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 Introduction

 Taxation
Taxation is a means by which governments finance their expenditure by imposing charges on citizens and corporate entities Governments use taxation to encourage or discourage certain economic decisions. Example: Reduction in taxable personal (or household) income by the amount paid as interest on home mortgage loans results in greater construction activity, and generates more jobs.

 Forms of Taxation
Taxes can be divided into two broad categories: y y Direct taxes: These are on individuals and corporations. E.g. Individual income tax, Corporation income tax, Property tax. Indirect taxes: These are on goods and services. E.g. Custom duties, Excise taxes, Sales tax or value-added tax.

 Five desirable characteristics of a tax system


There are five accepted properties of a good tax system: y y y y y Economic Efficiency Administrative Simplicity Flexibility Political Responsibility Fairness

 Economic Efficiency
Principle: The tax system should not interfere with the efficient allocation of resources. y In the absence of market failures, the competitive economy is efficient  Market prices would lead to production, exchange and product mix efficiency  Most taxes change relative prices, so the price signals are distorted, and thus the allocation of resources is altered.

 Effects of Taxation y y y y y y y y Behavioral effects Financial effects Organizational effects General equilibrium effects Announcement effects and Capitalization Distortionary and non-distortionary taxation Corrective taxation Behavioral effects

Income taxes may affect a variety of individuals and firms decisions: y y y Work, education, retirement Savings, investment, risk taking Marriage and divorce

Tax considerations are often of primary concern: it may seem more advantageous to allocate ones effort to reducing ones taxes than to designing better projects or producing more. y Financial effects

Sometimes taxation affects a transactions form more than its substance. Example: y Fringe benefits: Employees may receive income upon which they are taxes, or benefit that are not taxed. Financial structure of firms: Since dividends, capital gains and interest are treated differently there are important effects on the financial structure of corporations. Organizational effects

Taxes affect the way our economy is organized, and this may have real consequences for how resources get allocated. Examples: y y Corporation versus unincorporated enterprises Intertwined with financial effects (banks versus insurance versus other forms of finance)

General equilibrium effects

There are important indirect effects especially with broad-based taxes, such as on wages or interest, since they alter the equilibrium of the economy. Example: Tax on interest y y It may reduce the supply of savings, and eventually, the stock of capital and this may reduce the productivity of workers and their wages We refer to these indirect repercussions of the tax as its general equilibrium effects, which may have important distributional consequences. Announcement effects

The economy does not instantaneously adjust to a new tax. However, some of the effects of the tax may be felt even before it is imposed, simply upon its announcement. Example: An announcement concerning the future tax treatment of an asset has an immediate impact on the value of the asset. y Distortionary and Non-Distortionary Taxation  Distortionary Taxation: A tax is distortionary if the individual can change his tax liability simply by reducing his purchases of the commodity. Non-Distortionary Taxation: A tax is non-distortionary if, and only if, there is nothing an individual or firm do to alter his tax liability.

Corrective Taxation

In the presence of market failures, the allocation of resources will not, in general, be efficient. Taxation can sometimes be used in a positive way, to correct some market failure. Corrective taxes (as these taxes are called) both raise revenue and improve the efficiency of resource allocations. y Administrative Simplicity

Principle: the tax system ought to be easy and relatively inexpensive to administer.

 Types of Costs y y Direct costs borne by the administration Indirect costs borne by tax payers

 Factors that influence costs y y What records would be kept in the absence of taxation? Complexity (special provisions, differentiation, taxing some categories of income may be more expensive)

 Flexibility
Principle: The tax system ought to be able to respond easily (in some cases, automatically) to changed economic circumstances.  Automatic Stabilization   As an economy goes into a recession, a reduction in tax revenues may be extremely desirable, to provide needed stimulus for the economy. When prices are stable, a progressive tax structure will provide automatic stabilization.

 Political Responsibility
Principle: The tax system should be designed so that individuals can ascertain what they are paying, and evaluate how accurately the system reflects their preferences.  Transparent taxes: Taxes for which the burden of payment is clear. Transparency has increasingly been recognized as an important characteristic of a good government.

 Fairness
Principle: The system ought to be fair in its relative treatment of differences. y Horizontal equity: Individuals who are identical (or in essentially similar economic circumstances) should be treated the same. Vertical equity: Individuals who have greater ability to pay or who are better off or receive greater benefits from the government services should pay more taxes.

 Basis of Taxation
y y y Income Consumption Life time Income

y Income
Income is the most widely used basis of taxation, it is widely viewed by governments and policy makers as good measure to pay. Those who have greater ability to pay and should therefore pay higher taxes. Income is an indirect and imperfect measure of both ability to pay and economic well-being.

y Consumption
It seems fairer than income (it measures what one takes out of society rather what one contributes). Income and consumption differ by savings C+S=Y C=Y-S So, the major issue is whether savings ought to be exempt from taxation. It can be shown that this is equivalent to the question of whether the return to savings (interest, dividends and capital gains) ought to be exempt from taxation.

y Lifetime Income
If an individual lives for two periods and receives a wage w0 in the first period and w1 in the second period, we have that savings = w0 - c0.

 Next period consumption is:


c1=w1+(w0-c0)(1+r) or c1+ c0(1+r) =w1+w0(1+r)

 Dividing both by (1+r) we get the discounted present value of income


Y* = wo + w1 1+r

Of course, the present discounted value of an individuals consumption over his lifetime must be equal to the present discounted value of his income. That is, if c0 is the individuals consumption in the first period of his life and c1 is his consumption in the second period. Y* = c0 + c1 1+r It is clear that if we believe that the correct basis of taxation is the individuals lifetime income, this is equivalent to believing that the correct basis of taxation is the individuals lifetime consumption.

 Criticism of Income As a Basis of Taxation


Some have criticized the use of income as a basis of taxation, believing that neither income, life or annual nor consumption provides a fair basis of taxation.

y The Benefit Approach


Some economists argued that individuals should contribute to the support of the government in the proportion to the benefits they received from public services. The principle for charging for public services should be analogous to those used for private services and taxes can be viewed as simply the charge for the provision of public services.