Problem Set 1

Eren Gürer
Economics of Taxation, SS 2020

May 12, 2020

Feel free to reach me via ”guerer@wiwi.uni-frankfurt.de” for any questions. I wish you
all the best for the new semester!

1
Problem 1.1.
We should start by emphasizing the information given in the last paragraph of the
question. ”The net wage can be interpreted as producer-price or net-price of labor while
the total labor cost is said to be the consumer-price or gross-price of labor.” Producer price
is the amount that is paid to the supplier of a product (in this case the worker who supplies
labor), exclusively for the good that they supply. Consumer price, on the other hand, is
the total amount paid by the consumer of that product (in this case firms consuming
labor), including taxes (e.g., social insurance contributions). For the purposes of this
question, we assume that there are no other taxes but only social security contributions.
Some notation:

• q : consumer price (gross-price of labor)

• p : producer price (net-price of labor)

• θ : gross ad-valorem tax

• τ : net ad-valorem tax

(See Slide 23)

Net ad-valorem taxes represent the rate that should be added to the producer price to
calculate the consumer price (e.g., value-added taxes). That is:

q = p(1 + θ) (1)

Gross ad-valorem taxes represent the rate that should be subtracted from consumer
price to calculate the producer price (e.g., labor income taxes). That is:

p = q(1 − τ ) (2)

The question suggests that social insurance contributions represent 40% of the gross
wages. Let b denote the gross wage. Note that, because social insurance contributions
are paid half-half (50%-50%) by the employee and the employer, b is different than q and
p (e.g., p < b < q). The amount that should be added to or subtracted from b can be
calculated as b ∗ 50% ∗ 40%. Thus, producer price (p) and consumer price (q) read:

2
 p = b(1 − 50% ∗ 40%) (3)

q = b(1 + 50% ∗ 40%) (4)

In order to calculate the equivalent of social insurance contributions in terms of gross

and net ad-valorem taxes, we need to substitute (3) and (4) respectively into (1) and (2).
Substituting (3) and (4) into (1), we get:

b(1 + 50% ∗ 40%) = b(1 − 50% ∗ 40%)(1 + θ) (5)

b cancels out and we arrive at:

1.2 = 0.8(1 + θ) (6)

Hence, θ? = 50%, net ad-valorem tax equivalent of social insurance contributions.

Similarly, substituting (3) and (4) into (2), we can write:

b(1 − 50% ∗ 40%) = b(1 + 50% ∗ 40%)(1 − τ ) (7)

Solving (7) leads to τ ? = 33.3%, gross ad-valorem tax equivalent of social insurance
contributions.

3
Problem 1.2.
This question is fundamentally related to the concept ”Laffer Curve”, which explains
the relationship between the tax rates and tax revenues. Using the corporate income
tax rate and revenue data between 1979-2002 for 29 OECD countries, Clausing (2007)
estimates the relationship presented by Figure 1. In the figure, x-axis represent the
corporate income tax rates while y-axis represent te corporate income tax revenue as
a share of GDP. The parabolic relationship found between corporate income tax rate
and revenue is standard. Initially, higher tax rates allow a government to extract higher
tax revenue. Nevertheless, as tax rate increase more and more, it heavily distorts the
investment in a country, reducing the tax base and tax revenue.

Figure 1: Corporate Income Tax Laffer Curve

Source: Clausing (2007)

According to Clausing (2007), tax revenue maximizing rate (the point at x-axis where
the curve peaks) is 33%. Hence, at an initial glance, one may think that decreasing the
corporate income tax rate towards 33% (as asked in the question) may increase the tax
revenue. However, the author points out that 33% percent is calculated over a pooled
sample of 29 countries and it is not necessarily the tax-revenue maximizing rate for every
country. Tax revenue maximizing rate heavily relies on countries’ individual circumstances.
Consider the opennes of a country to Foreign Direct Investment (FDI). Suppose a
country is not very open to FDI due to various regulations (e.g., tariffs). In this scenario,
reducing corporate income taxes may not necessarily attract the desired amount of FDI.
This implies that, in fact, tax revenue maximizing rate for the country of interest could
be much higher than 33%. Hence, that country might still be on the left-hand side of the
peak in its individual Laffer Curve. Similar to the opennes of a country to FDI, there are

4
many other factors such as personal income taxes, sales taxes, tax avoidance strategies
etc. that determine the revenue-maximizing tax rate of a country. Hence, one cannot
conclude that decreasing corporate income tax rate towards 33% necessarily increase the
corporate income tax revenue.

5
Problem 1.3.

a.

Hidden Tax Progressivity

First, let’s discuss what is a progressive income tax scale. Some notation:

– y: gross income

– T (y): Net income tax

– T (y)/y: Average income tax rate

– T 0 (y): Marginal income tax rate (the rate at which an additional unit of income
dT (y)
is taxed, that is dy
)

A tax scale is called progressive if marginal income tax rates are strictly greater than
the average income tax rates, that is T 0 (y) > T (y)/y. As a result of this inequality,
∂T (y)/y
average income tax rates increase in income, that is ∂y
> 0. Overall, one can
claim that, individuals with higher earnings pay higher average tax rates under a
progressive scale (Slide 25).

Figure 2: Direct vs. Indirect (Hidden) Progression

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T(y)



Figure 2 presents two tax scales, with direct and hidden progression. Due to the
convexity of the solid (blue) line, one can easily infer that net income taxes increase
faster than income. Therefore, there are higher average taxes for individuals who
earn higher incomes. As a result, the solid tax scale is progressive. However, a
similar conclusion is not so obvious for the tax scale given by the dashed (red)

6
 line. For the dashed tax scale, there is an allowance (zero tax rate) up to a level,
combined with a constant marginal tax rate for the incomes after the threshold.
Such a tax scale generates hidden progressivity.1

Income Splitting (Slides 31-32)

Consider two possibilities for the taxation of couples: Individual Filing and Income
Splitting. Under Individual Filing, each partner is taxed as if they were not married.
Total tax liability of the household under individual filing reads:

I(y1 , y2 ) = T (y1 ) + T (y2 ) (8)

Under Income Splitting, half of the household’s tax liability is calculated by consid-
ering the average income of the partners as a single individual. Resulting amount is
multiplied by two to calculate the total tax liability of the household. Hence, total
tax liability of a household under income splitting reads:

y + y 
1 2
S(y1 , y2 ) = 2T (9)
2

As indicated in the question, consider a couple earning incomes y1 and y2 . See Figure
3. Under individual filing, half of the total tax liability of the household equals the
T (y1 )+T (y2 )
mid-way between T (y1 ) and T (y2 ) on the y-axis, that is 2
. Under Income
Splitting, half of the tax liability of the household is calculated by mapping the
average of the partners’ incomes (on the x-axis) to the y-axis, that is S(y1 , y2 )/2.
The difference yields the half of the splitting advantage.
1
An example should clarify that an allowance ensures the progressivity of the scale (hidden progression).
Suppose there is an allowance up to e 5000. Above e 5000, there is a constant marginal tax rate of 20%.
Consider two individuals respectively with gross incomes e 10000 and e 15000. Tax liabilities of the two
individuals are respectively (10000 − 5000) ∗ 0.2 = e 1000 and (15000 − 5000) ∗ 0.2 = e 2000. Dividing
tax liabilities to their gross incomes gives the average tax rates, that are 10% and 13.3%. Hence, higher
gross income yields higher average tax rate.

7
 Figure 3: Income Splitting Advantage

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2

What determines the advantage of income splitting compared to individual filing

under a step-wise tax scale as we discussed?

i. Income distribution between couples: First, the partners’ tax brackets

should be different than each other. If both partners were subject to the
same tax rate, splitting advantage would be zero. Second, splitting advantage
increase as the difference between y1 and y2 increase.

ii. The tax scale function: For example, a higher constant marginal tax rate
after the threshold would increase the splitting advantage.

Note: The answer should not mislead us to conclude that a progressive tax scale
necessarily generates advantage for the couples in different tax brackets under income
splitting (there are no concave parts in the tax scale studied in this question).

b.

As an answer to the question: yes, it is possible to have a progressive tax scale with
concave parts. Consider the following tax scale:





 0%, if e 0≤ y ≤e 5000


10%, if e 5000< y ≤e 10000


T 0 (y) =
6%, if e 10000< y ≤e 20000







20%, if e 20000< y


8
 Figure 4: Progressive Tax Scale with Concave Parts





T(y) 




     
y

The tax scale is illustrated in Figure 4. The section between 10000 and 20000 is is
the concave part of the graph. In this tax scale, the most advantageous individual is
the one who earns e 20000. This is because that individual takes complete advantage
of the low marginal tax rate 6%. Total tax liability of this individual is:

(10000 − 5000)0.1 + (20000 − 10000)0.06 = 1100 (10)

This yields an average tax rate of 5.5%. Hence, even for the most advantageous
individual, marginal tax rate (6%) exceeds the average tax rate. Hence, we conclude
that the tax scale is completely progresive, despite exhibiting a concave part.

Next, we turn to the implications on income splitting. Consider a married couple

with incomes of e 8000 and e 16000 who are subject to the tax scale above. Under
individual filing:

T (8000) = (8000 − 5000)0.1 = 300 (11)

T (16000) = (10000 − 5000)0.1 + (16000 − 10000)0.06 = 860 (12)

Hence, the total tax liability of the household is I(8000, 16000) = 1160. Under
income splitting:

 8000 + 16000 
T = (10000 − 5000)0.1 + (12000 − 10000) ∗ 0.06 = 620 (13)
2
9
Hence, the total tax liability of the household is S(8000, 16000) = 2 ∗ 620 = 1240
which is higher than the liability under individual filing. Therefore, we conclude that,
if a tax scale has concave parts, it might render Income Splitting disadvantageous
for some couples, although the tax scale is progressive.

10
Problem 1.4.

a.

In the context of a window tax, marginal tax can be considered as the amount
payable for having an extra window. The tax scale, given in the question, is presented
in Figure 5.

Figure 5: Marginal Window Tax


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As an example, according to Figure 5, a person who has 12 windows has to pay 6

Pence, if she wants have an extra window.

b.

As suggested in the question, assume that there are two types of consumers. Type-1
consumers have a high demand for windows. Event after the introduction of the
tax, they demand fewer (relative to the case without tax) but still more than 10
windows. Type-2 consumers would demand more than 10 windows before the tax,
but they demand exactly 10 windows after the introduction of the tax.

i.

Welfare loss for the Type-1 consumer is illustrated in Figure 6. Without any
tax, the marginal cost (supply) curve would be given by the green solid line.
We assume that Type-1 consumer’s demand curve (black solid line) is such that
she would demand more than 10 windows (e.g., w? ) at the equilibrium without
tax. When the tax is imposed (t = 6), supply curve is given by the green

11
 dashed line. New demand of the Type-1 consumer is fewer but still more than
10, that is w0 . Without considering any tax revenue, one may think that the
welfare loss is equal to the area A + B + C. However, note that the government
charges 6 pence per window after 10 windows. Therefore, the tax revenue of
the government equals (w0 − 10) ∗ 6 which corresponds to the area of B. This
should be subtracted from the welfare loss. As a result, welfare loss equals to
A + C.

Figure 6: Welfare Loss Type-1 Consumer

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ii.

To calculate the welfare loss of Type-2 consumer, we proceed in a similar

fashion. Once again, supply (marginal cost) curve of the windows without and
with tax are respectively given by green solid and dashed lines. Demand curve
of the Type-2 consumer is such that she would demand more than 10 windows
without tax (w? ). With tax she demands exactly 10 windows (w0 = 10). In this
scenario there is no tax revenue for the government because the consumer’s
demand do not exceed 10 windows. Hence, welfare loss equals to the area
D + E.

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 Figure 7: Welfare Loss Type-2 Consumer
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w′ = 10 w⋆
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c.

For simplicity, we investigate the effect of increasing demand elasticity on the welfare
loss of Type-2 consumer only. In Figure 8, the demand curve given by solid blue
line is more elastic compared to the demand curve presented by sold black line.
Notice that a unit change in price has a higher impact on demand for the blue line
compared to the black line.

Before the introduction of the tax, optimal quantity for the consumers with blue
demand curve would be outside the graph. After the tax, they demand exactly 10
windows. When it comes to calculating the welfare loss, realize that the area of F
should also be counted. Hence, with the more elastic demand curve, total welfare
loss equals D + E + F . In conclusion, welfare loss increased as we moved to a more
elastic demand curve.

Figure 8: Welfare Loss Type-2 Consumer: Effect of Elasticity

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13
d.

Notice that we abstract from the tax scheme given in the beginning of this question.
With the given demand (w = 10 − t) and the uniform tax rate, tax revenue of the
government reads t(10 − t). Thus, in order calculate the revenue maximizing tax
rate, the government solves:

max t(10 − t) (14)

t

One can derive the optimal t via the first-order condition with respect to t:

10 − 2t = 0, t? = 5 (15)

Hence, the total tax revenue equals t? (10 − t? ) = 25

Applying non-linear rates (e.g., different rates to the individuals who have different
levels of demand) would not improve on the tax revenue. With the non-linear rates
those who are exposed to a higher (lower) tax rate are going to be distorted more
(less). Essentially, total tax revenue cannot be improved as long as individuals have
the same preferences for windows.

14
Problem 1.5.

a.

In a competitive market without taxes, consumer price (q) must be equal to producer
price (p) at the market equilibrium. Hence,

x = 10 − x ⇒ x? = 5, p? = 5, q? = 5 (16)

b.

When there is a net ad-valorem tax of θ = 0.5 on the producer price, new market
equilibrium is given by p(1 + θ) = q, that is:

x(1 + 0.5) = 10 − x, ⇒ x0 = 4, p0 = 4, q 0 = 6 and t0 = 2 (17)

where 0 denotes the new equilibrium quantities and t0 is the tax wedge of the new
equilibrium.

Figure 9: Market Eqm. with and without Taxes

t=2
q =6
′

p =q =5
⋆ ⋆

p =4
′
}
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p = xS
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p = xS⋆1 + θ)
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x =4 x
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⋆
=5

Figure 9 illustrates the situation graphically. Without any tax, market equilibrium is
given by the intersection of solid blue (demand fct.) and green (supply fct. without
tax) lines, which yields x? = p? = q ? = 5. With taxes, on the other hand, market
equilibrium is the intersection of dashed red line (supply fct. with tax) and solid
blue (demand fct.) lines. As calculated above, this yields x0 = 4, q 0 = 6, p0 = 4 with
a tax wedge t = 2.

15
 In order to calculate the incidence, we should focus on the differences in consumer
and producer prices in the two equilibriums. Note that, in the equilibrium with tax,
consumer price (amount paid to buy a good) increases by one. On the other hand,
producer price (amount paid to the producer) decreases by one. Hence, during the
purchase of a good, consumers pay one monetary unit more while producers receive
one monetary unit less, compared to the equilibrium without taxes. Given that the
total tax wedge is 2, one can calculate incidence on both consumers and producers
as 1/2 = 50%.

Alternatively, we can also calculate the tax burden referring to the yellow and green
shaded areas in Figure 9. Given that there are 4 units of goods sold in equilibrium,
total tax burden of the consumers are given by the green area and equals 4x1 = 4.
Similarly, total tax burden of the producers is given by the yellow shaded area and
equals 4x1 = 4.

c.

When the tax is payable by consumers instead of producers, we are supposed to

modify the demand function instead of the supply function. New equilibrium is
q
given by: p = . Notice that, inherently, this does not change anything. Market
1+θ
equilibrium can be calculated as:

10 − x
x= , ⇒ x00 = 4, p00 = 4, q 00 = 6 and t00 = 2 (18)
1 + 0.5

Hence, the incidence is still shared 50%-50% by consumers and producers. The
intuition of this result is as follows. Tax incidence is directly related to the relative
price elasticities of supply and demand. Any governmental intervention that does
not change elasticities (such as ad-valorem taxes) will not have any impact on the
dq
tax incidence. Formally, define incidence on consumers as . At the equilibrium
dt
incidence on consumers read (Slides 42-43):

dq 
= (19)
dt −η

∂xs p ∂xd q
where  = is the supply elasticity and η = is the demand elasticity
∂p xs ∂q xd
(we will prove this is PS2). As an example, suppose the tax is payable by producers.

16
Supply functions with and without tax respectively reads xs = p and xs = p(1 + θ).
By calculating  with both demand functions, one can easily see that demand
elasticity does not change.
∂xs p
For the case where xs = p: ∂p
= 1. We also know that xs
= 1 because xs = p.
s p
Hence,  = ∂x
∂p s
= 1.
x
s
For the case where xs = p(1 + θ): ∂x
∂p
= 1 + θ. We also know that xps = 1+θ
1
because
s p
xs = p(1 + θ). Hence,  = ∂x∂p s
= 1. Ad-valorem tax on the producer price does
x
not change supply elasticity.

Can you calculate the demand elasticity in a similar fashion? (Hint: The result
should be equal to -1, which makes the result of Equation (17) 0.5).

17
References
Clausing, K. A. (2007). Corporate tax revenues in OECD countries. International Tax
and Public Finance, 14(2):115–133.

18