Chapter 6

Economic Impact of Taxation

Dr. Messele G.

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 Outline
• A Set of Important Taxation Concepts
• The Effects of a Tax
• Defining the income tax base: The Haig-Simons
comprehensive income definition
• Economic impacts of Direct Taxation: Theory of
Income Taxation, Tax on Business Income and
Wealth
• Economic impacts of Indirect Taxation: Taxes on
consumption and sales
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 A Set of Important Taxation Concepts:
Measuring the fairness of tax systems

• A marginal tax rate is the percentage that is paid in taxes on the

next birr earned.
• An average tax rate is the percentage of total income is that is paid
in taxes.
• Most think a progressive tax system is fairest, in that it respects the
ability to pay.
– A progressive tax system is one in which effective average tax rates rise
with income.
– A proportional tax system is one in which effective average rates do not
change with income, so that everyone pays the same proportion of their
income in taxes.
– A regressive tax system is one in which effective average tax rates fall with
income.

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 Measuring the fairness of tax systems
Effective versus statutory rates
• Another important distinction is between statutory
and effective tax rates.
• Statutory tax rates are tax rates laid out in the legal
tax schedule.
• Effective tax rates are tax rates an individual actually
pays.
– The two diverge because
• There are many exemptions and deductions from taxable income,
which reduces the tax base.
• the burden of some taxes can be shifted.

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 Measuring the fairness of tax systems
Vertical and horizontal equity
• Two distributional goals are frequently cited in measuring
tax fairness.
• Vertical equity is the principle that groups with more
resources should pay higher taxes than groups with fewer
resources.
• Horizontal equity is the principle that similar individuals
who make different economic choices should be treated
similarly by the tax system.
– In reality, horizontal inequities are hard to define, because the
person endogenously made a choice to earn more or less.
Refer
Guiding Principles for Tax Equity and Fairness - AICPA
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 The Seven Dimensions of Tax Equity and Fairness

•The AICPA further recommends that the following seven dimensions be considered
in determining tax equity and fairness:
• 
1.Exchange Equity and Fairness – Over the long run taxpayers receive appropriate
value for the taxes they pay.
2.Process Equity and Fairness – Taxpayers have a voice in the tax system, are given
due process and are treated with respect by tax administrators.
3.Horizontal Equity and Fairness – Similarly situated taxpayers are taxed similarly.
4.Vertical Equity and Fairness – Taxes are based on the ability to pay.
5.Time-Related Equity and Fairness – Taxes are not unduly distorted when income
or wealth levels fluctuate over time.
6.Inter-Group Equity and Fairness – No group of taxpayers is favored to the
detriment of another without good cause.
7. Compliance Equity and Fairness – All taxpayers pay what they owe on a timely
basis.
The seven equity and fairness dimensions are not listed in rank order. The relative importance of each will depend in
part on the type of tax involved and the nature of the tax law or administrative change being considered.

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 The Effects of a Tax
• A tax is a wedge between the price buyers pay
and the price sellers receive.
• A tax raises the price buyers pay and lowers
the price sellers receive.
• A tax reduces the quantity bought & sold.
• These effects are the same whether the tax is
imposed on buyers or sellers, so we do not
make this distinction in this chapter.

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 The Effects
P
of a Tax
With no tax,
eq’m price is PE and
quantity is QE . Size of tax = $T
Govt imposes a tax PB S
of $T per unit.
PE
The price buyers
pay is PB , PS D
the price sellers
receive is PS ,
and quantity is QT . Q
QT QE

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 The Effects
P
of a Tax
The tax generates
revenue equal to Size of tax = $T
$ T x QT .
PB S

PE

PS D

Q
QT QE

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 The Effects of a Tax
• Next, we use the tools of welfare economics
to measure the gains and losses from a tax.
• We will determine consumer surplus (CS),
producer surplus (PS), tax revenue, and total
surplus with and without the tax.
• Tax revenue is included in total surplus,
because tax revenue can be used to provide
services such as roads, police, public
education, etc.

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• Consumer surplus The benefit that consumers
derive from consuming a good, above and
beyond the price they paid for the good.
• Once we know the demand curve, consumer
surplus is easy to measure, because each point
on a demand curve represents the consumer’s
willingness to pay for that quantity.
• The consumer surplus is the area below the
demand curve and above the equilibrium
market price. 11
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• Producer surplus Consumers aren’t the only ones who derive a
surplus from market transactions. The benefit that producers
derive from selling a good, above and beyond the cost of
producing that good.
• There is also a welfare gain to producers, the producer surplus,
which is the benefit derived by producers from the sale of a
unit above and beyond their cost of producing that unit.
• Like consumer surplus, producer surplus is easy to measure
because every point on the supply curve represents the
marginal cost of producing that unit of the good.
• Thus, producer surplus is represented graphically by the area
above the supply (marginal cost) curve and below the
equilibrium price PE,

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 The Effects
P
of a Tax
Without a tax,
CS = A + B + C
PS = D + E + F A
Tax revenue = 0 S
B C
Total surplus PE
D E
= CS + PS
=A+B+C D
F
+D+E+F

Q
QT QE

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 The Effects
P
of a Tax
With the tax,
CS = A
PS = F
A
Tax revenue PB S
=B+D B C
Total surplus D E
=A+B PS D
+D+F F
The tax causes
total surplus to Q
fall by C + E QT QE

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 The Effects
P
of a Tax
C + E is called the
deadweight loss
(DWL) of the tax, the A
PB S
fall in total surplus
B C
that
results from a D E
market distortion, PS D
such as a tax. F

Q
QT QE

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 About the Deadweight
P
Loss
Because of the tax, the
units between
QT and QE are not
sold. S
PB
The value of these
units to buyers is
greater than the cost PS D
of producing them,
so the tax has
prevented some
mutually beneficial Q
QT QE
trades.
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 About the Deadweight Loss
• A tax on a good reduces the welfare of buyers and
sellers. This welfare loss usually exceeds the revenue
the tax raises for the govt.
• The fall in total surplus (consumer surplus, producer
surplus, and tax revenue) is called the deadweight loss
(DWL) of the tax.
• A tax has a DWL because it causes consumers to buy
less and producers to sell less, thus shrinking the
market below the level that maximizes total surplus.

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 What Determines the Size of the DWL?
• The govt needs tax revenue to finance roads, schools,
police, etc., so it must tax some goods and services.
• Which ones? One answer is that govt should tax the
goods or services with the smallest DWL.
• So when is the DWL small vs. large? Turns out it
depends on the elasticities of supply and demand.
• Recall: The price elasticity of demand (or supply)
measures how much quantity demanded
(or supplied) changes when the price changes.

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 Defining the income tax base: The Haig-Simons
comprehensive income definition

• The Haig-Simons comprehensive income definition defines taxable

resources as the change in an individual’s power to consume during the
year.
• It is best viewed as a measure of ability to pay – regardless of the actual
choices in terms of consumption and savings.
• In reality, the U.S. tax system deviates from this definition in many
ways, for example, the exclusion of employer-provided health
insurance.
– In practice it is very difficult to implement the Haig-Simons income concept.
Problems include
• Adjusting for an individual’s ability to pay (property and casualty losses, medical expenses,
state and local taxes); the costs of earning income; and difficult to value items (imputed rent
on owner-occupied housing).

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 Externality/Public goods rationales for
deviating from Haig-Simons: Tax
expenditures
• Tax expenditures are government revenue losses
attributable to tax law provisions that allow special
exclusions, exemptions, or deductions from gross
income, or that provide a special credit, preferential
tax rate or deferral of liability.
• The government measures how much tax revenue is
lost by excluding health insurance from taxable
compensation, or allowing deductibility of charitable
contributions.

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 Tax deductions vs. tax credits

• Tax credits are more equitable than deductions.

– The value of deductions (such as for home mortgage
interest or charitable contributions) rises with a person’s
marginal tax rate, making them regressive.
– Credits are equally available for all incomes, so they are
progressive.
• In reality, a tax credit may not be very progressive if
those with low tax liabilities cannot have the excess
of the credit refunded.
– A tax credit is refundable if it is available to individuals
even if they pay few or no taxes.

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Economic impacts of Direct Taxation:
Theory of Income Taxation, Tax on
Business Income and Wealth

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 Income Tax
• Taxes on personal income the dominant source of
revenue for the federal government in the U.S.
- Accounted for 42% of federal revenue in 2011.
• All but seven states have a personal income tax.
• Before 1913, major source of revenue for federal
government was customs duty, or tariffs.
• 1913 constitutional amendment empowered Congress
to levy taxes on personal and business incomes.

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 Comprehensive Income
• Comprehensive income is the sum of a person’s
annual consumption expenditures and the
increment in that person’s net worth in a given
year:
- I = C + ΔNW.
- Concept called the Haig-Simons definition of income.
• Net worth is the value of a person’s assets held
at any point in time less the value of a person’s
liabilities or debts.
• Capital gains are increases in the value of assets
over the accounting period. 29
 Sources and Uses of Income

• Net capital gains = capital gains - capital losses.

• Sources are always equal to uses.
• Comprehensive income tax is levied on all
income irrespective of its use or source.

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Sources of Personal Income

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 Measurement Problems
• Means of measuring income must be developed
before tax can be implemented.
• Haig-Simons definition would require both
realized and unrealized capital gains be included
in income.
− Mechanism needed to measure gains and losses in capital
assets being held.
− Difficult or impossible for some assets.
• Requires arbitrary judgment to determine which
expenses are costs of earning income and which
are consumption or increases in net worth. 32
 Income-in-Kind
• Income-in-kind is income in the form of goods and
services rather than cash payments. Income in goods
and services, not cash payments.
• Serious problem involved in administering income tax
is treatment of nonmonetary transactions
• Comprehensive income includes these services.
• Taxation of all types of income-in-kind is infeasible.
• Some easy to tax such as employee fringe benefits.
• When income-in-kind is non-taxable, employers are
encouraged to provide non pecuniary returns (non-
wage satisfaction) in lieu of taxable benefits.
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Among the problems encountered in
implementing a tax on comprehensive income are
(1) measuring the value of income-in-kind and other
nonmarket transactions,
(2) measuring unrealized capital gains, and
(3) determining what constitutes a cost of earning
income.
Under a comprehensive income tax, income of
corporations would be allocated to individuals
according to the proportion of their share in
ownership of the corporation, with no separate
corporate income tax.
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 Flat-Rate Income Tax

• Reformers suggest U.S. tax system would be

more efficient with a flat-rate income tax.
• No loss in efficiency in how people spend or earn.
• Tax is likely to distort choices made concerning
allocation between:
− work and leisure
− consumption and saving or productive investment.
– Can prevent labor and investment markets from
attaining efficiency.
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Flat-Rate Income Tax

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• Figure 13.1 shows a typical worker’s indifference curves
for money income from work and leisure.
• In drawing the curves, it is assumed that leisure is a
normal good for the worker. The indifference curves
exhibit diminishing marginal rates of substitution of
leisure for income. Twenty-four hours are available each
day to allocate between gainful employment and all
other activities for which the worker is not paid. Leisure
is a catchall term for any activity other than work for an
employer.
• You can think of leisure as a nonmarket activity including
home production activities, such as cooking, cleaning,
and engaging in do-it-yourself projects.
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 Income and Substitution Effects
• Impact of tax on work effort depends on income and
substitution effects of tax-induced reduction in wages.
• Tax lowers implicit price of leisure by reducing the
return from work effort.
• Income tax results in a substitution effect that is
unfavorable to work effort and tends to increase
consumption of leisure.
• Income effect provides an incentive to increase work
effort when leisure is a normal good as individual
tends to work harder to maintain previous (before tax)
income.
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• A general tax on comprehensive income would
tax all income at the same rate regardless of
its source or use.
• Although such a tax does not distort choices
concerning sources of income or consumption
expenditures, it will distort choices between
work and leisure and between present and
future consumption.

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 Perfectly Inelastic Labor Supply
• The impact of taxes on labor income, market wages, net
wages, and efficiency depends on the responsiveness of
workers to tax-induced wage declines.
• Tax-induced distortion in work-leisure choice used
to measure excess burden of tax must be based
only on change in work hours due to substitution
effect caused by the tax.
• Labor supply response must be adjusted to
remove income effect of tax-induced wage change.
• Curve showing how hours worked per day vary
with wages when income effect of wage changes
is removed is a compensated labor supply curve.
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Perfectly Inelastic Labor Supply

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Elasticity of Supply of Labor Exceeding Zero

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 Empirical Evidence on Labor Supply
• For males between 25 and 55, income effect of
wage changes roughly equal to substitution effect.
• Substitution effect of wage reductions caused by
income tax is large, but is offset by an equally
large income effect.
• Studies conclude income taxes have little effect
on labor supply decisions of workers who provide
main source of income to household.
• Greater effect on labor supply of other household
members.
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 Taxation of Interest Income
• Taxation of interest income lowers return to
saving but can either increase or decrease
actual amount of saving observed.
• Indifference curve analysis can be used to
analyze one’s choice between consumption
and saving.
• Marginal rate of time preference (MRTP) is the
slope of an indifference curve for present and
future consumption multiplied by –1.

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Taxation of Interest Income

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Savings and Taxation of Interest Income

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 Incidence of Taxes on Interest Income
• If annual amount of saving is responsive to tax-induced
declines in net interest payments, tax can be shifted from
savers to borrowers through increase in market rate of
interest.
• Higher interest offsets some tax burden on savers, but
increases production costs, resulting in tax being shifted to
consumers in form of higher prices.
• Decreased investment results in slower growth of nation’s
capital stock.
• Lower ratio of capital to labor decreases labor productivity,
implying that, in competitive labor markets, wages would
be lower than if there were no tax on interest income.
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• Taxation of interest income causes the interest rate paid by
investors to diverge from that received by savers.
• The result is a loss in efficiency in markets for loanable funds
used to finance investment and accumulation of assets.
• Most evidence appears to indicate that savings is quite
unresponsive to changes in the market rate of interest.
When interest rates change, income and substitution effects
influence both current and future consumption, making it
difficult to predict the effect of the change in the interest
rates on saving.
• Although some empirical studies have suggested that saving
is somewhat responsive to change in interest rates, most
economists believe that the effect, if any, is small—implying
that taxation of interest income has little effect on savings
rates in the United States. 50
 C h a p t e r 16

Economic impacts of Indirect Taxation: TAXES ON

CONSUMPTION AND SALES

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 Consumption as a Tax Base
• General tax on consumption equivalent to an income
tax that allows savings to be excluded from the tax
bases.
• Annual comprehensive consumption is annual
comprehensive income minus annual savings.
• Dominant form of taxation of consumption in the U.S.
is retail sales tax.
- About 1/3 of aggregate state government revenues.
• Federal government taxes consumption mainly
through use of excise taxes.

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 The Expenditure Tax

• Comprehensive consumption tax, or

“expenditure tax”, would work like an income
tax that allows exclusion of retirement
savings from the tax base.
• All savings, without limit, no matter for what
purpose, would be excluded from income.
• No tax penalty for withdrawing funds from
savings.
• Tax paid only when funds are converted to
cash and spent. 53
 Consumption, Saving & Capacity
• Can be argued that ability to pay more appropriately
measured by person’s basic capacity to earn income.
• Based on horizontal equity, two people with equal
potential to earn income should pay same amount of
taxes over their lifetimes.
• Lifetime income includes endowment of capital so
taxes would depend one’s tendencies to defer
consumption.
• One who saves nothing taxed entirely on basis of
labor income. One who saves pays taxes both on
labor earnings and income from accumulated capital.
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Comprehensive Consumption Tax Base
• Comprehensive consumption tax base excludes
any changes in net worth from the tax base.
• Only current expenditures are taxed under
consumption tax so measuring capital gains is
unnecessary.
• Since only current expenditures are taxes,
inflation is not a problem.
• Anything that increases net worth excluded from
tax base including savings, purchase of income-
producing assets and stocks and bonds.
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 Cash-Flow Tax
• Modified form of a general consumption tax.
• Savers would be permitted to deduct funds deposited
in qualified accounts from their income.
• Would allow taxpayers to deduct all savings deposited
in qualified accounts from AGI(adjusted gross income)
• Loans would be added to AGI as received but
deducted from income as they are repaid.
• Administrative mechanism exists to implement tax
similar to the cash-flow model but important decisions
would have to be made and difficult transition
problems could exist.
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Flat-Rate Consumption v. Flat-Rate Income Tax

• If both raise same revenue and saving is positive,

then tax rate under consumption tax would be
higher than under an equal-yield income tax.
• Tax base is smaller under consumption tax.
• Interest rate not affected by consumption tax so
no excess burden between current and future
consumption.
• Income tax taxes interest as it accrues and results
in loss in efficiency as individuals reallocate
resources between current and future use.
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Consumption Versus Income Tax

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 Impact on Labor Market Efficiency

• Gains from achieving efficiency in market for

loanable funds balanced with possible
additional losses in labor markets.
• Higher tax rate for consumption tax
decreases return to work effort and induces
labor market efficiency losses from distortion
of work-leisure choice.
• Substitution of consumption for income tax
increases effective tax on wages and shifts
down wages received at all hours of work. 59
Labor Market Efficiency

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 Incidence of Consumption Tax
• Because capital income excluded from taxation,
tax would be borne according to labor earnings.
• Portion borne by labor income could be shifted to
consumers if workers adjusted work hours in
response to tax.
• Consumption tax likely to be more regressive with
respect to income than equal-yield income tax.
• Rate structure of an expenditure tax could be
modified to achieve a collectively chosen
distribution of tax burden.
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 Excise Taxes
• Selective taxes levied on certain types of
consumption activities. Distorts choices among
goods and services resulting in efficiency losses
to the economy.
• Some designed to raise revenue (taxes on
tires).
• Others intended to discourage consumption
activities (taxes on liquor).
• Many consumption activities taxed are alleged
to generate negative externalities or are
considered luxury goods and services. 65
 Turnover Taxes
• Multistage sales taxes levied at some fixed rate on
transactions at all levels of production.
• Effective rate conditioned by number of stages of
production.
• Extremely productive levy, producing high, stable
yields at low rates.
• Low rate believed to discourage tax evasion.
• Studies show tax to be somewhat progressive.
• Effective rates on many food items lower than those on
clothing and other manufactured goods.

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 Value-Added Tax (VAT)
• General tax on consumption levied on value added to
intermediate products by businesses at each stage of
production.
• Value-added is difference between sales proceeds and
purchases of intermediate goods and services over a
certain period:
Value Added = Total Transactions – Intermediate Transactions
= Final Sales = GDP
= Wages + Interest + Profiles + Rents + Depreciation
• Not currently used by U.S. federal government.
• General tax on value added equivalent to tax on national
product.
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 Value-Added Tax (VAT)
• Product-type VAT allows no deduction from tax
base, either for firm’s outlays on capital goods
or for amortized deductions on such outlays.
• Income-type VAT allows no deduction for cost
of capital equipment in year of purchase, but
permits deduction for annual depreciation.
• Consumption-type VAT allows full cost of capital
to be deducted in year of purchase and is the
type used in most nations.

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 Administration of VAT
• Invoice method taxes all transactions at a fixed
proportional rate so firms only maintain invoices on
sales and purchases for each tax payment period.
• Tax liability determined by applying rate to total
sales invoices and deducting VAT paid on previous
intermediate purchases.
• Consumers purchase goods with VAT included in
the price.
• Firms that make capital purchases allowed tax
credit for taxes paid on capital goods.
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 Administration of VAT
• VAT typically rebated on export sales.
- Goods of nations that use the tax more competitive in
international markets when they are exported to nations
where there is no national sales tax.
• Imported products subject to VAT, increasing
prices to domestic consumers.
• A criticism of VAT is that costs of administration
and compliance high compared to other taxes.
- Estimated that administrative and compliance costs for
new VAT in U.S. could be $8 billion per year.

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Standard VAT Tax Rates, 2011

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 Final Exam 40%
• Ch3- Ch6
– 5 T/F
– 10 Multiple Choice
– 1 workout
– 5 Short Discussion Questions

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Thank You!!!

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