10CHAPTER

Positive Principles of Taxation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Positive Principles of Positive Principles of TaxationTaxation

Concerns the effects of taxationConcerns the effects of taxation General principles that apply to all General principles that apply to all

taxestaxes Not normativeNot normative

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Tax ShiftingTax Shifting

Unit taxUnit tax Tax charged per unit of a good Tax charged per unit of a good

exchangedexchanged Example:Example: most cigarette taxes most cigarette taxes

Ad valorem taxAd valorem tax Tax charged based on the dollar value of Tax charged based on the dollar value of

goods soldgoods sold Example:Example: retail sales tax retail sales tax

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

A Unit Tax on SuppliersA Unit Tax on Suppliers

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

A Unit Tax Placed on A Unit Tax Placed on DemandersDemanders

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

A Tax on Suppliers A Tax on Suppliers Versus a Tax on Versus a Tax on

DemandersDemanders No difference whether tax is placed No difference whether tax is placed

on suppliers or demanderson suppliers or demanders Ultimate burden of a tax depends on Ultimate burden of a tax depends on

relative elasticities of supply and relative elasticities of supply and demanddemand

Legal assignment has no impact on Legal assignment has no impact on tax incidencetax incidence

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

A Tax on Suppliers A Tax on Suppliers Versus a Tax on Versus a Tax on

DemandersDemanders

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Elasticities and Tax Elasticities and Tax IncidenceIncidence

The more elastic the schedule, the The more elastic the schedule, the larger the proportion of the tax that larger the proportion of the tax that will fall on the other side of the will fall on the other side of the marketmarket Elastic demand curve = larger Elastic demand curve = larger

proportion paid by suppliersproportion paid by suppliers Elastic supply curve = larger proportion Elastic supply curve = larger proportion

paid by demanderspaid by demanders

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Elasticities and Tax Elasticities and Tax IncidenceIncidence

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Perfectly Elastic or Perfectly Elastic or Perfectly Inelastic Perfectly Inelastic

SupplySupply Perfectly inelastic supplyPerfectly inelastic supply

A tax placed on demanders; will be A tax placed on demanders; will be shifted entirely to suppliersshifted entirely to suppliers

Perfectly elastic supplyPerfectly elastic supply A tax placed on demanders; will be paid A tax placed on demanders; will be paid

entirely by demandersentirely by demanders

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Perfectly Inelastic Perfectly Inelastic SupplySupply

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Perfectly Elastic SupplyPerfectly Elastic Supply

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Shifts in the Tax BurdenShifts in the Tax Burden

Tax shifting can be Tax shifting can be illustrated illustrated algebraicallyalgebraically

Ratio of the slope Ratio of the slope of the supply curve of the supply curve to the slope of the to the slope of the demand curvedemand curve

Q'))/(Q*P(P

Q')P*)/(Q*(P

S

D

*

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

The Welfare Cost of The Welfare Cost of TaxationTaxation

Also known as:Also known as: Excess burden of taxationExcess burden of taxation Deadweight loss of taxationDeadweight loss of taxation

Arises because taxpayers alter their Arises because taxpayers alter their behavior in response to a taxbehavior in response to a tax

Taxpayers are better off if they paid Taxpayers are better off if they paid tax without altering behaviortax without altering behavior

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

The Welfare Cost of The Welfare Cost of TaxationTaxation

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Excess Burden as a Cost Excess Burden as a Cost of Taxationof Taxation

Should be taken into account when Should be taken into account when calculating total cost of taxationcalculating total cost of taxation

Tax with minimum excess burden is Tax with minimum excess burden is optimal from an efficiency standpointoptimal from an efficiency standpoint

Minimizing social cost = minimizing Minimizing social cost = minimizing excess burdenexcess burden

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Lump Sum TaxesLump Sum Taxes

Completely eliminates excess burden Completely eliminates excess burden of taxationof taxation Example:Example: one-shot head tax one-shot head tax No ability to change behaviorNo ability to change behavior

Difficult to apply in the real worldDifficult to apply in the real world At odds with equity goalsAt odds with equity goals

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Excess Burden and Excess Burden and Individual ChoiceIndividual Choice

Excess burden exists because a tax:Excess burden exists because a tax: Takes the tax away from the taxpayerTakes the tax away from the taxpayer Discourages consumption of the taxed Discourages consumption of the taxed

goodgood Better off if tax did not distort Better off if tax did not distort

relative prices between goodsrelative prices between goods

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Excess Burden and Excess Burden and Individual ChoiceIndividual Choice

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Inelastic Labor Supply Inelastic Labor Supply and the Welfare Cost of and the Welfare Cost of

an Income Taxan Income Tax Perfectly inelastic supply curve = no Perfectly inelastic supply curve = no

excess burdenexcess burden Inability to substitute out of market is Inability to substitute out of market is

criticalcritical Example: income tax and labor supplyExample: income tax and labor supply

If inelastic supply is because of If inelastic supply is because of offsetting income and substitution offsetting income and substitution effects, there is still an excess effects, there is still an excess burdenburden

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Inelastic Labor Supply Inelastic Labor Supply and the Welfare Cost of and the Welfare Cost of

an Income Taxan Income Tax

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Utility Functions and Utility Functions and Excess BurdenExcess Burden

For a tax to have not excess burden, For a tax to have not excess burden, there must be no substitution effectthere must be no substitution effect

Individuals cannot substitute away Individuals cannot substitute away from relatively higher price of taxed from relatively higher price of taxed goodgood

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Utility Functions and Utility Functions and Excess BurdenExcess Burden

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Minimizing the Excess Minimizing the Excess Burden of TaxationBurden of Taxation

General magnitude General magnitude of welfare lossof welfare loss 13 to 24 cents of 13 to 24 cents of

every dollar raisedevery dollar raised The Ramsey RuleThe Ramsey Rule

Taxes should be Taxes should be placed on good in placed on good in inverse proportion inverse proportion to elasticity of to elasticity of demand for the demand for the goodsgoods

1221 // EETT Example:Example:

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

The Ramsey RuleThe Ramsey Rule

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

The Marginal Cost of The Marginal Cost of Public SpendingPublic Spending

The higher government spending is, The higher government spending is, the greater will be the cost of the greater will be the cost of increased government spendingincreased government spending

Excess burden rises with government Excess burden rises with government sizesize

Some potentially beneficial projects Some potentially beneficial projects not beneficial at current level of not beneficial at current level of government outlaysgovernment outlays

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Additional Costs of the Additional Costs of the Tax SystemTax System

Compliance CostsCompliance Costs Administrative CostsAdministrative Costs Political CostsPolitical Costs

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Earmarked TaxesEarmarked Taxes

Revenues are designated to a Revenues are designated to a specific activityspecific activity Example:Example: Social Security payroll tax Social Security payroll tax Most used at local government levelMost used at local government level

Alternative: general fund financingAlternative: general fund financing

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PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

Advantages and Advantages and Disadvantages of Disadvantages of

EarmarkingEarmarking DisadvantagesDisadvantages

Lack of FlexibilityLack of Flexibility AdvantagesAdvantages

Better opportunity to receive level of Better opportunity to receive level of output they find satisfactoryoutput they find satisfactory

Removes discretion from lawmakersRemoves discretion from lawmakers Make transparent how much taxpayers Make transparent how much taxpayers

pay for an activitypay for an activity