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CHAPTER 20:

Tax Inefficiencies and Their Implications for Optimal Taxation

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Tax Inefficiencies and Their Implications for Optimal Taxation

20.1 Taxation and Economic Efficiency

20.2 Optimal Commodity Taxation

20.3 Optimal Income Taxes

20.4 Tax-Benefit Linkages and the Financing of Social Insurance Programs

20.5 Conclusion

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Taxation and Economic Efficiency 1

• Usually, the market produces efficient outcomes. • Taxes interfere in the market and reduce efficiency. • Markets do not take taxes lying down. If there is some action

that market participants can undertake to minimize the burden of taxation, they will do so.

• People substitute away from the taxed product, using less efficient alternatives. o Eight-person motorcycles in Indonesia

• Some taxes have much larger efficiency costs than others.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Taxation and Economic Efficiency 2: Graphical Approach

Figure 20-1

Areaoftriangle Base xheight

SMC g

DWL 1.80 1.30 1100

900 2 DWL 2.5 billion

J SE

SMB

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Elasticities Determine Tax Inefficiency 1

The deadweight loss of a given tax is smaller when the demand curve is less elastic than when it is more elastic.

Figure 20-2

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CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Elasticities Determine Tax Inefficiency 2

• Deadweight loss is caused by individuals and firms making inefficient consumption and production choices in order to avoid taxation.

• The inefficiency of any tax is determined by the extent to which consumers and producers change their behavior to avoid the tax.

• The more elastic is demand or supply, the larger the DWL.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

APPLICATION: Tax Avoidance in Practice

Keynes: “The avoidance of taxes is the only pursuit that still carries any reward.” Some examples of avoidance: 1. The Papal States taxed salt heavily, so Tuscan bakers stopped

using it. Even today, Tuscan bread is saltless. 2. In the early 1980s, Cyprus’s building tax applied to finished

structures. Homeowners put steel bars jutting out from their roofs to avoid the tax.

3. Thailand taxes business signs on the outside, with higher taxes for English-only signs. So, many signs have a bit of Thai writing in the corner or are hung on curtains inside the shop.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Elasticities Determine Tax Inefficiency 2

• The more elastic is demand or supply, the larger the DWL => • Rules for optimal taxation: • (Inverse) elasticity rule for commodity taxation: To

minimize DWL, tax goods with relatively inelastic demand. • Behavioral response for income taxation: To minimize DWL,

tax income groups with relatively inelastic Ls, tax types of income that is relatively inelastic.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Determinants of Deadweight Loss 2

The marginal deadweight loss rises disproportionately with the tax rate.

Figure 20-5

SMC

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1K9gr SE

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Determinants of Deadweight Loss 1

The formula for DWL implies that

• The DWL rises with the square of the tax. • So marginal DWL rises with the tax rate. • Marginal deadweight loss: The increase in deadweight loss

per unit increase in the tax.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

A Tax System’s Efficiency Is Affected by a Market’s Preexisting Distortions 1 • Since marginal DWL rises with the tax rate, preexisting

distortions affect the efficiency of a new tax.

o Preexisting distortions: Market failures, such as externalities or imperfect competition, that are in place before any government intervention.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Determinants of Deadweight Loss 1

The fact that the DWL rises with the square of the tax =>

• Rules for optimal taxation: • Broad base rule for optimal commodity taxation: Better to

tax at low rates a large variety of goods than one good at a high rate.

• Broad base rule for income taxation: Better to eliminate exemptions, deductions, and exceptions and have low tax rates applied to everyone than high tax rates concentrated on a few tax payers.

• Tax smoothing: A relatively constant tax rate over time rather than high taxes in some periods and low taxes in others. High and then low tax rates produce a larger DWL then steady medium tax rates.

for

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Equity Implications of focusing on efficiency:

Imagine that the government had only two goods it could tax: cereal and caviar: • Elasticity of demand for caviar is much higher than that for

cereal. • The inverse elasticity rule would suggest that the government

tax cereal much more highly than caviar. • This means taxing more heavily the good consumed by poor

people. • This might hurt vertical equality.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Optimal Income Taxes: How progressive should the income tax system be? • Most tax revenue in the United States and other developed

countries is from income taxes.

• Optimal income taxation: Choosing the tax rates across income groups to maximize social welfare subject to a government revenue requirement.

• Social welfare function guides the trade-off between progressivity and efficiency.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

A Simple Example 1

1. Everyone in society has the same utility functions: !1 = !2 = …

2. These utility functions exhibit diminishing MU of income. 3. Total income in society is fixed, not determined by individual

choices that might respond to tax rates. 4. Society has an equally weighted utilitarian social welfare

function: # = !1 + !2 + .. .SW

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

General Model with Behavioral Effects 2

Optimal income taxation balances: • Behavioral responses: As taxes rise on any one group,

individuals in that group may respond by earning less income. • Vertical equity: Social welfare is maximized when those who

have a high level of consumption and thus a low marginal utility are taxed more heavily and when those who have a low level of consumption and thus a high marginal utility are taxed less heavily.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Progressive Tax Systems Can Be Less Efficient 2

Why is the deadweight loss larger for the higher-wage worker even with the same reduction in hours worked (same LS elasticity)?

• In a competitive labor market, wage equals the marginal product of labor, so the high-wage worker has a higher marginal product of labor.

• Society loses twice as much when the high-wage worker reduces her hours than when the low-wage worker reduces her hours.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Progressive Tax Systems Can Be Less Efficient 3: Graphical Approach

Initially the government imposes FLAT TAX on the low-wage worker and the high-wage worker, which results in deadweight losses of triangles BAC and EDF.

Figure 20-7

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Progressive Tax Systems Can Be Less Efficient 4: Graphical Approach

When system is replaced with PROGRESSIVE TAX no tax on low-wage workers, there is no DWL for this worker, but the DWL for the high-wage worker increases by the trapezoid GEFI. This results in an increase in deadweight loss because additional taxes must be collected from high-wage workers in order to collect the same revenues as before.

Figure 20-7

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Progressive Tax Systems Can Be Less Efficient 5

The deadweight loss is larger for the higher-wage worker despite the same reduction in hours worked.

The deadweight loss is even larger for the higher wage worker if her/his Ls elasticity is larger than the elasticity of the low-wage earner!

An increase in the progressivity of the tax system is good if SW increases because equity gains > efficiency losses.

An increase in the progressivity of the tax system is bad if SW decreases because equity gains < efficiency losses.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Recent research on progressivity of tax system • How elastic is the LS for top income earners? What should be the top

marginal tax rates? • Piketty and Saez derive the optimal top tax rate formula as a function

of behavioral elasticities. • First, higher top tax rates may discourage work effort and business creation among the most talented: the revenue-maximizing top tax rate would be 57%.

• Second, higher top tax rates can increase tax avoidance. With political will and international cooperation to enforce taxes, it is possible to eliminate most tax avoidance opportunities, and broaden the tax base, which are well known and documented.

• Third, while standard economic models assume that pay reflects productivity, there are strong reasons to be sceptical, especially at the top of the income distribution: Tax cuts have not consistently increased economic growth (boost economic efficiency). A substantial fraction of the response of pre-tax top incomes to top tax rates may be due to increased rent-seeking at the top rather than increased productive effort.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Recent research on progressivity of tax system • Their model and mid-range parameter values where the response of

top earners to top tax rate cuts is due in part to increased rent-seeking behavior and in part to increased productive work, we find that the top tax rate could potentially be set as high as 83% – as opposed to 57% in the pure supply-side model.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Conclusion on Tax reforms

• The fundamental issue in designing tax policy is the equity-efficiency trade-off.

• Simplifying the tax system • Broadening the tax base • Increasing the progressivity of the income tax (smoothly) • Considering hard to avoid/evade taxes such as

consumption taxes while increasing the progressivity of the tax system.

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Learn by Doing: Practice Question 1

Which of these are TRUE concerning taxation?

I. The inefficiency of a tax is determined by the elasticities of supply and demand.

II. Taxing a good that has a negative externality generates deadweight loss.

III. Progressive tax systems tend to be less efficient than proportional tax systems.

a) I and II only

b) I and III only

c) II and III only

d) I, II, and III

CHAPTER 20: Tax Inefficiencies and Their Implications for Optimal Taxation

Learn by Doing: Practice Question 1 (Answer)

Which of these are TRUE concerning taxation?

I. The inefficiency of a tax is determined by the elasticities of supply and demand.

II. Taxing a good that has a negative externality generates deadweight loss.

III. Progressive tax systems tend to be less efficient than proportional tax systems.

a) I and II only

b) I and III only (correct answer)

c) II and III only

d) I, II, and III