Excess burden of taxation

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In economics, the excess burden 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 have been 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] [3] [4]

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 ]

A common 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. [5]

In fact almost any tax measure will distort the economy from the path or process that would have prevailed in its absence. 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).

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

Pigovian taxes create distortions intended to correct for externalities and produce 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 tax revenue.[ citation needed ]

See also

Related Research Articles

A tax is a mandatory financial charge or levy imposed on a taxpayer by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax compliance refers to policy actions and individual behavior aimed at ensuring that taxpayers are paying the right amount of tax at the right time and securing the correct tax allowances and tax relief. The first known taxation occurred in Ancient Egypt around 3000–2800 BC. Taxes consist of direct or indirect taxes and may be paid in money or as labor equivalent.

<span class="mw-page-title-main">Deadweight loss</span> Measure of lost economic efficiency

In economics, deadweight loss is the loss of societal economic welfare due to production/consumption of a good at a quantity where marginal benefit does not equal marginal cost – in other words, there are either goods being produced despite the cost of doing so being larger than the benefit, or additional goods are not being produced despite the fact that the benefits of their production would be larger than the costs. The deadweight loss is the net benefit that is missed out on. While losses to one entity often lead to gains for another, deadweight loss represents the loss that is not regained by anyone else. This loss is therefore attributed to both producers and consumers.

<span class="mw-page-title-main">Index of economics articles</span>

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

Supply-side economics is a macroeconomic theory postulating that economic growth can be most effectively fostered by lowering taxes, decreasing regulation, and allowing free trade. According to supply-side economics theory, consumers will benefit from greater supply of goods and services at lower prices, and employment will increase. Supply-side fiscal policies are designed to increase aggregate supply, as opposed to aggregate demand, thereby expanding output and employment while lowering prices. Such policies are of several general varieties:

  1. Investments in human capital, such as education, healthcare, and encouraging the transfer of technologies and business processes, to improve productivity. Encouraging globalized free trade via containerization is a major recent example.
  2. Tax reduction, to provide incentives to work, invest and take risks. Lowering income tax rates and eliminating or lowering tariffs are examples of such policies.
  3. Investments in new capital equipment and research and development (R&D), to further improve productivity. Allowing businesses to depreciate capital equipment more rapidly gives them an immediate financial incentive to invest in such equipment.
  4. Reduction in government regulations, to encourage business formation and expansion.

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.

Tax reform is the process of changing the way taxes are collected or managed by the government and is usually undertaken to improve tax administration or to provide economic or social benefits. Tax reform can include reducing the level of taxation of all people by the government, making the tax system more progressive or less progressive, or simplifying the tax system and making the system more understandable or more accountable.

A Pigouvian tax is a tax on any market activity that generates negative externalities. A Pigouvian tax is a method that tries to internalize negative externalities to achieve the Nash equilibrium and optimal Pareto efficiency. The tax is normally set by the government to correct an undesirable or inefficient market outcome and does so by being set equal to the external marginal cost of the negative externalities. In the presence of negative externalities, social cost includes private cost and external cost caused by negative externalities. This means 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 negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.

A tax cut represents a decrease in the amount of money taken from taxpayers to go towards government revenue. Tax cuts decrease the revenue of the government and increase the disposable income of taxpayers. Tax cuts usually refer to reductions in the percentage of tax paid on income, goods and services. As they leave consumers with more disposable income, tax cuts are an example of an expansionary fiscal policy. Tax cuts also include reduction in tax in other ways, such as tax credit, deductions and loopholes.

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 the tax is initially imposed. The tax burden measures the true economic effect of the tax, measured by the difference between real incomes or utilities before and after imposing the tax, and taking into account how the tax causes prices to change. For example, if a 10% tax is imposed on sellers of butter, but the market price rises 8% as a result, most of the tax burden is on buyers, not sellers. 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. The concept of tax incidence is used in political science and sociology to analyze the level of resources extracted from each income social stratum in order to describe how the tax burden is distributed among social classes. That allows one to derive some inferences about the progressive nature of the tax system, according to principles of vertical equity.

A tax incentive is an aspect of a government's taxation policy designed to incentivize or encourage a particular economic activity by reducing tax payments.

<span class="mw-page-title-main">Tax policy</span> Choice by a government as to what taxes to levy, in what amounts, and on whom

Tax policy refers to the guidelines and principles established by a government for the imposition and collection of taxes. It encompasses both microeconomic and macroeconomic aspects, with the former focusing on issues of fairness and efficiency in tax collection, and the latter focusing on the overall quantity of taxes to be collected and its impact on economic activity. The tax framework of a country is considered a crucial instrument for influencing the country's economy.

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.

Economic theory evaluates how taxes are able to provide the government with required amount of the financial resources and what are the impacts of this tax system on overall economic efficiency. If tax efficiency needs to be assessed, tax cost must be taken into account, including administrative costs and excessive tax burden also known as the dead weight loss of taxation (DWL). Direct administrative costs include state administration costs for the organisation of the tax system, for the evidence of taxpayers, tax collection and control. Indirect administrative costs can include time spent filling out tax returns or money spent on paying tax advisors.

The marginal cost of public funds (MCF) is a concept in public finance which measures the loss incurred by society in raising less 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.

Optimal capital income taxation is a subarea of optimal tax theory which studies the design of taxes on capital income such that a given economic criterion like utility is optimized.

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

A wage subsidy is a payment to workers by the state, made either directly or through their employers. Its purposes are to redistribute income and to obviate the welfare trap attributed to other forms of relief, thereby reducing unemployment. It is most naturally implemented as a modification to the income tax system.

References

  1. ↑ "Adam Smith and Tax Burden Theory" . Retrieved 6 Jun 2012.
  2. ↑ Feldstein, Martin (1999). "Tax Avoidance and the Deadweight Loss of the Income Tax" (PDF). Review of Economics and Statistics. 81 (4). p. 674. doi:10.1162/003465399558391. S2CID   57568398.
  3. ↑ Ballard, Charles L.; Shoven, John B.; Whalley, John (1982). "The Welfare Cost of Distortions in the United States Tax System: A General Equilibrium Approach". National Bureau of Economic Research Working Paper (1043). doi: 10.3386/w1043 . S2CID   152604988.
  4. ↑ 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 Summers, Lawrence H. (1987). "Should Tax Reform Level the Playing Field?". National Bureau of Economic Research Working Paper (2132). Cambridge, MA. doi: 10.3386/w2132 .
  5. ↑ Ostry Jonathan, Berg Andrew, Tsangarides Charalambos. “Redistribution, Inequality, and Growth”. Staff Discussion Notes No. 14/02, International Monetary Fund, February 2014
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