Economic theory evaluates how taxes are able to provide the government with required amount of the financial resources (fiscal efficiency) 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.
Achieving an ideal tax system is not possible in practice. However, there is an effort to find the optimal form of taxation. For example personal income taxation should guarantee a high level of equity through progressiveness.
A financial process is said to be tax efficient if it is taxed at a lower rate than an alternative financial process that achieves the same end.[1]
Passing one's assets onto one's heirs using a Grantor Retained Annuity Trust, for example, is potentially more tax efficient than simply letting the heirs inherit the assets directly.
Tax effects
Each tax has two effects:
Income effect
Income effect expresses the fact that entity's tax deducts part of its disposable income, either directly or by forcing to pay a higher price for the goods consumer. Every tax has this effect. Its size depends on the amount of the tax. It grows with the growth of the average (effective) tax rate.
Substitution effect
Substitution effect means that the taxpayer changes his preferences as his marginal benefits from the consumption of goods, income, labor, leisure, etc. Only flat taxes do not cause this effect. Its size depends on the marginal tax rate. The higher is the marginal rate, the higher is the substitution effect.[2] Consumers will naturally prefer the goods which price dropped/stayed the same, since the price of other goods is the same/increased as an effect of imposing a tax. Their response is labeled as substitution effect, where the quantity demanded changes because of the relative change in price.
Impact of taxes
The important question is who actually pays the tax. It does not always have to be the entity that pays the state taxes. By the tax impact is meant who ultimately pays a certain tax meaning who is subject to the tax burden.
The tax subject can shift its cost to other entity (tax shift forward to consumer - VAT, backward shift of the tax to supplier or even employee). The possibility of using the tax shift is given by the flexibility of demand and supply in the market of goods on which the tax is imposed. If demand is relatively inelastic, it is easier for sellers to shift the tax to the buyer. However, if the demand is relatively inflexible, the tax will fall on the seller. The targets of the tax may coincide with its real effects. For example taxing luxury goods may result in a reduction of the revenues of luxury goods producers, not an actual increase in the tax revenue.[2]
Costs of taxation
Taxes can also have economic and social costs aside from the cost of the tax itself. These costs can arise from administering and collecting taxes. It is important for policymakers to consider the costs of taxation whilst designing efficient tax policies. In countries where the costs of taxation are too high (tax policies are inefficient), tax avoidance and tax evasion rates can be high. We can categorise these costs:
Efficiency costs
Taxes alter the incentives of economic agents and thus affect production decisions. Higher taxes make goods and services more expensive meaning individuals, firms and governments will search for alternatives. For example, higher taxes on incomes reduce the incentives of individuals to invest which can have long-term impacts on the productivity of the economy.
Efficiency costs can be quantified using marginal efficiency cost (MEC). MEC tells us the cost of raising $1 of tax through the use of different types of tax. For example: if capital tax has a MEC of $0.50 then it costs the government $0.50 to collect $1 from capital taxes. Marginal efficiency cost of taxes can help policymakers to decide what to implement taxes on by pursuing taxes with a low MEC.
Historical estimates of MEC show that taxes on consumption tend to have a significantly lower MEC than taxes on income. This is because taxing consumption does not create as many disincentives as taxing peoples incomes.[3]
Deadweight loss
Taxation leads to a reduction in the economic well-being known as deadweight loss. This loss occurs because taxes create disincentives for production. The gap between taxed and the tax-free production is the deadweight loss.[4] Deadweight loss reduces both the consumer and producer surplus.[5] The magnitude of deadweight loss depends on the elasticities of supply and demand for the taxed good or service.
Progressivity and Tax Efficiency
Progressivity is an important concept when evaluating tax efficiency. A progressive tax system is one in which the average tax rate increases as the taxable amount increases. The idea behind a progressive tax is to lessen the tax burden on people with a lower ability to pay, as they have lower incomes. Progressive taxes are generally seen as promoting equity and social welfare by reducing income inequality. However, there can be potential trade-offs between progressivity and tax efficiency. As taxes become more progressive, there may be increasing disincentives for higher-income individuals to work or invest, as they face higher marginal tax rates. This can lead to a decrease in overall economic activity and potential deadweight loss, reducing tax efficiency. Policymakers need to find a balance between progressivity and efficiency when designing tax systems in order to minimize these trade-offs and maintain economic growth while promoting social welfare.[6]
Compliance costs
It can be expensive to hire tax consultants or tax software, especially for smaller businesses and individuals. Compliance costs refer to the costs associated with complying or adhering to tax regulations. This includes the costs of book keeping, reporting, calculating and remitting tax payments. It is more difficult to quantify compliance costs relative to efficiency costs.
Administrative costs
Effective tax policies are crucial in maximizing the governments tax revenue. This fact is represented in the Laffer curve, where a too high tax rate can lead to lower tax revenues than the optimal tax rate. Policymakers need to devote a lot of attention to designing efficient tax policies and administering them. The costs associated with collecting, administering and managing tax collection systems are referred to as the administrative costs of taxation. Administrative costs are incurred by the government but are eventually borne by the citizens in the form of higher taxes.
Reducing costs of taxation
As discussed in the previous section, taxation can have other economic and social costs which affect the incentives of economic agents and alter economic behavior. For these reasons it is pivotal for policymakers to reduce these associated costs in designing an efficient tax system to maximise tax revenues. Here are some possible approaches to minimizing costs of taxation:
Simplification of tax laws
This can help to reduce compliance costs for individuals and businesses as well as administrative costs for governments. Tax laws can be simplified by minimizing the complexity of tax laws and standardizing tax filing requirements.
Use of technology
With the emergence of more technical tax software, the process of filing and paying taxes can be automated. This can be cheaper than the alternative of hiring expensive tax consultants and specialists. The use of technology can simplify the process of collecting taxes.
Reducing tax rate
Reducing tax rates can lower the marginal efficiency cost of taxation. Lower tax rates will thus lower the disincentives created by taxation and lower the deadweight loss allowing higher investment and economic activity. Conversely, reducing tax rates too much may lead to insufficient revenue generation, which could negatively impact public services and government functions.[7]
Improving tax efficiency
Tax efficiency can be improved by taxing areas with lower marginal efficiency cost. As discussed earlier, taxes on incomes and profits are likely to have a higher MEC than taxes on consumption.
Increasing transparency
Transparency of taxes can be improved by providing clear and accessible information about tax laws and regulations and how tax revenues are utilised by the government. This can help to reduce compliance and administrative costs.
Laffer curve
In economics, the Laffer curve is a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. If the tax rates are too high, discouraging labor and investment, a reduction in tax rates may in fact lead to an increase in government tax revenues, because it will encourage the entities to work and invest.[8]
As the picture shows, the Laffer curve tells us that the government's tax revenue is zero for tax rates 0% and 100%. In the middle the revenue is steadily increasing until a certain point from where it starts to decrease back to zero.
The government officials try to predict the behavior of taxpayers and therefore the consequences of tax reforms on the revenue. Understanding the mechanism is a great advantage during the times of deficit, since the government needs higher revenue and raising taxes can be seen by some as a solution. Critics of tax increases often stand by the fact that increases in tax rates make only small positive changes because of peoples' tendency to avoid taxation. Therefore, the little effect which it has on the revenue is negligible. Others could argue that not everyone would try to decrease the tax base (decrease the amount of the tax), since they have no way to do so. For example, corporate employees receive their income in a form of wage, which is a stable amount of money.[9]
At the Laffer point (T*), tax revenue no longer increases; on the contrary, as the tax rate increases further, revenue decreases. This is due to the fact that taxpayers refuse to pay high taxes to the state and look for alternative solutions (headquarters in other countries, money laundering, shadow economy).
Laffer curve
Behavioural Responses to taxation
Tax efficiency can be influenced by how individuals and businesses respond to changes in tax policies. Behavioral responses to taxation can vary widely, depending on factors such as income level, occupation, and the specific type of tax being changed. Some individuals may adjust their work hours, consumption patterns, or savings and investment strategies in response to tax changes, while others may not respond at all. Businesses may respond to tax changes by altering their production levels, employment decisions, or pricing strategies. Understanding these behavioral responses is crucial for policymakers when designing and evaluating tax policies, as the actual impacts of tax changes on revenue generation and economic activity may differ from their intended effects due to these behavioral adjustments. Researchers often use empirical studies and economic models to estimate these behavioral responses and inform policy decisions.[10]
A tax is a compulsory financial charge or some other type of levy imposed on a taxpayer by a governmental organization in order to collectively fund government spending, public expenditures, or as a way to regulate and reduce negative externalities. Tax compliance refers to policy actions and individual behaviour 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 took place in Ancient Egypt around 3000–2800 BC. Taxes consist of direct or indirect taxes and may be paid in money or as its labor equivalent.
A flat tax is a tax with a single rate on the taxable amount, after accounting for any deductions or exemptions from the tax base. It is not necessarily a fully proportional tax. Implementations are often progressive due to exemptions, or regressive in case of a maximum taxable amount. There are various tax systems that are labeled "flat tax" even though they are significantly different. The defining characteristic is the existence of only one tax rate other than zero, as opposed to multiple non-zero rates that vary depending on the amount subject to taxation.
In economics, deadweight loss is the difference in production and consumption of any given product or service including government tax. The presence of deadweight loss is most commonly identified when the quantity produced relative to the amount consumed differs in regards to the optimal concentration of surplus. This difference in the amount reflects the quantity that is not being utilized or consumed and thus resulting in a loss. This "deadweight loss" is therefore attributed to both producers and consumers because neither one of them benefits from the surplus of the overall production.
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, consumers will benefit from greater supplies 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:
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.
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.
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.
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. 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. 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, such as a sales tax, where the poor pay a larger proportion of their income compared to the rich.
A Pigouvian tax is a tax on any market activity that generates negative externalities. 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.
FairTax is a single rate tax proposal which has been proposed as a bill in the United States Congress regularly since 2005 that includes complete dismantling of the Internal Revenue Service. The proposal would eliminate all federal income taxes, payroll taxes, gift taxes, and estate taxes, replacing them with a single consumption tax on retail sales.
An indirect tax is a tax that is levied upon goods and services before they reach the customer who ultimately pays the indirect tax as a part of market price of the good or service purchased. Alternatively, if the entity who pays taxes to the tax collecting authority does not suffer a corresponding reduction in income, i.e., impact and tax incidence are not on the same entity meaning that tax can be shifted or passed on, then the tax is indirect.
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.
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.
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 Fair Tax Act is a bill in the United States Congress for changing tax laws to replace the Internal Revenue Service (IRS) and all federal income taxes, payroll taxes, corporate taxes, capital gains taxes, gift taxes, and estate taxes with a national retail sales tax, to be levied once at the point of purchase on all new goods and services. The proposal also calls for a monthly payment to households of citizens and legal resident aliens as an advance rebate of tax on purchases up to the poverty level.
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.
In economics, the Laffer curve illustrates a theoretical relationship between rates of taxation and the resulting levels of the government's tax revenue. The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and 100%, meaning that there is a tax rate between 0% and 100% that maximizes government tax revenue.
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.
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