) Any relevant international obligations arising there from, e.g double taxation agreements,
COMESA tariffs, PTA tariffs, East African Community tax treaty.
10.4: ISSUES THAT MOTIVATE TAX REFORMS IN DEVELOPING COUNTRIES

1. Resource mobilization versus the inefficiency of the tax system
The most important motivation for LDC tax reform is the need to raise more revenue (or
resource mobilization). The alternative is often deficit finance and money creation but the
inflation induced inefficiency is commonly thought to be as great as, if not greater than the
explicitly tax related one—its incidence is also more unpredictable. The tax agenda in LDCs is
therefore expanded to include the possibility of reforming and expanding the tax base.
The DC’s however are motivated most strongly by the perceived inefficiency of the tax system,
even though reforms have sometimes led to higher revenues (e.g., the European VATs). The
Page 65 of 90
focus is primarily on the taxation of saving and capital, but the disincentive effect of labor
taxation is also considered.
2. Luxury Good Taxation
The second major difference between LDC and DC tax reform is the “luxury good” taxation
issue. Though most European VATs have a higher than ‘standard’ rate on a diverse group of
luxury goods, this issue does not have a central role in DCs as it does in
LDC tax reform
Several reasons are advanced for this.
(i) One reason follows from the focus on resource mobilization and the higher income
elasticity of such goods.
(ii) Another possible reason is the greater concern for equity. The equity concerns may be
more acute due to poverty, or because of much skewed income distributions. Taxes on
luxury goods are therefore seen as an equitable way of raising revenues.
(iii) The greater reliance on indirect taxes. With income taxes limited by administrative and
other constraints, dependence on indirect taxes is higher in LDCs.
3. Savings-investment tax treatment
The saving-investment issue is the most important common driving force in LDC and DC tax
reform, though it is viewed from somewhat different perspectives. The LDC discussion is
motivated by the corporate income tax, with the focus on the unexpected effects of taxes on
investment allocation.
Though the corporate income tax is an important source of revenues in many developing
countries, the base often largely consists of foreign firms. Thus, the question in the latter case
is one of taxation of foreign investment.
Enterprise taxes on non-corporate entities and special taxes on organized agricultural producers
are also important in analyzing the capital tax issue in LDCs
4. Double taxation of savings
The issue of double taxation of savings inherent in the income tax is not raised with equal vigor
in LDCs. Several reasons are advanced for this.
(i) Income taxes are perceived to be more progressive than consumption taxes. At the simplest
level of analysis, those with larger tangible wealth would tend to have a greater proportion
of income from savings.
(ii) The overall tax system may be much closer to a consumption tax, because of the heavier
indirect taxation.
(iii) Further, the relative ease with which income taxes can be evaded, and the possible
differences in the proportion of evaded income consumed, could affect the savings-
consumption choice.
5. Policies to attract foreign investment and the internal consistency of tax policy
Given the diverse lot of policies to attract foreign investment, and to effect the sectoral and
regional pattern of allocation, one of the issues of concern in LDCs is whether each of these
policies, when viewed in isolation achieves its professed objective, and at what cost in revenue
expenditures.
The internal consistency of tax policy, the extent to which other policies related to credit
markets, import protection, and the price and investment controls contradict them, and the
overall effect of the policy regime, raise the complexity of the allocation issue in LDCs.
Page 66 of 90
6. Avoidance versus Evasion of tax
The fairness/ avoidance issue in developed countries appears to be very similar to the evasion
issue in developing countries. Both issues are related to the complexity of the tax system and
the high marginal rates of taxation.
Base broadening, simplification, and reduction in marginal rates is part of the proposed solution
in both cases. Beyond this, equating these two is highly misleading. In LDCs, administrative
costs, evasion, and corruption are critical factors which seem to underlie, shape, and constrain
virtually all reform proposals.
7. Efficiency of the Indirect tax system

Efficiency of the indirect tax system is a non issue in most DCs. One explanation for this could
be that the most important efficiency issue has been input taxation, and a VAT or final sales
tax is quite common.
There are some LDCs which already allow deduction of sales-excise taxes paid at intermediate
stages of production and consequently the efficiency issue is not an important issue even in this
case—the optimal commodity tax approach which deals with consumption distortions is
seldom used LDC reform proposals. However, there are several LDCs which depend on
turnover taxes and excises on intermediate goods. For this group of LDCs, the efficiency of the
indirect tax system is important.
10.5: ECONOMIC PROBLEMS OF DEVELOPING COUNTRIES AND TAX

REFORM
The special economic problems of developing countries present situation regarding the tax base in
a typical developing economy. The economy consists of a small organized sector and numerous
household producers. Tax on wages is largely a tax on the wage and salaried employees of the
organized sector, and sometimes even more restricted to the government and corporations. By and
large, only the income of urban entrepreneurs and professionals is taxable in the household sector.
Labour employed by the household sector and the mass of small farmers pose important equity
constraints to tax reform policies. The Economic problems and their effect on tax reform are
discussed below
(i) Capital versus Wage taxes

Since the economy consists of a small organized sector and numerous household producers. Any
wage tax is essentially a tax on the wage and salaried employees of the organized sector, and
sometimes even more restricted to the government and corporations. In the household sector, only
the income of urban entrepreneurs and professionals is taxable. The issue of capital versus wage
taxes is largely irrelevant, given the difficulty of separating out the wage and capital components
of this income. Therefore, the capital tax element of income (plus wealth) should not be higher than
the wage tax, and should bear some relation to the tax rate on luxury goods due to the possibility
of substitution between capital income and luxury goods.
(ii) Administrative-Evasion Problem
Another importance of the above classification (of developing country economies) arises from the
administrative-evasion problem which underlies most reform proposals. Any income and
commodity taxes imposed on households fall haphazardly on the household sector, depending on
evasion skills and costs, and administrative attention. One major exception to the uncertain
application of taxes on the household sector is that taxes on transactions with the organized sector
Page 67 of 90
and the rest of the world can and have been used widely in LDCs. Examples here include taxes on
household sector exports, even though they may be sub-optimal in a traditional perspective.
However, sales to the organized sector seem to have been much less used as a tax point due to
prohibitive administration costs of ensuring compliance.
(iii) Import and organized sector production taxes

The most important source of distortions in the commodity tax structure is import and organized
sector production taxes. Besides losses from input substitution, there is an incentive for vertical
integration when input taxes can legally be avoided by doing so. In other cases, there is an incentive
for inefficient fragmentation of organized production into smaller household sector units. In a post-
reform system the organized sector should be permitted to credit input taxes paid (including non-
protective tariffs) to the output tax liability. However, because of fraudulent claims for subsidies,
payments to firms with positive credit may not be administratively feasible. In this case, the net
final consumption goods taxes can be adjusted keeping both the changes in effective rates and
optimal tax considerations in mind.
iv) Taxing inputs in the Household Sector

Since final sales of the household sector are not effectively taxable, crediting may not be necessary
for the household sector. The tax rates on inputs used by the household sector can be based on two
principles. First, inputs into this sector which are more substitutable in production, should be taxed
less heavily than those used in relatively fixed proportions. Cross elasticities have to be taken into
account especially since some inputs may require a subsidy. Second, if a greater proportion of the
input is used in producing a final good which needs to be taxed more heavily, a higher tax rate
should be imposed on the input.
(v) Consumption versus income taxes
Studies show that a consumption tax is “superior” to the income tax. One reason for this is that the
former involves a substantial indirect capital levy on existing household wealth when it is
surrendered for consumption goods. The reason is a shift in tax burden from younger to older
generations with less elastic responses. In LDCs, three factors have to be kept in mind. First, the
set of tax payers for different taxes are often significantly different, which calls for a mix of income
and commodity taxes. Second, high marginal rates on income provide incentives for evasion,
increase resource costs of evasion and distort decisions towards areas in which evasion is easier
and administrative costs of ensuring compliance greater (e.g., real estate). Third, as the proportion
of value added by the self-employed is much larger in LDCs, the difficulty of separating labor
income of the self employed from returns to capital investment creates additional problems.
Therefore, the choice of an optimal tax mix is consequently not entirely an economic one.
(vi) Distributional constraints
As mentioned above, the choice between consumption and income taxes in LDCs is very limited.
The consumption tax is essentially a tax on organized sector output coupled with an indirect tax
(through inputs) on the household sector. The income tax has three main components: a wage tax
on organized sector employees, a tax on entrepreneurs income (all sectors), and a tax on organized
sector interest payments.
Since the base of the two taxes is different, distributional constraints also need to be considered.
These are usually met in practice by fairly progressive rates of income tax and fairly high rates of
taxation on certain subsets of luxury goods. Both of these will nominally fall on entrepreneurs (in
addition to others). The appropriate mix of consumption and income taxes therefore impinges on
the equity considerations of tax reforms. Similarly in case of high luxury goods taxes, production
Page 68 of 90
of these goods would tend to shift towards the household sector. Thus, multiple base taxation which
has the ability to limit the applicable marginal rates, is recommended.
(vii) Administrative inefficiency: caused by inadequate capacity, skills and technology to run an
efficiently a tax system.
(viii) Problem of the hard-to-tax sector: the informal sector has grown very fast over time and
yet there are no proper reports and mechanism put in place for efficient taxation.
10.6: CASE EXAMPLES OF TAX REFORM PROBLEMS

1. Corporation Tax Reform
If corporate income were untaxed, individuals could avoid personal income taxes by accumulating
income within corporations. Evidently, this would lead to serious equity and efficiency problems.
The government’s response has been to construct a system that taxes corporate income twice: first
at the corporate level, where a statutory tax rate is levied, and again at the personal level, where
distributions of dividends are taxed as ordinary income.
A number of proposals have been made to integrate personal and corporate income taxes into a
single system. The most radical approach is the partnership method, sometimes referred to as full
integration. Under this approach, all earnings of the corporation during a given year, whether they
are distributed or not, are attributed to stockholders just as if the corporation were a partnership.
Each shareholder is then liable for personal income tax on his/her share of the earnings.
Issues raised with respect to the desirability of adopting the partnership method:
(i) Nature of the Corporation: Those who favour full integration emphasizes that a corporation
is, in effect, merely a conduct for transmitting earnings to shareholders. It makes more sense
to tax the people who receive the income than the institution that happens to pass it along.
Those who oppose full integration argue that in large modern corporations, it is ridiculous to
think of the shareholders as partners, and that the corporation is best regarded as a separate
entity.
(ii) Administrative Feasibility: Opponents of full integration stress the administrative difficulties
that it would create. How are corporate earnings imputed to individuals who hold stock for
less than a year? Would shareholders be allowed to deduct the firm’s operating losses from
their personal taxable income? Proponents of full integration argue that a certain number of
fairly arbitrary decisions must be made to administer any complicated tax system.
(iii) Effects on Efficiency: Those who favour integration point out that the current corporate tax
system imposes large excess burdens on the economy, many of which would be eliminated or
at least lessened under full integration. The economy would benefit from four types of
efficiency gains:
▪ The misallocation of resources between the corporate and non-corporate sectors would be
eliminated
▪ To the extent that integration lowers the rate of taxation on the return to capital, tax-induced
distortions in savings decisions would be reduced.
▪ Integration would remove the incentives for excessive retained earnings that characterize the
current system. Firms with substantial retained earnings are not forced to convince investors
to finance new projects. Without the discipline that comes from having to persuade outsiders
that projects are worthwhile, such firms may invest inefficiently.
▪ Integration would remove the present system’s bias toward debt financing because there
would be no separate corporate tax base from which to deduct payments of interest. High
ratios of debt to equity increase the probability of bankruptcy. This increased risk and the
actual bankruptcies that do occur lower welfare without any concomitant gain to society.
Page 69 of 90
Opponents of full integration point out that given all the uncertainties concerning the operation of
the corporation tax, the supposed efficiency gains may not exist at all. For example, to the
extent that Stiglitz’s view of the tax as equivalent to a levy on pure profits is correct, the tax
induces no distortion between the corporate and non-corporate sectors. Similarly, there is no
solid evidence that corporations invest internal funds less efficiently than those raised
externally.
(iv) Effects on Saving: Some argue that full integration would lower the effective tax rate on capital
and therefore lead to more saving. However, from a theoretical point of view, the volume of
saving may increase, decrease, or stay the same when the tax rate on capital income decreases
(v) Effects on the Distribution of Income: If the efficiency arguments in favour of full integration
are correct, then in principle, all taxpayers could benefit if it were instituted. Still, people in
different groups would be affected differently. For example, stockholders with relatively high
personal income tax rates would tend to gain less from integration than those with low personal
income tax rates. At the same time, integration would tend to benefit those individuals who
receive a relatively large share of their incomes from capital. Taking these effects together,
Fullerton and Rogers (1993) find a roughly U-shaped pattern to the distribution of benefits of
integration - People at the high and low ends of the income distribution gain somewhat more
than those in the middle. However, the results depend on the values of a number of parameters
such as the elasticity of saving with respect to the tax rate. And yet there is much uncertainty
about their magnitudes.
2. Politics and Personal income tax Reform
A natural question is why is it so difficult to improve the tax system?
(i) Many cases, even fairly disinterested experts disagree about what direction reform should
take. For example, we noted earlier that despite a consensus among economists that
differentially taxing various types of capital income is undesirable, there is dispute about
how this should be remedied. What one person views as a reform can be perceived by
another as a turn for the worse
(ii) Attempts to change specific provision encounter fierce political opposition from those
whom the changes will hurt. Government officials, for example, lobby ferociously
whenever proposals to limit the deductibility of income taxes are floated. In the presence
of special-interest groups, the political process can lead to expenditure patterns that are
suboptimal from society’s point of view. Hence create difficulties in attempts to improve
the tax system.
Also once a tax provision is introduced, ordinary people modify their behaviour on its basis
and are likely to lose a lot if it is changed. For example, many families may purchase larger
houses than they otherwise would have because of the deductibility of mortgage interest
and property taxes. Presumably, if these provisions were eliminated, housing values would
fall. Homeowners would not take this lying down. Certain notions of horizontal equity
suggest it is unfair to change provisions that have caused people to make decisions that are
costly to reverse.
Attempts to make broad changes in the tax system are likely to be more successful than
attempts to modify specific provisions on a piecemeal basis. Accept the whole set of
changes or no changes at all.
Page 70 of 90
3. Reforming Estate and Gift Taxes
For those who wish to expand the role of estate and gift taxes, the most straightforward approach
would be to lower the lifetime exemption. However, if the estate tax is ever to play an important
part in the revenue system, methods for dealing with avoidance via trusts and other such
instruments must be devised. A popular reform among many theorists is integrating the estate-and
gift-tax system into the personal income tax. Gifts and inheritances would be taxed as income to
the recipients, and should therefore be included in adjusted gross income.
There is however, resistance to taxing gifts and inheritances as ordinary income. A different method
of changing the focus of estate and gift taxation from the donor to the recipient is an accession tax,
under which each individual is taxed on total lifetime acquisitions from inheritances and gifts. The
rate schedule could be made progressive and include an exemption, if so desired. The attraction of
such a scheme is that it relates tax liabilities to the recipient’s ability to pay rather than to the estate.
Administrative difficulties would arise from the need for taxpayers to keep record of all sizable
gifts and estates.
10.7: SUMMARY
The need to change the tax system in a country may be motivated by need for governments to
raise extra revenue, management of macroeconomic policy, to favour one type of activity
rather than another, to implement aspects of social policy in terms of income distribution and
to address needs of lobby groups including special interest groups, political parties and
government departments
Tax reform proposals should be evaluated carefully by considering the cost or yield to the tax
authority, the distribution of gainers and losers among the different categories of taxpayers,
effects on economic behaviour, consistency with the general objectives of the government
policy, effect on equity and the administrative implications,
Developing countries tax reform debates are mainly driven by issues around resource
mobilisation, savings – investment tax treatment, Policies to attract foreign investment and the
internal consistency of tax policy, Efficiency of the Indirect tax system, while in developing
countries focus more n issues about Inefficiency of the tax system, luxury good taxation,
double taxation of savings.
However, evasion and avoidance issue in developed countries appears to be very similar to the
evasion issue in developing countries. Both issues are related to the complexity of the tax
system and the high marginal rates of taxation.
The special economic problems of developing countries present situation regarding the tax
base in a typical developing economy. The economy consists of a small organized sector and
numerous household producers. Tax on wages is largely a tax on the wage and salaried
employees of the organized sector. In most cases only the income of urban entrepreneurs and
professionals is taxable in the household sector. Labour employed by the household sector and
the mass of small farmers pose important equity constraints to tax reform policies.
Page 71 of 90
TOPIC ELEVEN: FISCAL FEDERALISM

(i) Distinguish between a federal system and a unitary state
(ii) Explain the advantages and disadvantages of decentralisation
(iii)Explain optimal allocation of expenditure and taxation rights to different levels
of government in a federal system
11.2: DEFINITIONS
A federal system consists of different levels of government that provide public goods and services
and have some scope for making decisions. The subject of fiscal federalism examines the functions
undertaken by different levels of government and how the different levels interact with each other.
One federal system is more centralized than another when more of its decision-making powers are
in the hands of authorities with a larger jurisdiction. The most common measure of the extent to
which a system is centralized is the centralization ratio, the proportion of total direct government
expenditures made by the central government. Direct government expenditure comprises all
expenditure except transfers made to other governmental units.
In a unitary country where there is only a central government, the expenditure responsibilities and
taxation/revenue-raising rights of the government are usually clearly stated. Thus, the public
finance of a unitary state can be analyzed in a relatively simple framework with respect to the
allocation of resources, distribution of income and goals for stability and growth.
A unitary state may generate serious problems resulting from the remoteness of public goods
recipients from the political mechanisms, cultural differences within a country, variations in
individual and group tastes for public goods, cost factors; and regional economic differences within
a country. The existence of these and other factors gives rise to forces that suggest a breakdown of
expenditure responsibilities and taxing rights into smaller or sub-federal units, such as provinces,
regions, metropolitan areas and municipalities. How this breakdown should be accomplished, in
terms of what rights and responsibilities should go to what political jurisdiction, is a problem that
needs to be solved.
A federation (or confederation) is an amalgam of two or more political jurisdictions, such that,
each participant retains some degree of local political and economic power. Just how much power
is a retained by the separate political units (states or provinces) depends upon: The initial agreement
to federate, the interpretation of the agreement by the courts over time, and the ability to alter the
agreement.
The reasons why individuals opt for a federal country include:

a) Defense: where it is felt that a single, collective defense effort might be greater deterrent to
foreign invasion than each jurisdiction acting on its own.
b) Economic: that is each individual state could reap advantages of a common currency, foreign
policy and single transportation network that would not exist in single-country status.
c) The desire for a federation reflects a wish for the retention of some local autonomy.
In terms of marginal analysis, the local state is willing to give up some of its power up to the point
where the marginal benefit of centralization equals the marginal cost of sacrificing local autonomy.
Page 72 of 90
11.3: OPTIMAL FEDERALISM
What is the optimal allocation of economic responsibilities among levels of government in a federal
system?
With respect to macroeconomic functions, it is generally agreed that spending and taxing decisions
intended to affect the levels of unemployment and inflation should be made by the central
government. No state or local government is large enough to affect the overall level of economic
activity. It would not make sense, for example, for each locality to issue its own money supply
and pursue an independent monetary policy. To the extent a stabilization policy is feasible and
desirable it should be done at the national level.
With respect to microeconomic activities of enhancing efficiency and equity, there is considerably
more controversy. The question is whether a centralised system is more likely to maximize social
welfare.
11.3.1 Disadvantages of a decentralized system
Consider a country composed of small communities each of whose government makes decisions
to maximise a social welfare function depending only on the utilities of its members. How would
the results compare to those that would emerge from maximising a national social welfare function
that took into account all citizens utilities.
a) Efficiency Issues
The overall goal is to bring efficiency in the allocation of resources in the economy. A system of
decentralized governments might lead to an inefficient allocation of resources due to the following
reasons:
(i) Presence of externalities in the provision of public goods: The activities undertaken by one
community can sometimes affect the well being of people in other communities. E.g. if one
town provides good public education for its children and some of them eventually emigrate,
then other communities may benefit from having a better educated workforce. Towns can affect
each other also negatively e.g. dumping of wastes into stream. If each community cares only
about its own members, externalities are overlooked. Hence, according to the standard
argument, resources are allocated inefficiently.
(ii) Scale economies in provision of public goods: For certain public services, the cost per person
may fall as the number of users increases. For example, the more people who use a public
library, the lower the cost per user. If each community sets up its own library, costs per user
are higher than necessary. A central jurisdiction on the other hand, could build one library,
allowing people to benefit from the scale economies. Alternatively, some communities can
contract out to other governments or to the private sector for the provision of certain public
goods and services.
(iii)Inefficient tax system: efficient taxation requires that inelastically demanded or supplied goods
be taxed at relatively high rates, and vice versa. Suppose that the supply of capital to the entire
country is fixed, but capital is highly mobile across sub-federal jurisdictions. Each jurisdiction
realizes that if it levies a substantial tax on capital, the capital will simply move elsewhere, thus
making the jurisdiction worse off. In such a situation, a rational jurisdiction taxes capital very
lightly or even subsidizes it.
Page 73 of 90
Taxes levied by decentralized communities are unlikely to be efficient from a national
standpoint. Instead, communities are likely to select taxes on the basis of whether they can be
exported to outsiders. For example, if a community has the only coal mine in the country, there
is a reasonable chance that the incidence of a locally imposed tax on coal will fall largely on
coal users outside the community. A coal tax would be a good idea from the community’s
point of view, but not necessarily from the viewpoint of the nation.
An important implication of tax shifting is that communities may purchase too many local
public goods. Efficiency requires that local public goods be purchased up to the point where
their marginal social benefit equals marginal social cost. If communities can shift some of the
burden to other jurisdictions, the community’s perceived marginal cost is less than marginal
social cost. When communities set marginal social benefit equal to the perceived marginal cost,
the result is an inefficiently large amount of local public goods.
(iv) Scale economies in tax collection: Individual communities may not be able to make advantage
of scale economies in the collection of taxes. Each community has to devote resources to tax
administration, and savings may be obtained by having a joint taxing authority. It may for
example be more rational to split the cost of one computer to keep track of tax returns rather
than each community purchasing its own computer. Other than consolidation, cooperation
between communities can also lead to achievement of such economies.
b) Equity issues
In a utilitarian philosophical framework, the maximization of social welfare may require income
transfers to the poor. Suppose that the pattern of taxes and expenditures in a particular community
is favourable to its low-income members. If there are no barriers to movement between
communities, we expect an in-migration of the poor from the rest of the country. As the poor
population increases, so does the cost of the redistributive fiscal policy. At the same time, the
town’s upper-income people may decide to exit. There will be no reason for them to pay high taxes
for the poor when they can move to another community with a more advantageous fiscal structure.
Thus, the demands on the community’s tax base increase while its size decreases. Eventually the
redistributive programme has to be abandoned.
NOTE
Macroeconomic control and stabilization policy is best practiced by a central government.

Redistribution, including social insurance, to ensure that social services delivered locally are
consistent with national goals. This is not possible with decentralization. The other roles to be left
to the national government include; Reducing tax and benefit competition to attract mobile labour
and firms for the economy as a whole; internalizing geographic spill-over effects of public goods
and services e.g. education and health; avoiding corruption especially at the Local Government
level and enhancing administrative competence in the economy due to availability of manpower
that can work across levels in the economy
11.3.2 Advantages of a decentralized system

1. Tailoring outputs to local tastes
Heterogeneous preferences combined with information advantage of local decision makers;
levels of consumption of some public goods can be tailored to the preferences of subsets of
society. A centralized government tends to provide the same level of public services throughout
the country, regardless of the fact that people’s tastes differ. It is inefficient to provide
individuals with more or less of a public good than they desire if the quantity they receive can
Page 74 of 90
be more closely tailored to their preferences. Under a decentralized system, individuals with
similar tastes for public goods group together, so communities provide the types and quantities
of public goods desired by their inhabitants.
A closely related notion is that local government’s greater proximity to the people makes it
more responsive to citizens’ preferences than central government. This is likely to be the case
in a large country where the costs of obtaining and processing information on everybody’s
tastes are substantial. Many decisions need to be decided closer to the marketplace and a federal
system applies the same principle to government decision making. Economic regulations
enacted at the national level may not make sense in every community
2. Fostering inter-government competition
If citizens can choose among communities, then substantial mismanagement may cause citizens
simply to choose to live elsewhere. This threat creates incentives for government managers to
produce more efficiently and be more responsive to their citizens
3. Experimentation and innovation in locally provided goods and services: A system of diverse
governments enhances the chances that new solutions to problems will be sought. For example,
varying techniques of instruction in public schools. In this way one courageous community
may if citizens choose, serve as a laboratory and try moral, social and economic experiments
without risk to the rest of the economy.
4. Political accountability and citizen participation in the political process, is easier in smaller
jurisdictions and this promotes better and inclusive decision-making
Implications
The discussions make it clear that a purely decentralized system cannot be expected to maximize
social welfare. Efficiency requires that those commodities with spillovers that affect the entire
country (i.e. national public goods like defense) be provided at the national level. On the other
hand, it seems appropriate for local public goods to be provided locally. This leaves an in-between
case of community activities that create spillover effects that are not national in scope.
What are the possible solutions?
a) One solution is to put all the communities that affect each other under a single regional
government. In theory, this government would take into account the welfare of all its citizens,
and so internalize the externalities. However, a larger governmental jurisdiction carries the
cost of less responsiveness to local differences in tastes.
b) An alternative is to put in place a system of Pigouvian taxes and subsidies. The government
can enhance efficiency by taxing activities that create negative externalities and subsidizing
activities that create positive externalities. For example, if primary and secondary education
creates benefits that go beyond the boundaries of a jurisdiction, the central government can
provide communities with educational subsidies. Local autonomy is maintained, yet the
externality is corrected.
NOTE
The theory suggests a clean division of responsibility for public good provision i.e. local public
goods by localities, and national public goods by the central government. In practice, there is
considerable interplay between levels of government.
Page 75 of 90
The mobility considerations rule out relying heavily on local governments to achieve distributional
objective. An individual jurisdiction that attempts to do so is likely to find itself in financial trouble.
A great bulk of spending for income maintenance should be done at the central level. Social
Security, Supplemental Security Income, food stamps, and the earned income credit among others
should be central government programmes.
11.4: TAX ASSIGNMENT

This refers to assigning tax sources to different tiers of the government. The more the spending
responsibilities assigned to a particular level of government, the more the tax revenue sources
should be assigned to it. As the different expenditure and tax assignments increases, sub-national
governments will become more dependent on grants from national government in order to meet
their spending obligations. As a result, the ability of the electorate to enforce fiscal accountability
will decrease.
The following factors should be considered in determining the most appropriate tax assignment:
a) Equity: ensuring vertical and horizontal equity among individual tax payers as well as a cross
across regions
b) Efficiency: minimizing the cost of collection and compliance as well as minimizing any
market distortions.
14.4.1 Guidelines for tax assignment
Due to equity and efficiency considerations, Musgrave (1983) proposed the following guidelines:
(i) Progressive redistributive taxes should be assigned to the national government (example,
personal and income taxes)
(ii) Unequal tax bases among jurisdictions should be assigned to the national government (example
taxes on mineral mining)
(iii)Taxes appropriate for macroeconomic stabilization should be centralized (example VAT, and
personal income tax). These taxes are sensitive to economic and business fluctuations
(iv) Taxes on mobile factors of production should centralized (example corporate income tax, VAT
where companies are able to shift the accounting base of the tax to lower-tax jurisdiction)
(v) The local authorities should levy taxes on immobile factors of production, such as property
taxes.
(vi) Residence-based taxes such as excise taxes should be assigned to the provinces.
(vii) All levels of government may charge user charges and benefits taxes.
11.4.2 Common problems with revenue assignments
Vertical imbalance: inadequate correspondence between expenditure responsibilities of sub-
national governments and their assigned sources of revenue. Tax autonomy and increased use of
subsidiary in taxation are preferable to transfers. Taxes should be assigned to the lowest level of
government that can implement them.
Lack of meaningful tax autonomy: revenue assignments are predominated by shared taxes and
transfers
Unstable assignments: assignments are decided in the annual budget rather than stated in the laws
and fixed for a number of years
Wrong incentives and lack of uniformity: the regulation of taxes and tax assignments being
customized for each local government to fit a minimum budget
Page 76 of 90
Unfair apportionment of tax revenues among sub-national jurisdictions: The exclusive sharing
of taxes on a derivation basis (usually paid at the headquarters of the firm) leads to the unfair
allocations of VAT and CIT revenues
Confused system resulting in the misallocation of resources and significant administration and
compliance costs
Large horizontal disparities: The uneven distribution of tax bases requires the introduction of
equalization grants. The problem is more acute when it comes to sharing of natural resource taxes
11.5: TAX COMPETITION

Tax competition is a governmental strategy of attracting foreign direct investment and high value
human resources by minimizing the overall taxation level. Where barriers to free movement of
capital and people are high, governments have more freedom in setting their taxes. The gradual
process of globalization is lowering these barriers and results in rising capital flows and greater
manpower mobility.
In this situation, politicians have to keep tax rates reasonable in order to dissuade workers and
investors from moving to a lower tax environment. Most economies started to reform their tax
policies to improve their competitiveness. Governments typically react with "carrot-and-stick"
policies such as:
• Reduction of both personal and corporate income tax rates

• Tax breaks/holidays (i.e. time limited tax exemptions)
• Rising the barriers to free movement of capital
• Not allowing companies hiding in tax havens to bid for public contracts
• Political pressure on lower tax countries to harmonize (i.e. raise) their taxes
Tax competition and tax harmonization in federalism

In the context of sub-national governments, tax competition occurs when the sub-governments
adjust (lower) their tax rates to attract mobile factors of production such as capital, from other
jurisdictions.
Tax harmonization occurs when sub-national governments coordinate their tax policies, for
example by limiting the degree of variation in tax rates levied, or by defining the tax bases in a
uniform way.
Tax competition was regarded as distortionary, non-neutral, and leading to sub-optimal outcomes.
It was thought that this could be corrected via tax harmonization. The reasoning was that if one
province decides to pursue a competitive tax strategy, the other provinces would respond likewise.
The provinces would continue to undercut each other leading to identical and sub-optimally low
tax rates on mobile production factors. The distribution of mobile factors would be distorted.
Uncoordinated tax policies would lead to market distortions with regards to mobile factors of
production as well as tradable goods and services.
Tax competition however, can be seen as having a positive influence and efficiency enhancing.
Decentralized tax powers could:
- Promote innovations, as sub-national governments would be able to experiment with various

fiscal packages. Successes would be emulated elsewhere and failures abandoned.
Page 77 of 90
- Permit sub-governments to tailor tax mixes to their citizens’ preferences and furthermore
encourage accountability. If governments are providing services that individuals and firms want
and are willing to pay for, the adverse effect of tax competition may be limited. If governments
overspend and tries to place the tax burden on those who do not benefit, tax competition may
be construed as a positive spur to increased government responsiveness.
- Encourage investment to remains within the country (because is merely displaced to another
region), instead of migrating across national borders in the face of globalization that leads to
international mobility of capital.
11.6: SUMMARY
A federal system consists of different levels of government that provide public goods and
services and have some scope for making decisions. The different governments provide
different services to overlapping jurisdictions. On the contrary, a unitary state is one where
there is only a central government.
In a unitary state, problems resulting from the remoteness of public goods recipients from the
political mechanisms, cultural differences within a country, variations in individual and group
tastes for public goods, cost factors and regional economic differences within a country often
gives rise to forces that suggest a breakdown of expenditure responsibilities and taxing rights
into smaller or sub-federal units (decentralisation)
Fiscal federalism thus examines the functions undertaken by different levels of government
and how the different levels of government interact with each other. It provides understanding
on how the breakdown in terms of what rights and responsibilities should go to what political
jurisdiction should be accomplished.
One federal system is more centralized than another when more of its decision-making powers
are in the hands of authorities with a larger jurisdiction and therefore the centralization ratio,
the proportion of total direct government expenditures made by the central government is
larger.
Disadvantages of decentralisation are intercommunity externalities, foregone scale
economies in the provision of public goods, inefficient taxation and lack of ability to
redistribute income.
Advantages of decentralisation are the ability to alter the mix of public services to suit local
tastes, the beneficial effects of competition among local governments and the potential for
low cost experimentation at the sub-federal level
Page 78 of 90
TOPIC TWELVE: PUBLIC DEBT

- Define deficit, surplus and Debt
- State the sources of public debt
- Describe types of public obligations
- Explain arguments on the burden of debt
- Explain the causes of debt crises in developing countries
- Discuss the various approaches to deal with vicious cycle of debt
12.2: PUBLIC DEBT AND BUDGET DEFICITS

Borrowing is a revenue source especially in developing countries. It involves an issue by the
government of some sort of security such as treasury bills, bonds etc. Total amount of securities
issued is known as a national debt which is defined as a total sum of government indebtedness
accumulated over a period of time.
The government borrows when government revenue does not match government expenditure. Thus
government borrows to offset the budget deficits. Government also borrows for meeting emergency
needs. For example during war or calamities to meet the unexpected increase its expenditure.
Borrowing can also be pursued to correct market behaviour and bring about economic stabilisation
and to accelerate capital accumulation and economic growth through borrowing and investing the
borrowed funds.
The deficit during a time period is the excess of spending over revenues during a period of time. If
revenues exceed expenditures, there is a surplus. Deficit is a flow variable (measured during a
period of time). Denoting budget deficit as BD, Total revenues to the government as R and total
government expenditure G, Budget deficit for a given period is given as:
BD = R − G
Some government revenues and expenditures are always off budget. A proper measure of the extent
of government borrowing requires that all revenues and expenditures be taken into account, thus it
is useful to consider the sum of the on-budget deficits (surplus) and off-budget deficits (surplus) to
arrive at the total deficit or surplus.
On-budget deficits result from on-budget expenditures and revenues while off-budget deficits are
those resulting from off-budget expenditures and revenues
The debt at a given time is the sum of all past budget deficits. It is the cumulative excess of past
spending over past receipts. Therefore if we denote Debt at period t as D t, and Budget deficit during
a given period by BDt, the debt at period t is given as:
t
Dt =  BD t
t =0
In a year with a deficit the debt goes up while in a year with a surplus, the debt goes down. It is a
stock variable (measured at a point in time). In a year with a deficit the debt goes up while in a year
with a surplus, the debt goes down. It is a stock variable (measured at a point in time).
Debt is therefore a stock variable (measured at a point in time), while deficits and surpluses are
flow variables (measured during a period of time).
Page 79 of 90
When debt is expressed as a proportion of GDP, for example if the debt is 35 percent of GDP, the
interpretation is that 35 cents of every shilling produced would be required to liquidate the debt.
The government must pay interest to its lenders. This implies that between any two periods, debt
grows by an amount larger than the deficit. In most African countries, interest grows over time as
a component of spending and as a proportion of GDP.
12.3: SOURCES AND TYPES OF GOVERNMENT OBLIGATIONS/DEBT
Public debt is defined as the obligations of the government incurred through borrowing either
internally or externally.
The sources of public borrowing include the following
• Individuals who purchase government bonds and other securities
• Commercial banks which create an additional purchasing power through making additional
loans up to amount determined by the credit multiplier which is determined by their excess
cash reserve and the required reserve ratio.
• Central bank which supports government loans in the money and capital markets. By
purchasing government bond the central bank credits the account of government.
• External sources including individuals, institutions (e.g. IMF, World Bank etc.) and countries.
• Non-Banking financial institutions such as insurance companies, investment trusts, mutual
savings banks etc
There are various types of obligations depending on their characteristics as follows:
12.3.1: External and Internal debt
External debt: is debt owed to agents located abroad. The holders of the debt are not resident in the
economy that issued the debt. On such debt there is an interest charge that must be paid each period
and this must be financed by either further borrowing or by taxation. The important features of
such debt are that it is not in competition with physical capital as a savings instrument for the
consumers of the issuing economy. However, its servicing and repayment leads to a flow of
resources out of the economy. However, the amount obtained is limited by the credit rating of the
government in foreign markets and political consideration.
Internal debt: on the other hand, is held by residents of the economy in which it is issued. The
government borrows off its citizens by providing bonds which compete with private capital. Private
savings are divided between the two investments instruments. When there is no uncertainty bond
and capital will be perfect substitutes, so in equilibrium they should pay the same rate of return.
The cost of financing internal debt again met by further borrowing or by taxation. However, in
contrast to external debt, internal debt does not lead to any resources being transferred away from
the economy that issues the debt. However, the amount obtained is limited by the saving capacity
of the people and the government’s self-imposed limitation.
12.3.2 Short term and permanent Debt
Short term debt - obligations of a maturity of less than one year at the time of issue. Consists of
items such as treasury bills etc
Permanent/funded debt - loans with a maturity of more than one year at the time of issue. The
government establishes a separate fund which is credited every year by a certain amount. On
Page 80 of 90
maturity, the debt is repaid out of the fund. If they are non-terminable, the government is only to
pay the interest on such debt but not the principal.
Floating debt: Obligations with no specific maturity although part of it may be repayable subject
to various items and conditions, for example, provident fund, and reserve fund and deposits
12.3.3 Marketable and non marketable debt
Marketable debt: loans which can be sold by the existing holders to others.
Non-marketable debt: issued in favour of particular debt holders only and cannot be sold to others.
12.3.4 Productive and unproductive loan
Productive loan gives rise to income yielding assets or projects.
Unproductive loan does not give rise to income yielding assets for example borrowing to spend on
war.
12.3.5 Other types of obligations
Currency itself (Demand debt): what the government owe to the private sector of the economy
through the Central bank. This not usually included as a public debt.
Interest bearing loans: one paid with interest. These consists of a loan with a coupon where the
holder is entitled to a given interest payment periodically and a loan sold below the redemption
value i.e. at a discount.
Redeemable public debt: debt the principal amount of which is repaid by the government after a
predetermined period of time. Interest is regularly paid.
Voluntary public debt: obtained from the people without coercing them. Forced public debt:
obtained from the public against their wishes through coercion using its powers.
Special floating debt: certain special securities for meeting government obligations toward
international institutions like IMF, World Bank etc.
12.4: EFFECTS OF GOVERNMENT BORROWING ON THE ECONOMY

Borrowing can have different effects on the economy
a) Changes the distribution of income as interest payments on the debt are financed from taxation.
b) Reduces availability of funds for private sector which will result in a welfare loss if the return
on the funds used in the private sector is greater than in the public sector.
c) If loan is external, there is a potential loss of social welfare because then its repayments and
interest charge mean that society has to consume less than it has produced.
d) If external borrowing is used to create assets which expand the economy’s productive capacity,
then in the long run, there may be a gain rather than a loss in welfare.
e) Government borrowing may be more inflationary than tax finance. This is because raising
taxes reduces disposable incomes and so curbs consumption spending which offsets, to some
extent, the rise in government spending.
12.5: THEORIES ON THE BURDEN OF THE DEBT

Why should we care about the national debt, and whether it is increasing or decreasing?
It is important to note that the future generations either have to retire the debt, or refinance it.
(Refinancing means borrowing new money to pay existing creditors/debt). Whether the future
Page 81 of 90
generation retires or refinances the debt, there is a transfer from future taxpayers to bondholders
because even if the debt is refinanced, interest payments must be made to new bondholders. The
future generation therefore must bear the burden of the debt. But this might not be the case. The
theory of incidence rules out this line of reasoning. Merely because the legal burden is on future
generations does not mean that they bear a real burden. Just as in the case of tax incidence, the
chain of events set in motion when borrowing occurs can make the economic incidence quite
different from the statutory incidence. Who actually bears the burden of debt jus as with other
incidence problems, depends on the assumptions made about economic behaviour.
There are various Schools of thought about the burden of the debt
12.5.1 Lerner’s View

Lerner (1948) assumes the government borrows from its own citizens such that the obligation is an
internal debt. Lerner’s view is that an internal debt creates no burden for the future generation.
Members of the future generation simply owe it to each other. When the debt is paid off, there is a
transfer of income from one group of citizens (those who do not hold bonds) to another
(bondholders). However, the future generation as a whole is no worse off in the sense that its
consumption level is the same as it would have been.
However for an external debt the story is quite different. If a country borrows from overseas to
finance current consumption the future generation certainly bears a burden, because its
consumption level is reduced by an amount equal to the loan plus the accrued interest that must be
sent to foreign lenders. If, on the other hand, the loan is used to finance capital accumulation, the
outcome depends on the project’s productivity. If the marginal return on the investment is greater
than the marginal cost of funds obtained abroad, the combination of the debt and capital
expenditure actually makes the future generation better off. To the extent that the project’s return
is less than the marginal cost, the future generation is worse off.
12.5.2: An Overlapping Generations Model

In the Lerner’s model, a “generation” consists of everyone who is alive at a given time. A more
sensible way to define a generation is everyone who was born at about the same time. Hence at any
given time several generations coexist simultaneously, a phenomenon that is taken into account in
an overlapping generation’s model. Analysis of this model shows how the burden of a debt can be
transferred across generations. Assume that
- The population consists of equal numbers of young, middle-aged, and old people.
- Each generation is 20 years long and each person has a fixed income of $12,000 over the 20-
year period.
- There is no private saving (everyone consumes their entire income) and the situation is expected
to continue forever.
- Income levels for three representative people for the period 2001 to 2021 are depicted in row 1
of table that follows.
Suppose the government decides to borrow $12,000 to finance public consumption. The loan is to
be repaid in the year 2021. Only the young and the middle-aged are willing to lend to the
government. The old are unwilling because they will not be around 20 years to obtain repayment.
Assume that half the lending is done by the young and half by the middle-aged, so that consumption
of each person is reduced by $6,000 during the period 2001 to 2021. This fact is recorded in row 2
of the table. However, with the money obtained from the loan, the government provides an equal
amount of consumption for all and each person receives $4,000. This is noted in row 3.
Page 82 of 90
Table 12.1: Overlapping Generations Model
The Period 2001 - 2021

Young Middle-aged Old
(1) Income $12,000 $12,000 $12,000
(2) Government borrowing -6,000 -6,000
(3) Government-provided consumption 4,000 4,000 4,000
The year 2021____________________

Young Middle-aged Old
(4) Government raises taxes
to pay back the debt $-4,000 $-4,000 $-4,000 $-4,000
(5) Government pays back the debt +6,000 +6,000
Source: Rosen, 2002
With the passage of time and the arrival of the year 2021, the generation that was old in 2001 has
departed from the scene. The formerly middle-aged are now old, the young are now middle-aged,
and a new young generation has been born.
The government has to raise $12,000 to pay off the debt. It does so by levying a tax of $4,000 on
each group of persons. This is recorded in row 4. With the tax receipts in hand, the government
can pay back its debt holders, the now middle-aged and old (row 5). Introducing a positive rate of
interest would not change the substantive result and means there is no need to discount future
consumption to find its present value.
The following results emerge
- As a consequence of the debt and accompanying tax policies, the generation that was old in
2001 to 2021 has a lifetime consumption level $4,000 higher than it otherwise would have had.
- Those who were young and middle-aged in 2001 to 2021 are no better/ worse off from the point
of view of lifetime consumption.
- The young generation in 2021 has a lifetime consumption stream that is $4,000 lower than it
would have been in the absence of the debt and accompanying fiscal policies. In effect, $4,000
has been transferred from the young of 2021 to the old of 2001. The debt repayment in 2021
involves a transfer between people who are alive at the time, but the young are at the short end
of the transfer because they have to contribute to repaying a debt from which they never
benefited. The internal-external distinction that was vital in Lerner’s model is irrelevant here.
Even though the debt is all internal, it creates a burden for the future generation.
The overlapping generations model suggests a natural framework for comparing across generations
the burden (and benefits) of government fiscal policies. This framework, known as generational
accounting is a method of measuring the consequences of government fiscal policy that takes into
account the present value of all taxes and benefits received by members of each generation. By
comparing the net taxes paid by different generations, one can get a sense of how government
policy redistributes income across generations. The method involves the following steps:
(i) Take a representative person in each generation and compute the present value of all taxes
she pays to the government.
(ii) Compute the present value of all transfers received from the government, including Social
Security etc.
Page 83 of 90
(iii)Compute the difference between the present value of the taxes and the transfers which is the
“net tax” paid by a member of that generation.
NOTE
Most calculations using this framework suggest that current generations benefits at the expense of
future generations.
Such calculations rest heavily on assumptions about future tax rates, interest rates, and so on.
Further, they do not allow for the possibility that individuals in a given generation may care about
their descendants as well as themselves.
The main contribution of the generation accounting framework is to focus attention on the lifetime
(rather than annual) consequences of government fiscal policies.
12.5.3 Neoclassical Model

The intergenerational models so far discussed do not allow for the fact that economic decisions can
be affected by government debt policy, and changes in these decisions have consequences for who
bears the burden of the debt. The models assume that the taxes levied to pay off the debt do not
affect work nor savings behaviour. The effects of debt finance on capital formation are also
ignored. If taxes distort these decisions, real costs are imposed on the economy. The neoclassical
model of the debt stresses that when the government initiates a project, whether financed by taxes
or borrowing, resources are removed from the private sector.
It is usually assumed that when tax finance is used, most of the resources removed come at the
expense of consumption. On the other hand, when the government borrows, it competes for funds
with individuals and firms who want the money for their own investment projects. Hence, it is
generally assumed that debt has most of its effect on private investment. If this is taken as true,
debt finance leaves the future generation with a smaller capital stock, holding other factors constant
(including public sector capital stock). Its members therefore are less productive and have smaller
real incomes than otherwise would have been the case. Thus, the debt imposes a burden on future
generations through its impact on capital formation. But if the public sector undertakes productive
investment with the resources it extracts from the private sector, the total capital stock increases.
The assumption that government borrowing reduces private investment is referred to as “the
crowding out hypothesis” because when the public sector draws on the pool of resources available
for investment, private investment is reduced. Crowding out results from changes in the interest
rate - As the government increases its demand for credit, the interest rate, which is the price of
credit, increases. But if the interest rate increases, private investment becomes more expensive and
less of it is undertaken.
NOTE
To test the crowding out hypothesis, one needs to simply examine the historical relationship
between the interest rate and government deficits (as a proportion of gross domestic product). A
positive correlation between the two variables would support the crowding out hypothesis.
However, other variables can also affect interest rates. During a recession, for example, investment
decreases and hence the interest rate falls. At the same time, slack business conditions lead to
smaller tax collections, which increase the deficit ceteris paribus. Hence the data may show an
inverse relationship between interest rates and deficits, although this says nothing about crowding
out. The problem is therefore to sort out the independent effect of deficits on interest rates.
12.5.4 Ricardian Model

Page 84 of 90
The discussions so far has ignored the potential importance of individuals’ intentional transfers
across generations. Barro (1974) argued that when the government borrows, members of the old
generation realize that their heirs will be made worse off. If the old care about the welfare of other
descendants and therefore do not want their descendants’ consumption levels reduced, one
possibility is to increase their bequests by an amount sufficient to pay the extra taxes that will be
due in the future. The result is that nothing really changes. Each generation consumes exactly the
same amount as before the government borrowed. In effect, private individuals undo the
intergenerational effects of government debt policy so that tax and debt finance are essentially
equivalent. Thus according to the Ricardian model (by David Ricardo), the form of government
finance is irrelevant.
Barro’s provocative hypothesis on the irrelevance of government fiscal policy has been the subject
of much debate. Those who oppose the idea hold that the idea is based on incredible assumptions
of people understanding precisely how current deficits will lead to future tax burdens. Information
on the implications of current deficits for future tax burdens is not easy to obtain and it isn’t even
clear how big the debt is. Another criticism is that people are not as farsighted as they are supposed
to be in the model.
If the Ricardian model was correct, one would have expected private saving to increase
commensurately, at the same time the deficit increase, however, private saving (relative to net
gross domestic product) may actually fall. While this finding is suggestive, it is not conclusive
because factors other than the deficit affect the saving rate.
12.6: CONSEQUENCES OF PUBLIC DEBT

Impact on fiscal adjustment: huge public debt undermines the effectiveness and sustainability of
an otherwise credible reform programme. For instance, due to the need to raise more revenues for
debt repayment and servicing, a sizable public debt may hinder a requisite reduction in tax rates on
some tax bases to increase the efficiency of the tax system.
Current and future resources to enhance economic potential and growth are limited due to
increased debt servicing requirements
Effect on private and public investment: investors may interpret these as threats to the ability to
sustain reforms and also as a basis for future tax increases to meet debt servicing requirements
Servicing rapidly growing stock of debt crowds out other expenditures: the servicing of rising debt
ratios absorbs a significant share of public revenues and expenditure and limits resources available
for investment in social and human development such as education, health, water, and
infrastructure. This implies reduced availability of resources for supporting renewal growth Non-
restoration of growth worsens solvency problems leading to vicious cycle.
Composition of investment: debt overhang tend to skew investment toward short-term investments
in trading activities with quick returns rather than in high-risk investment in production. Flight
capital tends to be held in liquid assets such as treasury bills and foreign currency denominated
assets in domestic banks rather than in capital assets
Places unfair burden to the future generation who have to pay - For this to happen, it is assumed
that the current generation does not reduce its savings and that the government does not add to the
capital stock and productive capacity of the country.
Page 85 of 90
12.7: DEBT SITUATION IN DEVELOPING COUNTRIES
Many developing countries have very large debts, and the amount of money they owe is quickly
increasing. Paying off the debt (debt service) has become a serious problem for these countries,
and it causes great hardship for their people. Sub-Saharan Africa, for example, pays $10 billion
every year in debt service. That is about 4 times as much money as the countries in the region spend
on health care and education.
12.7.1 Causes of debt crisis in developing countries

The debt problem in developing countries is a result of both external and internal factors
(a) External factors:
• External borrowing to compensate for rising oil prices and slumps in prices of their principal
export commodities.
• Imprudent lending on the part of commercial banks in a period of petrodollar glut.
• Sharp rises in interest rates and the value of the dollar in the 1980’s exacerbated the debt
situation, increasing the cost of debt service.
• Continued lending by Bretton Woods institutions (IMF and World Bank) to countries that
were highly indebted.
• Protectionist measures in the industrialised countries and fluctuating prices of primary
commodities resulted in declines in export revenues.
(b) Internal factors:
• Lack of restraint on the part of governments and borrowing to cover budget deficits.
• Unwise investments i.e. unproductive investments in the public sector
• High levels of consumption in relation to the country’s resources
• Excessively valued currencies and insular commercial policies which have distorted
domestic price system resulting in economic imbalances with growing budget and current
account deficits.
• Unpopularity of the taxation: since people do not like paying taxes the government goes for
an easier method which is borrowing.
• During calamities such as earthquakes, floods, famine etc
• In case of waging wars, the government has to borrow from the public to sustain war.
• Controlling inflation: by raising public debt, the government can withdraw a large amount
of money from the economy and prevent prices from rising.
• Borrowing to accelerate economic growth and development
12.7.2 Factors necessary for breaking the debt vicious cycle
Improve governance and resolve conflict: poor governance and civil unrest is one of the major
causes of the spiralling public debt in developing countries especially in SSA. This is via the effects
of conflict on economic performance and acquisition of military related debt to assist in “stamping”
out rebel insurgents.
Invest in people: investment in education and health is critical to human development and
productivity both of which lead to growth and reduced dependence on donor aid.
Increase competitiveness and diversify economies: to ensure increased export earnings for debt
servicing and repayment.
Page 86 of 90
Macroeconomic stability to ensure that these efforts take root and lead to sustainable growth:
including inflation control, exchange rate stability which increases investor confidence leading to
increased domestic investment and foreign direct investment.
Measures which address fiscal solvency concerns: including fiscal consolidation and
restrained/prioritized government expenditures
Enhance public debt management: Articulation and formulation of policy for external borrowing,
control and surveillance of external borrowing, and keeping comprehensive and accurate data on
external borrowing
12.8: DEBT REDEMPTION
Redemption refers to ending a debt obligation. There are several methods that a government can
adopt. They include:
Repudiate the debt (refuse to pay). The problem with this is that the government will find it
difficult to borrow in the future at a reasonable rate, and it is financial blow to those creditors who
had invested their savings in government debt and those who receive interest as their income. It
could also be that inflation has reduced its value in real terms since the par value of outstanding
debt is fixed.
Establish a sinking fund: The government can regularly save for the retirement of the debt and uses
the funds for this purpose when it has accumulated enough.
Regularly retire a small portion of the debt.
Pay off short term debt with corresponding surplus.
Refund: convert the existing debt into a new one of longer maturity i.e. holders purchase a new
loan.
Terminal annuity; the government pays its debt in equal annual installments which includes
interest, bedsides the principal debt amount.
Debt conversion: a high interest public debt is converted into low interest public debt. Thus the
government contracts a new debt at low - interest cost debt and uses its proceeds to pay off the old
high-interest rate debt.
Ask for debt relief: Lowers credit rating of the country.

Debt cancellation: Lowers credit rating of the country.
Debt rescheduling; Lowers credit rating of the country.
Compulsory reduction in the interest rate. Happens when a government is confronted with a
financial crisis.
Capital levy: imposed all at once tax on all capital value possessions of the people. A minimum
limit of value is first determined beyond which a tax is imposed.
Monetization: all the matters concerning public debt are dealt with by the banks in such manner
that it results in an increase in total money supply in the economy.
Page 87 of 90
12.9: TO TAX OR TO BORROW
The choice between debt and taxes is one of the most fundamental questions in public finance.
From the various schools of thought on the burden of debt, we can evaluate several approaches to
answering the above question
12.9.1 Benefits-Received principle
This is a normative principle stating that the beneficiaries of a particular government spending
programme should have to pay for it. Thus, to the extent that the programme creates benefits for
future generations, it is appropriate to shift the burden to future generations via loan finance.
Example is borrowing to pay for schools that benefit students by increasing their future earnings
12.9.2 Intergenerational equity

If due to technological progress or other discoveries, our grandchildren will be richer than the
current generation. It makes sense to transfer income from the rich generation to the poor
generation via loan finance. But if the future generations are expected to be poorer than the present
generation due for example, the exhaustion of non renewable resources, then this logic leads to just
the opposite conclusion.
12.9.3 Efficiency considerations

From an efficiency standpoint, the question is whether debt or tax finance generates a higher excess
burden. The key to analyzing this question is to realize that every increase in government spending
must ultimately be financed by an increase in taxes. The choice between tax and debt finance is a
choice between the timing of the taxes. With tax finance, one large payment is made at the time
the expenditure is undertaken. With debt finance, many small payments are made over time to
finance the interest due on the debt. The present values of the tax collections must be the same in
both cases.
If the present values of tax collections for the two methods are the same, is there any reason to
prefer one or the other on efficiency grounds?
Assume for simplicity that all revenues to finance the debt are raised by taxes on labour income.
Such a tax distorts the labour supply decision, resulting in an excess burden of :
½  wLt2
where  is the compensated elasticity of hours of work with respect to the wage, w is the before-
tax wage, L is hours worked, and t is the ad valorem tax rate.
Excess burden increases with the square of the tax rate. Thus when the tax rate doubles, the excess
burden quadruples. Thus, from the excess burden point of view, two small taxes are not equivalent
to one big tax. Two small taxes are preferred. This point is made graphically in the following figure
12.1 which depicts the quadratic relationship between excess burden and the tax rate. The excess
burden associated with the low tax rate, t1, is X1, and the excess burden associated with the higher
rate, t2, is X2.
Page 88 of 90
Excess
Burden
X2
X1
t1 t2 Tax rate (t)

Figure 12.1: The relationship between tax rate and excess burden
From an efficiency point of view, it is better to be taxed twice at rate t1, than once at rate t2. The
implication is that debt finance, which results in a series of relatively small tax rates, is superior to
tax finance on efficiency grounds
This argument however, ignores the fact that to the extent the increase in debt reduces the capital
stock; it creates an additional excess burden. Thus, while debt finance may be more efficient from
the point of view of labour supply choices, it will be less efficient from the point of view of capital
allocation decisions. A priori it is unclear which effect is more important, so we cannot know
whether debt or tax finance is more efficient.
Thus, the “crowding out” issue, which was important in the intergenerational burden of the debt
discussion, is also central to the efficiency issue. According to the Ricardian model, there is no
crowding out. Thus, taxes distort only labour supply choices, and debt finance is superior on
efficiency grounds. However, to the extent that crowding out occurs, tax finance becomes more
attractive. Clearly, as long as the empirical evidence on crowding out is inconclusive, we cannot
know for sure the relative efficiency merits of debt versus tax finance.
12.9.4: Macroeconomic considerations

The assumption made in all prior discussions is that all resources are fully employed. This is
appropriate for characterizing long-run tendencies in the economy. But how does one choose
between tax and deficit finance in the short run when unemployment is possible? In the standard
Keynesian macroeconomic model, the choice depends on the level of unemployment. When
unemployment is very low, extra government spending might lead to inflation, so it is necessary to
siphon off some spending power from the private sector by increasing taxes. Conversely, when
unemployment is high, running deficits is a sensible way to stimulate demand. This approach is
sometimes referred to as functional finance: use taxes and deficits to keep aggregate demand at the
right level, and not worrying about balancing the budget per se.
12.9.5 Moral and political considerations

The decision between tax and debt finance could be a moral issue. Too much reliance on deficits
may reflect moral failing, a defect in the formation of the public’s character and conservatisms.
Morality requires self-restraint and deficits are indicative of a lack of restraint, hence deficits are
Page 89 of 90
immoral. This view may help explain political attractiveness of using the surplus, if any, to pay
down the debt.
Ethical issues are critical in the formulation of public policy, so arguments that deficits are immoral
deserve serious consideration. Note that the argument rests on the hypothesis that the burden of the
debt is shifted to future generations. On the other hand, the benefits-received principle implies that
sometimes borrowing is the morally right thing to do.
Another argument against deficit spending is a politics. The political process tends to
underestimate the costs of government spending and to overestimate the benefits. The discipline of
a balanced budget may produce a more careful weighing of benefits and costs, thus preventing the
public from growing beyond its optimal size.
12.10: SUMMARY
12.10: SUMMARY
Borrowing is an important method of government finance
The deficit during a given period of time is the excess of spending over revenues while surplus
is the excess of revenues over spending while Debt at given point in time is the algebraic sum
of past deficits and surpluses
Whether or not the burden of debt is borne by future generations is controversial. One view is
that an internal debt creates no net burden for the future generation because it is simply an
intergenerational transfer. However, in an overlapping generation’s model, debt finance can
produce a real burden on future generations.
The burden of the debt also depends on whether debt finance crowds out private investment.
If it does, future generations have a smaller capital stock, and hence, lower real incomes, ceteris
paribus. In a Ricardian model, voluntary transfers across generations undo the effects of debt
policy, so that crowding out does not occur.
Several factors influence whether a given government expenditure should be financed by taxes
or debt. The benefits-received principle suggests that if the project will benefit future
generations, then having them pay for it via loan finance is appropriate. Also, if future
generations are expected to be richer than the present one, some principles of equity suggest
that it is fair to burden them.
From an efficiency standpoint, one must compare the excess burden of tax and debt finance. If
there is no crowing out, debt finance has less of an excess burden, because a series of small tax
increases generates a smaller excess burden than one large tax increase. And the reverse is
true if crowding out occurs.
Page 90 of 90

Econ 225 - Economics of Taxation: Course Objectives

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Econ 225 - Economics of Taxation: Course Objectives

Uploaded by

Copyright:

Available Formats

P.O.

Box 1100-20300, TEL: +254-(0) 20 2696596;

NYAHURURU, Cell: +254 713-552761/ (0)736-299961

KENYA ECON 225 – ECONOMICS OF TAXATION

By the end of the course the learner should be able to:

1.1: TOPIC OBJECTIVES

By the end of this topic learner should be able to:

1.2 PUBLIC REVENUE

(ii) Fees (user charges):

1.4: CANONS OF TAXATION

(v) Productivity/fiscal adequacy

(vi) Elasticity (Buoyancy)

(xii) Efficiency (neutrality)

2.1: TOPIC OBJECTIVES

By the end of this topic learner should be able to:

2.2: THE CIRCULAR FLOW MODEL AND TAX IMPACT POINTS

Figure 2.1: Points of Tax Impact in the Circular Flow model

From Figure 2.1 the following can be noted;

Table 2.2: Impact Points and types of Taxes

Point Type of tax Source (base)

2.3.2 Direct and Indirect taxes

3.1: TOPIC OBJECTIVES

3.2: THE BENEFIT PRINCIPLE

∆𝑇𝑎𝑥 𝑃𝑟𝑖𝑐𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 ∆𝑃 𝑌

3.2.2 Conditions under which Benefit Tax Criteria is Feasible

3.3: THE ABILITY-TO-PAY PRINCIPLE

3.3.4 Equal Sacrifice Rules

But how should these amounts differ?

0 Y2' Y2 Y1' Y1 Income (Y)

(ii) Equal Proportional Sacrifice

0 Y2' Y2 Y1' Y1 Income (Y)

(iii) Equal marginal sacrifice

0 Y1' = Y2' Y2 Y1 Income (Y)

Figure 3.4: Equal marginal sacrifice with taxation

3.4: TAX PROGRESSIVENESS

Total tax paid Proportional

Figure 3.5: Types of tax rate structure

Table 3.1: Tax Liabilities under a hypothetical tax system

10,000 1,400 0.14 0.2

Here the expression to be evaluated is v2, defined as

4.1: TOPIC OBJECTIVES

By the end of this topic learner should be able to:

4.2 TAXABLE CAPACITY

4.2.2 Definition and Measurement of taxable Capacity

Taxable capacity is usually used in two senses

(i) Absolute Taxable Capacity

Limitations of the interpretation

4.2.3 Factors Determining Taxable Capacity

4.3 TAX EFFORT

4.3.1 Tax Effort and Tax shares

4.3.2 Methods of estimating tax effort

5.1: TOPIC OBJECTIVES

By the end of this topic learner should be able to:

5.2: TAX LIABILITY, TAX BURDEN AND EXCESS BURDENOF TAX

5.3: MEASURING EXCESS BURDEN OF TAX

5.3.1 Indifference curve approach

Fig.X5.1: Measuring excess burden using Indifference curves approach

The pre-tax budget line is AD with consumer equilibrium at E1.

5.3.2 The compensated demand approach

Price a Tax Revenue

Excess Tax Burden

6.1: TOPIC OBJECTIVES

By the end of this topic learner should be able to: