ECO313 OCTOBER 2022

MEMORANDUM
RHODES UNIVERSITY
DEPARTMENT OF ECONOMICS AND ECONOMIC HISTORY
ECONOMICS 313: PUBLIC FINANCE
Test 2: 3 October 2022
Examiners: Dr. J. Marire MARKS: 50
Dr. T. Friderichs DURATION: 1½ hours
Dr. S. Phakathi

GENERAL INSTRUCTIONS TO CANDIDATES

1. All questions are to be answered.
2. Please indicate your name, your tutor’s name, your tutorial period, tutorial
venue on the front cover of your answer booklet.
3. It is in the candidate’s interest to write legibly.
4. The paper has 50 marks

PLEASE DO NOT TURN OVER THIS PAGE UNTIL TOLD TO DO SO.

 ANSWER ALL QUESTIONS

Question 1 10 marks
a) Using indifference curve analysis, discuss the statement ‘A selective tax on cigarettes is
inefficient’. Hint: Use a general tax as a means of comparison to the selective tax.
[7 marks]

a) Answer: Basically using indifference curve analysis it is noted that selective taxes (eg
selective tax on alcohol) have a deadweight loss which general taxes do no – that is
selective taxes result in consumers being on a lower indifference curve in comparison
to a general tax. [1 mark correct diagram]

Illustrating the impact of the selective tax

• Budget line swivel – selective tax on X can afford less of X but same Y (relative
prices changed). Budget line P L1 to PL2. (1 mark)
• Indifference curve lower – IC 3 to IC1 (purchase now in favour of Y).
(1 mark)
Illustrating the burden in comparison to selective tax (general/lump sum tax)
• Budget line would be a parallel shift from original budget line (P L1 to AB). The
budget line AB and PL2 must intercept at Q1 so that the same tax income in
raised by both the selective tax and the lump/general sum. Allows for accurate
comparison. (2 marks)
• Indifference curve now IC2. (1 marks plus correct on diagram)
Overall impact

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Utility for lump sum tax shows normal burden (IC 3 to IC2) relative prices do not change (so
proportion of X purchased in comparison to Y is the same) from original allocation but for
selective tax (IC3 to IC1) there is an excess burden. Normal burden IC 2 and excess burden
IC1. (1 mark).

b) With reference to equity considerations should cigarettes be taxed? You should make
reference to the ability-to-pay and benefit tax equity principles. [3 marks]

Answer: It depends who the tax falls on and who the tax burden falls on – so depends on
tax incidence (1 mark). If it falls on the poor then from ability to pay perspective they
should not (1 mark). With regards to benefit principle if smokers use most of the hospital
services given poor health then they should be taxed (regardless of income) (1 mark).

Question 2 20 marks
a) List and discuss the methods used to evaluate an individual or household wealth.
[10 marks]

Memo
1. Estate duty method (½ mark)
• The method uses the dead as a sample of the living by taking the value of assets
recorded in the estate duty records (the dead), and by multiplying it by (the inverse
of) the mortality rate, deriving an estimate of what the value of assets of those living
would be. (1 mark)
• This is then compared to the total personal sector wealth (from an external source,
such as the national accounts) and population figures to assign these observations to
a position in the upper end of the distribution. (½ mark)
• Revenue collected has been declining because of under reporting and under valuation
of assets as many forms of wealth can be hidden from the tax authorities due to
administrative issues such tax evasion and avoidance (illegal and legal ways of
minimising tax); Generation skipping-devices (trusts). (1 mark)
•
NB//3 marks total for Estate duty method

2. Sample and household surveys (½ mark)

Household survey collect primary data through door to door interviews. These surveys
furnish information about pension holdings and savings for other methods, but also
provide information about those not in the tax system(1 mark). However, the main
limitations includes
• Sampling error (½ mark)

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 • Incomplete information, and high potential for understatement in terms of
both completeness and valuation. (½ mark)
• Incomplete coverage in survey design means that some types of assets are
excluded, and so the definition of net worth is not comprehensive. (½ mark)

NB//3 marks total for Sample and household surveys

3. Income capitalisation method (½ mark)

• Capitalization is any method used to convert an income stream into value. (½ mark)
• It applies a yield multiplier to the distribution of investment income recorded for
each taxpayer to calculate the asset base on which the income was earned. (1 mark)
• The choice to perform this method is highly dependent on how strong the tax system
is on enforcing taxpayers to submit information on investment income. (1 mark)
• However, the main limitations are that;
✓ PIT provides no information on forms of wealth that do not generate taxable
investment incomes to the tax , such as owner-occupied housing, pension assets or
assets held in trusts. (½ mark)
✓ PIT excludes all individuals whose incomes are below the fling thresholds. (½ mark)

NB//4 marks total for Income capitalisation method

b) The number of OECD countries that levy individual net wealth taxes dropped
from twelve in 1990 to only four in 2017 (Arendse, J. & Stack, L., 2018). Briefly discuss
the main reasons for dropping net wealth taxes? [10 marks]

Memo
1. Capital flight and brain drain (1 mark)
• A wealth tax may unfortunately cause investors and entrepreneurs to leave a
country so as to avoid the taxation. (1 mark)
2. Capital formation: entrepreneurs may consider wealth tax as a burden not worth the
investment risk (1 mark)
• Assets maybe invested with low yield to minimize risk because a wealth tax
will cause undue liability (e.g. liable for tax even though no cash flow). (1/2
mark)
• Wealth taxes reduce the net return on savings (i.e. after-tax interest rate,
therefore causing deadweight loss. (1/2 mark)

3. Valuation of capital is complex because majority of assets are non-financial (1

mark)

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 • Valuation is based on ‘manipulatable’ assumptions and accounting
maneuvers, which may under or over estimates. (1/2 mark)
• Prices of assets, including shares, may fluctuate considerably and the values
of, say, paintings or jewellery cannot be determined until they are sold. (1/2
mark)
• It is hard to know how wealthy individuals are, property and shares may be
held in trusts that are not easily linked to individuals. (1/2 mark)
• Wealthy individuals tend to have the resources to seek advice from tax experts
on how to reduce their tax burden or how to avoid wealth taxation (1/2 mark).
• When this occurs, the burden of the tax falls on the less wealthy (middle class)
who do not have the resources to seek expensive tax advice. (1 mark)

4. Administration cost (1 mark)

• Collection costs are generally high because of the required inspection and
valuation of assets. The fact that wealth taxes are comprehensive makes their
compliance costs high.
(1 mark).

NB// students should list and briefly discuss each point as shown above.

Question 3 20 marks
Indicate whether each of the following statements is TRUE/FALSE and explain why, using
examples.
a) Tax avoidance is also called tax evasion. [5 marks]

False (1 mark). Tax avoidance is legal (1 mark). It simply means that businesses with good
acumen invest in finding loopholes in the tax legislation (1 mark) and use them to reduce tax
liability (1 mark). Tax evasion means smuggling of taxable funds in a bid to not to pay tax. In
this
case, one has a true tax liability but they try to dodge it illegally (1 mark).

b) corporate tax revenue moves countercyclical to commodity price cycles. [5 marks]

False (1 mark). Prices of mineral resources tend to experiences ups and downs also called
commodity price cycles (1 mark) and so corporate tax revenue follows the same patterns i.e.
it is procyclical to changes in commodity prices (1 mark). This is because as commodity
prices decrease, firms have no incentive to produce more and so, the sell less and thus pay
less corporate tax revenue (1 mark). Sometimes they incur losses and government simply
gives them relief from paying taxes. (1 mark)

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c) Tax inversion means government reverses a tax formerly imposed on corporate income.
[5 marks]
False (1 mark). A tax inversion occurs when a South African company merges with a foreign
one (1 mark) and, in the process, reincorporates abroad (1 mark).
Such mergers have many motives, but often one of them is to take advantage of the more
favourable tax treatment offered by some other nations (2 mark)

d) Tax competition occurs when firms compete to pay their taxes early so that they get rebates
from tax authorities. [5 marks]

False (1 mark). Happens when countries compete to cut corporate tax rates in a bid to
attract investment (1 mark). Two potential effects of tax competition: [a] Competition might
lead to a natural process of tax rate convergence, and thus a limitation on the growth of
governments (1.5 mark). [b] On the opposing side of the spectrum, it might lead to under-
taxation, and consequently, an undersupply of government services (1.5 mark).

END OF PAPER

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