Excess burden of taxation

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In economics, the excess burden of taxation, also known as the deadweight cost or deadweight loss of taxation, is one of the economic losses that society suffers as the result of taxes or subsidies. Economic theory posits that distortions change the amount and type of economic behavior from that which would occur in a free market without the tax. Excess burdens can be measured using the average cost of funds or the marginal cost of funds (MCF). Excess burdens were first discussed by Adam Smith. [1]

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An equivalent kind of inefficiency can also be caused by subsidies (which technically can be viewed as taxes with negative rates).[ citation needed ]

Economic losses due to taxes were evaluated to be as low as 2.5 cents per dollar of revenue, and as high as 30 cents per dollar of revenue (on average), and even much higher at the margins. [2]

Measures of the excess burden

The cost of a distortion is usually measured as the amount that would have to be paid to the people affected by its supply, the greater the excess burden. The second is the tax rate: as a general rule, the excess burden of a tax increases with the square of the tax rate.[ citation needed ]

The average cost of funds is the total cost of distortions divided by the total revenue collected by a government. In contrast, the marginal cost of funds (MCF) is the size of the distortion that accompanied the last unit of revenue raised (i.e. the rate of change of distortion with respect to revenue). In most cases, the MCF increases as the amount of tax collected increases.[ citation needed ]

The standard position in economics is that the costs in a cost-benefit analysis for any tax-funded project should be increased according to the marginal cost of funds, because that is close to the deadweight loss that will be experienced if the project is added to the budget, or to the deadweight loss removed if the project is removed from the budget.[ citation needed ]

Distortion and redistribution

In the case of progressive taxes, the distortionary effects of a tax may be accompanied by other benefits: the redistribution of dollars from wealthier people to poorer people who could possibly obtain more benefit from them - in effect reducing economic inequalities and improving GDP growth. [3]

In fact almost any tax measure will distort the economy from the path or process that would have prevailed in its absence (land value taxes are a notable exception together with other capital or wealth taxes). For example, a sales tax applied to all goods will tend to discourage consumption of all the taxed items, and an income tax will tend to discourage people from earning money in the category of income that is taxed (unless they can manage to avoid being taxed). Some people may move out of the work force (to avoid income tax); some may move into the cash or black economies (where incomes are not revealed to the tax authorities).[ citation needed ]

For example, in Western nations the incomes of the relatively affluent are taxed partly to provide the money used to assist the relatively poor. As a result of the taxes (and associated subsidies to the poor), incentives are changed for both groups. The relatively rich are discouraged from declaring income and from earning marginal (extra) income, because they know that any additional money that they earn and declare will be taxed at their highest marginal tax rates.[ citation needed ] At the same time the poor have an incentive to conceal their own taxable income (and usually their assets) so as to increase the likelihood of their receiving state assistance (welfare trap). It can be argued that the distortion of incentives (the move away from a fiscally neutral stance that does not affect incentives) does more harm than good.[ citation needed ]

There was an example of distortion of the economy by tax policy some years ago in the UK when cars supplied by employers to their employees were taxed at advantageous rates (e.g. encouraging the growth of company car fleets). Over several years the distortion grew to the point that the majority of cars used by working families were company cars and the dealership structures, and even the types of cars used, altered to adjust to the tax regime.[ citation needed ]

Deliberate distortion

Not all distortions are bad; Pigovian taxes create distortions that correct for externalities and therefore have a negative MCF.[ citation needed ]

Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin taxes" are levied on products that incur additional costs to society, such as alcohol, tobacco and pollution. Ideally, these taxes raise the price to the exact level that the market would bear if the negative externalities were included in the price. Pigovian taxes are often preferable to outright prohibition, since prohibition incites trafficking, often resulting in crime and other social costs, but no revenue.[ citation needed ]

See also

Related Research Articles

A tax is a compulsory financial charge or some other type of levy imposed upon a taxpayer by a governmental organization in order to fund various public expenditures. A failure to pay, along with evasion of or resistance to taxation, is punishable by law. Taxes consist of direct or indirect taxes and may be paid in money or as its labour equivalent. The first known taxation took place in Ancient Egypt around 3000–2800 BC.

Deadweight loss

A deadweight loss, also known as excess burden or allocative inefficiency, is a loss of economic efficiency that can occur when the free market equilibrium for a good or a service is not achieved. That can be caused by monopoly pricing in the case of artificial scarcity, an externality, a tax or subsidy, or a binding price ceiling or price floor such as a minimum wage.

This aims to be a complete article list of economics topics:

An ecotax is a tax levied on activities which are considered to be harmful to the environment and is intended to promote environmentally friendly activities via economic incentives. Such a policy can complement or avert the need for regulatory approaches. Often, an ecotax policy proposal may attempt to maintain overall tax revenue by proportionately reducing other taxes ; such proposals are known as a green tax shift towards ecological taxation. Ecotaxes address the failure of free markets to consider environmental impacts.

A regressive tax is a tax imposed in such a manner that the tax rate decreases as the amount subject to taxation increases. "Regressive" describes a distribution effect on income or expenditure, referring to the way the rate progresses from high to low, so that the average tax rate exceeds the marginal tax rate. In terms of individual income and wealth, a regressive tax imposes a greater burden on the poor than on the rich: there is an inverse relationship between the tax rate and the taxpayer's ability to pay, as measured by assets, consumption, or income. These taxes tend to reduce the tax burden of the people with a higher ability to pay, as they shift the relative burden increasingly to those with a lower ability to pay.

A progressive tax is a tax in which the tax rate increases as the taxable amount increases. The term "progressive" refers to the way the tax rate progresses from low to high, with the result that a taxpayer's average tax rate is less than the person's marginal tax rate. The term can be applied to individual taxes or to a tax system as a whole; a year, multi-year, or lifetime. Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a lower ability to pay, as such taxes shift the incidence increasingly to those with a higher ability-to-pay. The opposite of a progressive tax is a regressive tax, where the average tax rate or burden decreases as an individual's ability to pay increases.

A Pigovian tax is a tax on any market activity that generates negative externalities. The tax is intended to correct an undesirable or inefficient market outcome, and does so by being set equal to the social cost of the negative externalities. In the presence of negative externalities, the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. Often-cited examples of such externalities are environmental pollution, and increased public healthcare costs associated with tobacco and sugary drink consumption.

A sin tax is an excise tax specifically levied on certain goods deemed harmful to society and individuals, for example alcohol and tobacco, candies, drugs, soft drinks, fast foods, coffee, sugar, gambling and pornography. Two claimed purposes are usually used to argue for such taxes. In contrast to Pigovian taxes, which are to pay for the damage to society caused by these goods, sin taxes are used to increase the price in an effort to lower their use, or failing that, to increase and find new sources of revenue. Increasing a sin tax is often more popular than increasing other taxes. However, these taxes have often been criticized for burdening the poor, taxing the physically and mentally dependent, and being part of a nanny state.

A proportional tax is a tax imposed so that the tax rate is fixed, with no change as the taxable base amount increases or decreases. The amount of the tax is in proportion to the amount subject to taxation. "Proportional" describes a distribution effect on income or expenditure, referring to the way the rate remains consistent, where the marginal tax rate is equal to the average tax rate.

In economics, tax incidence or tax burden is the effect of a particular tax on the distribution of economic welfare. Economists distinguish between the entities who ultimately bear the tax burden and those on whom tax is initially imposed. The tax burden measures the true economic weight of the tax, measured by the difference between real incomes or utilities before and after imposing the tax. An individuality on whom the tax is levied does not have to bear the true size of the tax. For the example of this difference, assume a firm, that contains employer and employees. The tax imposed on the employer is divided. The concept of tax incidence was initially brought to economists' attention by the French Physiocrats, in particular François Quesnay, who argued that the incidence of all taxation falls ultimately on landowners and is at the expense of land rent. Tax incidence is said to "fall" upon the group that ultimately bears the burden of, or ultimately suffers a loss from, the tax. The key concept of tax incidence is that the tax incidence or tax burden does not depend on where the revenue is collected, but on the price elasticity of demand and price elasticity of supply. As a general policy matter, the tax incidence should not violate the principles of a desirable tax system, especially fairness and transparency.

Arnold Carl Harberger is an American economist. His approach to the teaching and practice of economics is to emphasize the use of analytical tools that are directly applicable to real-world issues. His influence on academic economics is reflected in part by the widespread use of the term "Harberger triangle" to refer to the standard graphical depiction of the efficiency cost of distortions of competitive equilibrium. His influence on the practice of economic policy is manifested by the high positions attained in national agencies such as central banks and ministries of finance, and in international agencies such as the World Bank.

A tax incentive is an aspect of a country's tax code designed to incentivize or encourage a particular economic activity.

The Indian government has, since war, subsidised many industries and products, from fuel to gas.

In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and the ownership of private property. A distortion is "any departure from the ideal of perfect competition that therefore interferes with economic agents maximizing social welfare when they maximize their own". A proportional wage-income tax, for instance, is distortionary, whereas a lump-sum tax is not. In a competitive equilibrium, a proportional wage income tax discourages work.

Optimal tax theory or the theory of optimal taxation is the study of designing and implementing a tax that maximises a social welfare function subject to economic constraints. The social welfare function used is typically a function of individuals' utilities, most commonly some form of utilitarian function, so the tax system is chosen to maximise the aggregate of individual utilities. Tax revenue is required to fund the provision of public goods and other government services, as well as for redistribution from rich to poor individuals. However, most taxes distort individual behavior, because the activity that is taxed becomes relatively less desirable; for instance, taxes on labour income reduce the incentive to work. The optimization problem involves minimizing the distortions caused by taxation, while achieving desired levels of redistribution and revenue. Some taxes are thought to be less distorting, such as lump-sum taxes and Pigouvian taxes, where the market consumption of a good is inefficient and a tax brings consumption closer to the efficient level.

The marginal cost of public funds (MCF) is a concept in public finance which measures the loss incurred by society in raising additional revenues to finance government spending due to the distortion of resource allocation caused by taxation. Formally, it is defined as the ratio of the marginal value of a monetary unit raised by the government and the value of that marginal private monetary unit. The applications of the marginal cost of public funds include the Samuelson condition for the optimal provision of public goods and the optimal corrective taxation of externalities in public economic theory, the determination of tax-smoothing policy rules in normative public debt analysis and social cost-benefit analysis common in practical policy analysis.

In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of government revenue. The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and 100%, and that there is a tax rate between 0% and 100% that maximizes government tax revenue. The curve illustrates the concept of taxable income elasticity – i.e., taxable income changes in response to changes in the rate of taxation.

The OneTax is a tax reform plan and proposed amendment to the United States Constitution that eliminates the federal income tax for all individuals earning less than $215,870. The OneTax is described as revenue-neutral, which means that it compensates for lost revenue from the income tax by closing loopholes and eliminating tax expenditures in the current income tax system.

Optimal capital income taxation is a subarea of optimal tax theory which refers to the study of designing a tax on capital income such that a given economic criterion like utility is optimized. Starting from the conceptualization of capital income as future consumption, the taxation of capital income corresponds to a differentiated consumption tax on present and future consumption. Consequently, a capital income tax results in the distortion of individuals' saving and consumption behavior as individuals substitute the more heavily taxed future consumption with current consumption. Due to these distortions, zero taxation of capital income might be optimal, a result postulated by the Atkinson–Stiglitz theorem (1976) and the Chamley–Judd zero capital income tax result (1985/1986). Subsequent work on optimal capital income taxation has elucidated the assumptions underlying the theoretical optimality of a zero capital income tax and advanced diverse arguments for a positive optimal capital tax.

Optimal labor income tax is a subarea of optimal tax theory which refers to the study of designing a tax on individual labor income such that a given economic criterion like social welfare is optimized.

References

  1. "Adam Smith and Tax Burden Theory" . Retrieved 6 Jun 2012.
  2. See Martin Feldstein, Tax Avoidance and the Deadweight Loss of the Income Tax, 81(4), Review of Economics and Statistics (1999), at p. 674; Charles L. Ballard, John B. Shoven and John Whalley, The Welfare Cost of Distortions in the United States Tax System: A General Equilibrium Approach, National Bureau of Economic Research Working Paper No. 1043. For a review of literature arguing that moving to a uniform taxation of investment will lead to 0.1% to 0.3% increase in GNP, see Lawrence H. Summers, Should Tax Reform Level the Playing Field?, National Bureau of Economic Research Working Paper No. 2132, Cambridge, MA, January 1987.
  3. Ostry Jonathan, Berg Andrew, Tsangarides Charalambos. “Redistribution, Inequality, and Growth”. Staff Discussion Notes No. 14/02, International Monetary Fund, February 2014