Key Concepts
Adam Smith's "canons of taxation"
• Equality : Tax payments should be proportional to income, % of income paid in tax is same for all
• Certainty: Tax liabilities should be clear and certain
• Convenience of payment : Taxes collected in a convenient time and manner, minimise tax bureaucracy
• Economy of collection: Taxes should not be expensive to collect and not discourage business
Economics of Tax Policy
• 2 issues: efficiency cost (distortionary effect) and tax incidence (burden)
• Distortions as change behaviour in ways they wouldn’t without tax (e.g. work less, buy other goods) & cause DWL
• Taxation is a political issue so short term political goals can interfere with taxes.
• Tax can signal values of society e.g. smoking, R&D. Unobtrusive taxation may be preferred ("stealth taxes")
Economic incidence of taxation
• Formal incidence: legally liable to pay. Effective incidence: burden of the tax and whose living standard falls
• Formal incidence is irrelevant for long run effective incidence of tax. Formal incidence determines curve shift
• Tax on buyer shifts demand down. Tax on supply shifts up. With this tax, buyer pays PB & seller receives PS
• A sales tax is typically collected from retail businesses. But the effective incidence is on customers.
- Every tax on a business is borne by customers, workers or shareholders: shifted back
• Effective incidence of a sales tax in a perfectly competitive market: whoever is less elastic
- If demand is more elastic, the effective incidence is more on the seller as they lack alternatives
Sales tax incidence with imperfect competition
• If MC is horizontal, in perfect competition, consumer bears whole burden
• Monopoly: a per-unit sales tax shifts MC up by the full amount of the tax
- If demand is linear, a tax of T raises price by 0.5T
- Constant elasticity demand: price rises by more than T (tax over-shifted, burden to consumers exceeds T)
• Oligopoly: with tax, if A raises its price, rivals may not so they can steal A’s market share (tax is more incident
on the firms). Or the firms may also raise their price
Excess Burden
• Excess burden= deadweight welfare loss: the additional cost of raising a given revenue through distortionary
taxation as compared with a lump sum tax that yields equal revenue. 20-30cents per $
• Marginal excess burden: additional excess burden for £1 extra revenue. In an efficient tax system, to raise a
given revenue at the least economist cost, the MEB of each tax is equalised
• Diagram shows consumer’s preferences between taxed good S and other goods.
• Assume burden is fully on consumer. The tax raised is the distance between the before & after budget constraint
- The sales tax S has an income and substitution effect and new equilibrium is Et
• Income effect: shown by parallel budget constraint as income lower but relative prices unchanged
- this effect depends on the average tax rate
• Lump sum tax moves us to EY instead (parallel shift). Has no distortion as cannot escape it by changing behaviour
• At Et the revenue collected from the sales tax (measured in terms of other goods given up) is vertical distance RS
• The lump sum tax could have raised RL in total which is more than the sales tax revenue RS
- whilst the utility of the person would be the same (same IC)
• DWL from sales tax on S is RL –RS. This is wasted: not transferred to the government, welfare loss for consumer
- Magnitude of the DWL depends on the size of the sub effect which depends on the marginal tax rate
- With L shaped ICs, no sub effect so no DWL
• Top diagram illustrates how deadweight loss rises with the square of the tax rate. Assume horizontal supply
• DWL with tax rate t is D . Now tax doubles so DWL is shaded area plus white triangle. Now DWL is 4D
- So high tax rates are bad as they cause a large DWL: spread taxes across goods for a certain revenue
• Bottom diagram illustrates how deadweight loss is greater with more elastic demand
- DWL higher for a more elastic good. So tax inelastic goods (to where MEB inelastic=MEB elastic good)
- If demand or supply is perfectly inelastic, there is no DWL nor distortion
• E.g. Income tax of 25% on total earnings of £100 vs £25 lump sum tax. Latter not reduce hours worked (or
goods consumed) so has no disincentive effect. Also has no incentive effect to work more hours due to tax
Distributional Incidence of Tax
• Matters as the policymaker wants equity or fairness and cares about who gains and loses from the tax
• Proportional tax: household’s tax payments are a constant percentage of income
• Progressive: tax payments increase as a % of income as incomes rise. Average tax rate rises with income
- The MTR>ATR even if MTR is falling. Digram shows a linear tax which is always progressive
- If ATR is steeper, tax is more progressive. When income is below personal threshold, given tax credit
• We can consider for single taxes but better to look overall as a progressive tax can offset a regressive one
Current vs lifetime income redistribution
• Current: income fluctuates over time and low income can be temporary and not suggest household is poor
- Household can borrow or use its savings to make up its living standard
• Lifetime: can borrow and save to smooth temporary income fluctuations but lifetime income if the budget constraint
- A better measure of who is truly poor but it’s an expected value & cannot measure objectively
• Current consumption (spending) may be a good proxy for lifetime income if households smooth consumption
• Issue of lumpy spending (e.g. durables) so non-durable spending may be the best indicator of living standards
, Key Concepts
• Issue of inability to borrow: e.g. market failures like credit constraints, moral hazard so we may want some within-lifetime redistribution
• Poterba: we could consider tax as a % of total expenditure, putting people into quintiles of expenditure. Taxes appear less regressive
• Stiglitz: The government cannot change only one policy at a time: altering one tax means altering another (differential analysis) or
altering spending (balanced budget incidence)
Tax Capitalisation
• Bond sells for £100 and yields 10% per year forever. Income tax of 50% is levied on it so post-tax return is £5 per year
- Now the bond is tax exempt so its yields £10 per year. To a taxpayer, it is worth twice as much so price doubles to £200
• Those who purchased it for £200 only earn 5% (£10) on it so they don’t benefit: no better off from the concession
• However if tax free status was withdrawn, they will suffer as they paid more for it but it will now only sell for £100 and because they
will now only earn £5 post tax: tax capitalisation trap. Better if never given but if given, inequitable to withdraw it
- Only those who held the bond before the tax free status benefit: the capital value of their asset doubled
Taxes on Spending: VAT
• Contributes about one sixth of total UK revenue. Standard rate of 20% to 56% of consumer expenditure
• Tax on the value of sales by VAT-registered businesses (e.g. small firms don’t register or pay it)
- Registered businesses charge VAT on sales but can claim back VAT paid for inputs into production
- If all goods and services were taxed at the same rate, this would be equivalent to taxing value added by businesses
• All EU members have a VAT since 70s and VAT base must be harmonised.
- VAT rates are less harmonised ( member states choose their rates but there are minimum rate and restrictions on low or 0 rating)
• UK VAT: 5% for domestic fuel & power; 0 for food, books, public transport & kids’ clothing: significant spending for poor households
- Zero rating means no VAT on sales but producers can reclaim VAT on inputs
- Exemptions for banking and other financial services, and for small firms (below VAT registration threshold)
- Exempt firms charge no VAT on sales, but cannot reclaim VAT on inputs. So G&S have an effective tax rate of 4-7%
Types of Sales Tax
1. Value Added Tax
2. Retail sales tax: on the value of sales to final consumers. Sales to other businesses are untaxed.
3. Turnover tax ("Cascade tax”): on value of sales (including intermediate goods), with no credit for tax on inputs.
• Advantages: A low rate of tax yields same revenues as a higher VAT or RST, with little incentive for evasion as rate is so low
• Disadvantage: 1) Tax burden varies on the number of intermediate transactions
- it creates an incentive for vertical integration i.e. do everything in house to avoid to transactions even if it’s less efficient
• 2) Exports are more expensive and less competitive but exact export rebates cannot be calculated as we only know tax on final price
• Imported goods can’t be taxed in the same manner as domestic goods. Could lead to subsidised exports (refund more tax)
VAT vs RST
• Firm 1 produces intermediate goods which are used in production by firm 2 which reclaims some VAT
• RST & VAT collect the same total revenue (600) with the same tax rate (20%)
• VAT collects tax earlier (cash flow benefit) whilst RST is at the final sale & in smaller amounts from
each taxpayer (reducing exposure to evasion) as RST is from firm 2 only so may underreport sales
• The tax burden on the product sold to the final consumer is the same.
- 20% of the pre-tax selling price
• Both impose final tax burden on final consumption goods only. Firm 2 can reclaim VAT
- So the decision of how many intermediate inputs to buy are not distorted by the VAT on inputs
- Firm 2 is indifferent to the VAT that is charged on its input
- Mirlees: revenue raising tax shouldn’t be imposed on intermediate goods: no effective burden
• RST: requires a distinction on the end user since businesses are untaxed. Gives scope for evasion
• A sales tax levied uniform percentage rate will tend to be mildly regressive, judged in relation to
current household incomes. Since poorer people spend a higher proportion of their income. Richest
have lowest VAT paid as a % of household income
• So make sales tax more progressive by reducing rate on necessities e.g. 0 rating on food.
- 0 rating can give more cash to richer households who spend more on food in absolute terms
- $0.2 in every $1 not taxed info goes to the richest 10%: gain the most benefit from foregone
revenue as 0 rating subsidies high consumption of food.
• Called tax expenditure & means there is poor targeting. Other methods more effective to redistribute
• Advantage of VAT over RST is that small firms can be made exempt with less revenue loss
- Since they still face VAT on intermediate goods which they can’t reclaim so they face a small effective VAT rate
• Policy change: for small firms tax sales at lower rate with no reclaims. Firms under threshold could volunteer as can then reclaim
• Keen Mintz: optimal VAT threshold is where MB of additional revenue= MC of higher admin costs for gov + compliance for firms
• At optimum: (D-1)tVZ = DA + C . Rearrange to find optimal threshold Z*
• D= MC of public funds= 1+ Marginal excess burden; t=tax rate; Z= turnover threshold, and V the share of value-added in turnover.
• We factor in D as there is a distortion in transferring funds from the private to government. A&C are admin and compliance costs
• Factor in V as we lose the tax revenue from final sales but not inputs. Factor in the MEB and not the full dollar value as its the
opportunity cost
• Issue: bunching under threshold to avoid compliance costs which are fixed (don’t depend on output) and due to the Discontinuity in tax
liability – once registered, tax is paid on all turnover . Some firms will remain below efficient size to be under threshold
• Optimal VAT decision is hard: higher threshold reduces output distortion of firms below threshold who now purchase more
intermediate goods which raises VAT revenue. But firms above threshold will reduce output to below threshold
Adam Smith's "canons of taxation"
• Equality : Tax payments should be proportional to income, % of income paid in tax is same for all
• Certainty: Tax liabilities should be clear and certain
• Convenience of payment : Taxes collected in a convenient time and manner, minimise tax bureaucracy
• Economy of collection: Taxes should not be expensive to collect and not discourage business
Economics of Tax Policy
• 2 issues: efficiency cost (distortionary effect) and tax incidence (burden)
• Distortions as change behaviour in ways they wouldn’t without tax (e.g. work less, buy other goods) & cause DWL
• Taxation is a political issue so short term political goals can interfere with taxes.
• Tax can signal values of society e.g. smoking, R&D. Unobtrusive taxation may be preferred ("stealth taxes")
Economic incidence of taxation
• Formal incidence: legally liable to pay. Effective incidence: burden of the tax and whose living standard falls
• Formal incidence is irrelevant for long run effective incidence of tax. Formal incidence determines curve shift
• Tax on buyer shifts demand down. Tax on supply shifts up. With this tax, buyer pays PB & seller receives PS
• A sales tax is typically collected from retail businesses. But the effective incidence is on customers.
- Every tax on a business is borne by customers, workers or shareholders: shifted back
• Effective incidence of a sales tax in a perfectly competitive market: whoever is less elastic
- If demand is more elastic, the effective incidence is more on the seller as they lack alternatives
Sales tax incidence with imperfect competition
• If MC is horizontal, in perfect competition, consumer bears whole burden
• Monopoly: a per-unit sales tax shifts MC up by the full amount of the tax
- If demand is linear, a tax of T raises price by 0.5T
- Constant elasticity demand: price rises by more than T (tax over-shifted, burden to consumers exceeds T)
• Oligopoly: with tax, if A raises its price, rivals may not so they can steal A’s market share (tax is more incident
on the firms). Or the firms may also raise their price
Excess Burden
• Excess burden= deadweight welfare loss: the additional cost of raising a given revenue through distortionary
taxation as compared with a lump sum tax that yields equal revenue. 20-30cents per $
• Marginal excess burden: additional excess burden for £1 extra revenue. In an efficient tax system, to raise a
given revenue at the least economist cost, the MEB of each tax is equalised
• Diagram shows consumer’s preferences between taxed good S and other goods.
• Assume burden is fully on consumer. The tax raised is the distance between the before & after budget constraint
- The sales tax S has an income and substitution effect and new equilibrium is Et
• Income effect: shown by parallel budget constraint as income lower but relative prices unchanged
- this effect depends on the average tax rate
• Lump sum tax moves us to EY instead (parallel shift). Has no distortion as cannot escape it by changing behaviour
• At Et the revenue collected from the sales tax (measured in terms of other goods given up) is vertical distance RS
• The lump sum tax could have raised RL in total which is more than the sales tax revenue RS
- whilst the utility of the person would be the same (same IC)
• DWL from sales tax on S is RL –RS. This is wasted: not transferred to the government, welfare loss for consumer
- Magnitude of the DWL depends on the size of the sub effect which depends on the marginal tax rate
- With L shaped ICs, no sub effect so no DWL
• Top diagram illustrates how deadweight loss rises with the square of the tax rate. Assume horizontal supply
• DWL with tax rate t is D . Now tax doubles so DWL is shaded area plus white triangle. Now DWL is 4D
- So high tax rates are bad as they cause a large DWL: spread taxes across goods for a certain revenue
• Bottom diagram illustrates how deadweight loss is greater with more elastic demand
- DWL higher for a more elastic good. So tax inelastic goods (to where MEB inelastic=MEB elastic good)
- If demand or supply is perfectly inelastic, there is no DWL nor distortion
• E.g. Income tax of 25% on total earnings of £100 vs £25 lump sum tax. Latter not reduce hours worked (or
goods consumed) so has no disincentive effect. Also has no incentive effect to work more hours due to tax
Distributional Incidence of Tax
• Matters as the policymaker wants equity or fairness and cares about who gains and loses from the tax
• Proportional tax: household’s tax payments are a constant percentage of income
• Progressive: tax payments increase as a % of income as incomes rise. Average tax rate rises with income
- The MTR>ATR even if MTR is falling. Digram shows a linear tax which is always progressive
- If ATR is steeper, tax is more progressive. When income is below personal threshold, given tax credit
• We can consider for single taxes but better to look overall as a progressive tax can offset a regressive one
Current vs lifetime income redistribution
• Current: income fluctuates over time and low income can be temporary and not suggest household is poor
- Household can borrow or use its savings to make up its living standard
• Lifetime: can borrow and save to smooth temporary income fluctuations but lifetime income if the budget constraint
- A better measure of who is truly poor but it’s an expected value & cannot measure objectively
• Current consumption (spending) may be a good proxy for lifetime income if households smooth consumption
• Issue of lumpy spending (e.g. durables) so non-durable spending may be the best indicator of living standards
, Key Concepts
• Issue of inability to borrow: e.g. market failures like credit constraints, moral hazard so we may want some within-lifetime redistribution
• Poterba: we could consider tax as a % of total expenditure, putting people into quintiles of expenditure. Taxes appear less regressive
• Stiglitz: The government cannot change only one policy at a time: altering one tax means altering another (differential analysis) or
altering spending (balanced budget incidence)
Tax Capitalisation
• Bond sells for £100 and yields 10% per year forever. Income tax of 50% is levied on it so post-tax return is £5 per year
- Now the bond is tax exempt so its yields £10 per year. To a taxpayer, it is worth twice as much so price doubles to £200
• Those who purchased it for £200 only earn 5% (£10) on it so they don’t benefit: no better off from the concession
• However if tax free status was withdrawn, they will suffer as they paid more for it but it will now only sell for £100 and because they
will now only earn £5 post tax: tax capitalisation trap. Better if never given but if given, inequitable to withdraw it
- Only those who held the bond before the tax free status benefit: the capital value of their asset doubled
Taxes on Spending: VAT
• Contributes about one sixth of total UK revenue. Standard rate of 20% to 56% of consumer expenditure
• Tax on the value of sales by VAT-registered businesses (e.g. small firms don’t register or pay it)
- Registered businesses charge VAT on sales but can claim back VAT paid for inputs into production
- If all goods and services were taxed at the same rate, this would be equivalent to taxing value added by businesses
• All EU members have a VAT since 70s and VAT base must be harmonised.
- VAT rates are less harmonised ( member states choose their rates but there are minimum rate and restrictions on low or 0 rating)
• UK VAT: 5% for domestic fuel & power; 0 for food, books, public transport & kids’ clothing: significant spending for poor households
- Zero rating means no VAT on sales but producers can reclaim VAT on inputs
- Exemptions for banking and other financial services, and for small firms (below VAT registration threshold)
- Exempt firms charge no VAT on sales, but cannot reclaim VAT on inputs. So G&S have an effective tax rate of 4-7%
Types of Sales Tax
1. Value Added Tax
2. Retail sales tax: on the value of sales to final consumers. Sales to other businesses are untaxed.
3. Turnover tax ("Cascade tax”): on value of sales (including intermediate goods), with no credit for tax on inputs.
• Advantages: A low rate of tax yields same revenues as a higher VAT or RST, with little incentive for evasion as rate is so low
• Disadvantage: 1) Tax burden varies on the number of intermediate transactions
- it creates an incentive for vertical integration i.e. do everything in house to avoid to transactions even if it’s less efficient
• 2) Exports are more expensive and less competitive but exact export rebates cannot be calculated as we only know tax on final price
• Imported goods can’t be taxed in the same manner as domestic goods. Could lead to subsidised exports (refund more tax)
VAT vs RST
• Firm 1 produces intermediate goods which are used in production by firm 2 which reclaims some VAT
• RST & VAT collect the same total revenue (600) with the same tax rate (20%)
• VAT collects tax earlier (cash flow benefit) whilst RST is at the final sale & in smaller amounts from
each taxpayer (reducing exposure to evasion) as RST is from firm 2 only so may underreport sales
• The tax burden on the product sold to the final consumer is the same.
- 20% of the pre-tax selling price
• Both impose final tax burden on final consumption goods only. Firm 2 can reclaim VAT
- So the decision of how many intermediate inputs to buy are not distorted by the VAT on inputs
- Firm 2 is indifferent to the VAT that is charged on its input
- Mirlees: revenue raising tax shouldn’t be imposed on intermediate goods: no effective burden
• RST: requires a distinction on the end user since businesses are untaxed. Gives scope for evasion
• A sales tax levied uniform percentage rate will tend to be mildly regressive, judged in relation to
current household incomes. Since poorer people spend a higher proportion of their income. Richest
have lowest VAT paid as a % of household income
• So make sales tax more progressive by reducing rate on necessities e.g. 0 rating on food.
- 0 rating can give more cash to richer households who spend more on food in absolute terms
- $0.2 in every $1 not taxed info goes to the richest 10%: gain the most benefit from foregone
revenue as 0 rating subsidies high consumption of food.
• Called tax expenditure & means there is poor targeting. Other methods more effective to redistribute
• Advantage of VAT over RST is that small firms can be made exempt with less revenue loss
- Since they still face VAT on intermediate goods which they can’t reclaim so they face a small effective VAT rate
• Policy change: for small firms tax sales at lower rate with no reclaims. Firms under threshold could volunteer as can then reclaim
• Keen Mintz: optimal VAT threshold is where MB of additional revenue= MC of higher admin costs for gov + compliance for firms
• At optimum: (D-1)tVZ = DA + C . Rearrange to find optimal threshold Z*
• D= MC of public funds= 1+ Marginal excess burden; t=tax rate; Z= turnover threshold, and V the share of value-added in turnover.
• We factor in D as there is a distortion in transferring funds from the private to government. A&C are admin and compliance costs
• Factor in V as we lose the tax revenue from final sales but not inputs. Factor in the MEB and not the full dollar value as its the
opportunity cost
• Issue: bunching under threshold to avoid compliance costs which are fixed (don’t depend on output) and due to the Discontinuity in tax
liability – once registered, tax is paid on all turnover . Some firms will remain below efficient size to be under threshold
• Optimal VAT decision is hard: higher threshold reduces output distortion of firms below threshold who now purchase more
intermediate goods which raises VAT revenue. But firms above threshold will reduce output to below threshold
