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Public Economics
1
Public Revenues
• In general, public revenue may be considered to
include any revenue flowing to the public budgets.
Among those public budgets there may be budgets
of governments, lower regional administration units
(districts and municipalities), parafiscal funds and
also budgets of health insurance funds. The most
substantial item on the revenue side of public
budgets are taxes. It further contains non-tax
public revenue (interest revenue, fees and fines,
and revenue from selling and renting out state or
municipal property).
2
A tax is
• a payment in money
• required by a government
• that is unrelated to any specific benefit
or service received from the government.
3
Other definition… A tax is …
• a financial, mandatory, nonequivalent,
non-specific charge or other levy
imposed on a taxpayer by a state.
• The tax is implemented by law.
• The failure to pay taxes is punishable by
law.
• The taxes can be paid regularly or
occasionally based on certain conditions
stipulated by the tax legislation. 4
Properties of tax
• imposed by a government
• not tied directly to the benefit received by
the taxpayer.
5
Sources of finance
6
The Main Issues of Tax Theory
There are two main issues related to tax theory:
- Normative: How to design taxes to promote social welfare
in terms of the public interest in efficiency and equity
- Positive: The economic effects of the various taxes that
governments use
- What effects do taxes have on people’s desires
to consume, save, supply their labor, or on firms’
desire to invest?
- Who bears the burden of various taxes?
- Public officials need to be able to answer these questions
to design taxes that promote social welfare
7
Tax Principles
Economists believe that any broad-based tax should possess
five characteristics:
(3) Flexibility
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Tax Principles
9
Ease of collection (direct
adminis. cost)
• CIT, VAT – 2% of total tax revenue
• Payroll Tax – 1 %
• Bad results for… (why? Due to very low
tax rates)
– PIT – self employed persons – 30 %
– Road tax – 5 %
– Heritage tax (now abolished) - !169 %
10
Ease of compliance (indirect
adminis. cost)
11
Tax Principles
(3) Flexibility
- Tax policy is a primary tool of macroeconomic policy (i.e.
economic stabilization)
- To be able to respond quickly to address potential
difficulties in the economy, tax authorities must be able to
change tax liabilities easily and quickly and those
changes must quickly be felt throughout the economy
12
Tax Principles
13
Tax Principles
(4) Economic Efficiency
- Individuals must face same prices for economy to reach
Pareto-optimal outcome
- Broad-based taxes are distorting (i.e. drive wedge between
price paid by consumer and prices kept by firms) so they
violate this property
- The goal then is to design a tax that introduces the least
distortion and keeps society as close to the Pareto-
optimal outcome as possible
14
Six Main Taxes (1)
17
The Ability-to-Pay Principle
- Dates from Adam Smith and John Stuart Mill in late 1700s
and early 1800s
- Holds that people must be willing to sacrifice for the public
good
- Gave rise to view of taxes as necessary evil
- Key question: How to determine what people should
sacrifice?
- Two potential approaches based on ability to pay
- Horizontal Equity: Two people deemed equal in
every relevant economic dimension should pay
same tax
- Vertical Equity: It is permissible to tax unequals
unequally
18
The Ability-to-Pay Principle continued
19
Horizontal Equity: The Ideal Tax Base
(OPTIONAL)
20
Horizontal Equity: The Ideal Tax Base
Haig–Simons income
- Argues that the best surrogate for utility is the increase in
purchasing power during the year
YHS = consumption + change in net worth = C + ∆NW
- Concludes that people with the same YHS should be considered
equals and should pay the same tax because they will sacrifice the
same utility
- Once YHS is accepted as ideal tax base it implies that the optimal
tax structure is the broadest possible personal income tax
21
Horizontal Equity: The Ideal Tax Base
- Under the Haig–Simons definition of income, there are a number of
distinctions that should not matter (but usually do)
- Factors that should be treated the same, but usually are not
Sources of Income Uses of income
- Personal income and capital - Consumption and saving (saving
gains (portion of capital gains usually excluded)
usually excluded from tax base) - Various forms of consumption
- Earned and unearned income (medical care, mortgage interest
(receipt of transfer payments payments, etc. usually excluded)
usually excluded from tax base) - Form of capital gains (accrued
- Different sources of earned capital gains usually excluded,
income (interest earned on realized usually included)
savings and fringe benefits
usually excluded)
22
Horizontal Equity: The Ideal Tax Base
- These differences usually exist because policymakers often use
tax policy to try to promote social ends which might run counter to
the concept of horizontal equity
- Business expenses should be excluded because they subtract
from purchasing power out of income
- Calculation of YHS must be indexed to inflation because increasing
prices reduces purchasing power
- Conclusion: Combined, these facts suggest that the ideal tax
base is (YHS - business expenses), indexed for inflation
23
Horizontal Equity: The
Ideal Tax Base
24
Horizontal Equity: The
Ideal Tax Base
- But people do not have identical tastes and
opportunities
- Suppose people earn different wages
- Person with higher wage can receive
higher utility with same income by
taking more utility (i.e. can earn same
income with fewer hours work)
- Suppose people have different tastes
- Person with stronger preference for
consumption works more and earns
more income but both are on second
indifference curve which represents
same utility
25
Horizontal Equity: The Ideal Tax Base
26
Horizontal Equity: The Ideal Tax Base
27
Horizontal Equity:
The Ideal Tax Base
28
Vertical Equity
29
Progressive, Proportional, and
Regressive Taxes
• Proportional tax
– Percentage of taxpayers income
• Progressive tax
– Larger percentage of income as income rises
• Regressive tax
– Smaller percentage of income as income
rises
30
Progressive, Proportional, and
Regressive Taxes
31
Income and Consumption over
Life Cycle
32
Measuring of Consequences of
Taxation to Income Distribution I.
Lorenz Curve
33
Measuring of Consequences of
Taxation to Income Distribution II.
Gini‘s Coefficient
35
36
37
Tax Incidence
40
Tax Incidence: General Remarks
41
Tax Incidence: General Remarks
42
Tax Incidence: General Remarks
44
Tax Incidence: General Remarks
(optional)
• Measuring how progressive a tax system is
present additional difficulties. Consider two simple
definitions.
– The first one says that the greater the increase in
average tax rates as income rises, the more progressive
is the system.
T1
T0
v1
I1 I0
I1 I 0
45
Tax Incidence: General Remarks
(optional)
– The second one says a tax system is more progressive
if its elasticity of tax revenues with respect to income is
higher.
– Recall that an elasticity is defined in terms of percent
change in one variable with respect to percent change in
another one:
T1 T0
%T
v2
T0
%I I1 I0
I0
46
Tax Incidence: General Remarks
(optional)
47
Partial Equilibrium Models
48
Partial Equilibrium Models:
Per-unit taxes
52
Partial Equilibrium Models:
Per-unit taxes
53
Figure 2
54
Partial Equilibrium Models:
Per-unit taxes
56
Partial Equilibrium Models:
Taxes on suppliers vs. demanders
58
Partial Equilibrium Models:
Elasticities
60
Figure 4
61
Figure 5
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Partial Equilibrium Models:
Ad-valorem Tax
63
Partial Equilibrium Models:
Ad-valorem Tax
64
Figure 6
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Partial Equilibrium Models:
Ad-valorem Tax
• The payroll tax, which pays for Social Security
and Public Health Care, is an ad-valorem tax
on a factor of production – labor.
• Statutory incidence in the CR is split unevenly
with a total of 34% paid by employer and 11%
paid by employee.
• The statutory distinction is irrelevant – the
incidence is determined by the underlying
elasticities of supply and demand.
• Figure 7 shows the likely outcome on wages.
66
Figure 7
67
Tax Efficiency I.
• Administrative Efficiency – costs of tax
collection, salaries of financial officers, tax
forms, time spent fulfilling forms, cost of tax
advisors etc.
– Direct costs – costs for the state
– Indirect costs – costs for the taxpayers
• Administratively Efficient Tax – low
administrative costs and high revenue.
68
Tax Efficiency II.
69
The magnitude of the excess
burden of a unit tax
Tax
70
The effect of demand elasticity
on excess burden (optional)
71
The effect of tax rates on
excess burden
72
Excess Burden Measurement
• Implications of Figuers
– Higher (compensated) elasticities lead to
larger excess burden
– Excess burden increases with the square of
the tax rate
– The greater the initial expenditure on the taxed
commodity, the larger the excess burden
73
Excess Burden Review – Unit Tax
74
Excess Burden Review – Ad Valorem
Tax
75