1、Chapter 20 Tax Inefficiencies and Their Implications for Optimal Taxation,Jonathan Gruber Public Finance and Public Policy,Aaron S. Yelowitz - Copyright 2005 Worth Publishers,Introduction,Markets do not take taxes lying down. If there is some action that market participants can undertake to minimize
2、 the burden of a tax, they will do so. This is true both for consumers and producers.,Introduction,This lesson will illustrate how attempts to minimize tax burdens have efficiency costs for society. Since social efficiency is maximized at the competitive equilibrium (in the absence of market failure
3、s), taxing market participants entails deadweight loss.,TAXATION AND ECONOMIC EFFICIENCY Graphical approach,We now move from discussing the effects of taxation on equity to a discussion of its effect on efficiency. The focus therefore turns from prices to quantities. Consider the impact of a 50 per
4、gallon tax on the suppliers of gasoline, illustrated in Figure 1.,A,D1,S1,S2,B,P2 = $1.80,Q2 = 90,$0.50,Price per gallon (P),Quantity in billions of gallons (Q),C,P1 = $1.50,Q1 = 100,DWL,The tax on gasoline shifts the supply curve.,The tax creates deadweight loss.,Taxation and economic efficiency Gr
5、aphical approach,Before the tax was imposed, 100 billion gallons were sold. Afterwards, only 90 billion gallons are sold. Recall that the demand curve represents the social marginal benefit of gasoline consumption, while the supply curve represents the social marginal cost. SMB=SMC at 100 billion ga
6、llons Production less than that amount results in deadweight loss. Beneficial trades are not made because of the 50 per gallon tax.,Taxation and economic efficiency Elasticities determine tax inefficiency,The efficiency consequences would be identical regardless of which side of the market the tax i
7、s imposed on. Just as price elasticities of supply and demand determine the distribution of the tax burden, they also determine the inefficiency of taxation. Higher elasticities imply bigger changes in quantities, and larger deadweight loss. Figure 2 illustrates that deadweight loss rises with elast
8、icities.,P,Q,P2,P1,Q1,Q2,D1,S1,S2,B,A,C,DWL,P,Q,P2,P1,Q1,Q2,D1,S1,S2,B,A,C,DWL,(a) Inelastic Demand,(b) Elastic demand,50 Tax,50 Tax,Demand is fairly inelastic, and DWL is small.,Demand is more elastic, and DWL is larger.,Taxation and economic efficiency Elasticities determine tax inefficiency,With
9、inelastic demand, there is a large change in market prices with consumers bearing most of the tax, but little change in quantity. With more elastic demand, market prices change more modestly and the supplier bears more of the tax. The reduction in quantity is greater, as is the deadweight loss trian
10、gle.,Taxation and economic efficiency Elasticities determine tax inefficiency,The inefficiency of any tax is determined by the extent to which consumers and producers change their behavior to avoid the tax. Deadweight loss is caused by individuals and firms making inefficient consumption and product
11、ion choices in order to avoid taxation.,Tax avoidance in practice,In reality, there are many inefficient, tax-avoiding activities. For example, the Thai government levies a tax on signs in front of businesses, where the tax rate depends on whether the sign is completely in Thai (low tax), in Thai an
12、d English (medium tax), or completely in English (high tax). Many signs are in English, with a small amount of Thai writing!,Application,Deadweight loss in Thailand,Excess Burden Measurement with Demand Curves,Pounds of barley per year,Price per pound of barley,a,Db,Sb,q1,q2,i,h,Sb,Pb,(1 + tb)Pb,g,f
13、,d,Tax revenues,Excess burden of tax,Excess burden = Pbq1tb2,Taxation and economic efficiency Determinants of deadweight loss,This formula for deadweight loss has many important implications:Deadweight loss rises with the elasticity of demand. The appropriate elasticity is the Hicksian compensated e
14、lasticity, not the Marshallian uncompensated elasticity. Deadweight loss also rises with the square of the tax rate. That is, larger taxes have much more DWL than smaller ones.,Taxation and economic efficiency Determinants of deadweight loss,This point about DWL rising with the square of the tax rat
15、e can be illustrated graphically. Marginal deadweight loss is the increase in deadweight loss per unit increase in the tax. See Figure 3.,P,Q,P2,P1,Q1,Q2,D1,S1,S2,B,A,C,S3,Q3,P3,D,E,$0.10,$0.10,The first $0.10 tax creates little DWL, ABC.,The next $0.10 tax creates a larger marginal DWL, BCDE.,Taxat
16、ion and economic efficiency Determinants of deadweight loss,As the tax rate doubles, from 10 to 20, the deadweight loss triangle quadruples. The area DBCE is three times larger than BAC. The total deadweight loss from the 20 tax is DAE. As the market moves farther and farther from the competitive eq
17、uilibrium, there is a widening gap between demand and supply. The loss of these higher surplus trades means marginal DWL gets larger.,Taxation and economic efficiency Deadweight loss and the design of efficient tax systems,The insight that deadweight loss rises with the square of the tax rate has im
18、plications for tax policy with respect to: Preexisting distortions Progressivity Tax smoothing,Taxation and economic efficiency Deadweight loss and the design of efficient tax systems,Preexisting distortions are market failures that are in place before any government intervention. Externalities or i
19、mperfect competition are examples. Figure 4 contrasts the use of a tax in a market without any distortions and in one with positive externalities.,P,Q,Q1,D1,S1,S2,B,A,C,P,Q,Q1,D1,S1,S2,E,D,F,SMC,G,H,Q0,No positive externality,Positive externality,Q2,Q2,In a market with a preexisting distortion, taxe
20、s can create larger (or smaller) DWL.,Taxation and economic efficiency Deadweight loss and the design of efficient tax systems,Imposing the tax in the first market, without externalities, results in a modest deadweight loss triangle equal to BAC. When an existing distortion already exists where the
21、firm is producing below the socially efficient level, the deadweight loss is much higher. The marginal deadweight loss from the same tax is now GEFH. Of course, if there were negative externalities, such a tax would actually improve efficiency.,Taxation and economic efficiency Deadweight loss and th
22、e design of efficient tax systems,This insight about deadweight loss also demonstrates that a progressive tax system can be less efficient. Consider two tax systems one a proportional 20% payroll tax, and the other a progressive tax that imposes a 60% rate on the rich, and a 0% rate on the poor. Fig
23、ure 5 shows these cases.,Wage (W),Hours (H),W2=11.18,W1=10.00,H1=1,000,H2=894,D1,S1,S2,B,A,C,Wage (W),Hours (H),W2=22.36,W1=20.00,H1=1,000,H2=894,D1,S1,S2,S3,W3=23.90,H3=837,E,D,F,G,I,Low Wage Workers,High Wage Workers,DWL increases with the square of the tax rate. Smaller taxes in many markets are
24、better.,Taxation and economic efficiency Deadweight loss and the design of efficient tax systems,Under the proportional system the efficiency loss for society is the sum of two deadweight loss triangles, BAC and EDF. Under the progressive system, the efficiency loss is the triangle GDI that is, it a
25、dds the area GEFI but does not include BAC. Table 1 puts actual numbers to the picture.,A lower proportional tax creates less DWL than the higher progressive tax.,Taxation and economic efficiency Deadweight loss and the design of efficient tax systems,In this case, a proportional tax is more efficie
26、nt. The large increase in deadweight loss arises because the progressive tax is levied on a smaller tax base. In order to raise the same amount of revenues on a smaller base, the tax rate must be higher meaning a higher marginal DWL. This illustrates the larger point that the more one loads taxes on
27、to one source, the faster DWL rises. The most efficient tax systems spread the burden most broadly. Thus, a guiding principle for efficient taxation is to create a broad and level playing field.,Taxation and economic efficiency Deadweight loss and the design of efficient tax systems,The fact that DW
28、L rises with the square of the tax rate also implies that government should not raise and lower taxes, but rather set a long-run tax rate that will meet its budget needs on average. For example, to finance a war, it is more efficient to raise the rate by a small amount for many years, rather than a
29、large amount for one year (and run deficits in the short-run). This notion can be thought of as “tax smoothing,” similar to the notion of individual consumption smoothing.,The deadweight loss of taxing wireless communications,An interesting applied example computing DWL is Hausmans (2000) study of w
30、ireless communications. He found that: The federal/state tax on wireless phones was as high as 25%. There was 53 of DWL per $1 raised in revenue. Fairly priced elastic commodity. Imperfectly competitive market with high mark-ups. Preexisting tax distortions. Marginal DWL much higher as high as 90 of
31、 DWL per $1 raised.,Application,Excess Burden Defined,Pounds of corn per year,Pounds of barley per year,E1,B1,C1,D,F,A,Cb,Ca,B0,Government levies tax on barley,i,Effect of Tax on Consumption Bundle,Pounds of corn per year,Pounds of barley per year,E1,B1,C1,D,F,A,Cb,Ca,B0,E2,i,ii,G,Excess Burden of t
32、he Barley Tax,Pounds of corn per year,Pounds of barley per year,E1,B1,C1,D,F,A,Cb,Ca,B0,E2,i,ii,G,H,B3,M,I,Tax Revenues,Equivalent variation,Questions and Answers,If lump sum taxes are so efficient, why arent they widely used? Are there any results from welfare economics that would help us understan
33、d why excess burdens arise?,Optimal commodity taxation,Optimal commodity taxation is choosing tax rates across goods to minimize the deadweight loss for a given government revenue requirement.,The Ramsey Rule,X per year,PX,DX,P0,X0,c,P0 + uX,b,X1,X,a,Excess Burden,P0 + (uX + 1),f,X2,i,x,e,j,h,g,Marg
34、inal Excess Burden,marginal excess burden = area fbae = 1/2xuX + (uX + 1) = X,The Ramsey Rule continued,change in tax revenues = area gfih area ibae = X2 (X1 X2)uX marginal tax revenue = X1 X marginal tax revenue per additional dollar of tax revenue = X/(X1 - X) marginal tax revenue per additional d
35、ollar of tax revenue for good Y = Y/(Y1 - Y) To minimize overall excess burden = X/(X1 - X) = Y/(Y1 - Y) therefore,A Reinterpretation of the Ramsey Rule,inverse elasticity rule,Optimal commodity taxation Ramsey rule,The Ramsey Rule is:It sets taxes across commodities so that the ratio of the margina
36、l deadweight loss to marginal revenue raised is equal across commodities.,Optimal commodity taxation Ramsey rule,The goal of the Ramsey Rule is to minimize deadweight loss of a tax system while raising a fixed amount of revenue. The value of additional government revenues is the value of having anot
37、her dollar in the governments hands relative to its next best use in the private sector.,Optimal commodity taxation Ramsey rule,8 measures the value of having another dollar in the governments hands relative to the next best use in the private sector. Smaller values of 8 mean additional government r
38、evenues have little value relative to the value in the private market.,Optimal commodity taxation Inverse elasticity rule,The inverse elasticity rule, which expresses the Ramsey result in a simplified form, allows us to relate tax policy to the elasticity of demand. The government should set taxes o
39、n each commodity inversely to the demand elasticity. Less elastic items are taxed at a higher rate.,Optimal commodity taxation Equity implications of the Ramsey rule,Two factors must be balanced when setting optimal commodity taxes: The elasticity rule: Tax commodities with low elasticities. The bro
40、ad base rule: It is better to tax a wide variety of goods at a lower rate, because deadweight loss increases with the square of the tax rate. Thus, the government should tax all of the commodities that it is able to, but at different rates.,Price reform in Pakistan,An interesting application of thes
41、e rules is price reform in Pakistan. Deaton (1997) found that the Pakastani government was paying subsidies for wheat and rice, and was collecting taxes on oils and fats. The market conditions are summarized in Table 2.,Application,With these elasticities, the taxes and subsidies should be changed.,
42、Price reform in Pakistan,The subsidies generate overconsumption of wheat and rice, and lead to particularly large efficiency losses for rice. The tax on oils/fats also generates deadweight loss. Using a framework similar to Ramseys, Deaton suggested a tax reform that would increase efficiency and be
43、 revenue neutral: reduce the tax on oils and fats, and make up for the lost tax revenues by reducing the subsidies to rice (especially) and wheat.,Application,Price reform in Pakistan,Deaton also found that distributional considerations might offset some of these conclusions. Wheat and fats/oils wer
44、e consumed quite heavily by the poor, but rice was consumed fairly evenly throughout the income distribution. This suggests not to decrease the wheat subsidy on equity grounds.,Application,OPTIMAL INCOME TAXES,Optimal income taxation is choosing the tax rates across income groups to maximize social
45、welfare subject to a government revenue requirement. A key concern in the analysis is vertical equity.,Optimal income taxes A simple example,Imagine we make the following assumptions: Identical utility functions Diminishing marginal utility of income Total income is fixed Utilitarian social welfare
46、function The optimal income tax system in such a case gives everyone the same level of post-tax income. Implies marginal tax rate of 100% for those with above-average income. The unrealistic assumption is that total income (labor supply) is fixed with respect to taxes.,Optimal income taxes General m
47、odel with behavioral effects,More generally, there are equity-efficiency tradeoffs. Raising tax rates will likely affect the size of the tax base. Thus, increasing the tax rate on labor income has two effects: Tax revenues rise for a given level of labor income. Workers reduce their earnings, shrink
48、ing the tax base. At high tax rates, this second effect becomes important.,Optimal income taxes General model with behavioral effects,The Laffer curve, which motivated the supply-side economic policies of the Reagan presidency is shown in Figure 7. If tax rates are too high and we are on the wrong side of the Laffer curve, lowering tax rates increases revenue.,Tax rate,Tax revenues,*%,0,100%,right side,wrong side,The Laffer curve demonstrates that at some point, tax revenue falls.,Optimal income taxes General model with behavioral effects,
