Taxation

• A tax is a compulsory payment of money to the Government by an Individuals or Organizations

as the Government covers it’s expenses on various public functions, and is interference in political,
economic and society life without direct return of benefit to be derived by the taxpayer.
• In other words, there is no direct return to the taxpayer for what he pays, though public in general
derives a common benefit.
• Adam Smith: “A tax is a contribution from citizens for the support of the state.
• P. E. Taylor: ‘A compulsory payment to Government without expectation of direct return in benefit
to the taxpayer is known as tax’.
• According to Seligman: “A tax is compulsory contribution from the person to the Government to
defray the expenses incurred in the common interest of all, without reference to special benefits
conferred”
• Dalton. “A tax is a compulsory contribution imposed by a public authority irrespective of the exact
amount of service rendered to the taxpayer in return”
Adam Smith Canon’s of Taxation

• The canon of equity/ability

• The canon of certainty
• The canon of convenience
• The canon of economy
• Tax and its types
• Basic categorization of taxes:
• Direct and indirect tax
• Personal income tax and corporation tax
• Capital gains : Earnings from selling capital assets, such as stocks, paintings, and houses.
• Corporate income tax: Tax levied on the earnings of corporations.
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• Wealth taxes: Taxes paid on the value of the assets, such as real estate or stocks, held by a person
or family.
• Property taxes A form of wealth tax based on the value of real estate, including the value of the
land and any structures built on the land.
• Estate taxes A form of wealth tax based on the value of the estate left behind when one dies.
• Custom and tariff.
• Sales tax.
Principles of Taxation

• Efficiency : the tax system should not be distortionary, if possible it should be used to enhance
economic efficiency.
• Simplicity: the tax system should have low cost of administration and compliance.
• Flexibility: the tax system should allow easy adaption to changed circumstances.
• Political responsibility: the tax should be transparent.
• Fairness: the tax system should be and seen to be fair , treating those in similar conditions and
circumstances similarly and imposing higher taxes on those who can better bear the burden of
taxation.
Economic Efficiency
• Absence of market failures and price as signalling system.
• Behavioural effects of taxation:
• Work, Education and retirement
• Saving , investment and risk taking.
• Energies devoted to avoiding taxes instead of creating wealth.
• Financial effects of taxation.
• Organisational effects of taxation.
• General equilibrium effects of taxation.
• Announcement effects.
• Distortionary and Nondistortionary Taxation: if and only is there is nothing an individual or
firm can do to alter his tax liability:- lump sum or head tax.
• If individuals or firm can attempt to alter his tax liability…virtually all taxes imposed are
distortionary.
• Corrective taxation: improves efficiency..
Administrative costs

• Administering our tax system entails significant costs.

• There is both direct and indirect costs.
• Direct costs include the cost of running the internal revenue services
• Indirect cost include , cost of filling tax returns, cost of keeping record and the cost of services of
accountant and tax lawyers.
• These cost depends upon the number of factors:
• Tax laws and their complexity.
• Differentiable treatment of various source of income and various goods.
• Nature of business.
Flexibility

• Automatic Stabilization and indexing.

• Political difficulties of adjusting rates.
• Speed of adjustment.
• Average and Marginal Tax Rates
• Marginal tax rate, the percentage of the next dollar of taxable income that is paid in taxes.
• The average tax rate, the percentage of total income that is paid in taxes, which is computed as the
ratio of total tax payments to total income.
• Progressive Tax systems in which effective average tax rates rise with income.
• Proportional Tax systems in which effective average tax rates do not change with income, so that
all taxpayers pay the same proportion of the income in taxes.
• Regressive Tax systems in which effective average tax rates fall with income.
Political responsibility

• Transparency and clear like daylight : who is paying and who is benefiting.
• Feedback type legislation.
• Fairness :
• Most of criticism of tax system begin with its unfair nature. However it is very difficult to define
what is fair and what is unfair. There are two distinct concepts of fairness: horizontal equity and
vertical equity.
• A tax system is said to be horizontally equitable if individuals who are same in all relevant
respects are treated same
• Vertical equity: this principle says that some individuals are in position to pay higher taxes than
others and that individuals should do so.
• Problems associated with vertical equity: how to decide who is in better position to pay ,
• second if some one is in a position to pay then how much he has to pay more than others
Bases of taxation:

• Income as a base of taxation: it is persons income who decides his ability to pay.
• Consumption as a basis for taxation.
• Lifetime income as the basis for taxation.
Benefit Approach

According to this theory, dating back to Adam Smith and earlier writers, an equitable tax system
is one under which each taxpayer contributes in line with the benefits which he or she
receives from public services.
According to this principle, the truly equitable tax system will differ depending on the
expenditure structure. The benefit criterion, therefore, is not one of tax policy only but of tax-
expenditure policy.
The other strand, also of distinguished ancestry, rests on the ability-to-pay principle. Under this
approach, the tax problem is viewed by itself, independent of expenditure determination.
A given total revenue is needed and each taxpayer is asked to contribute in line with his or
her ability to pay.
• This approach leaves the expenditure side of the public sector dangling and is thus less
satisfactory from the economists's point of view. Yet actual tax policy is largely determined
independently of the expenditure side and an equity rule is needed to provide guidance.
• The ability-to-pay principle is widely accepted as this guide.
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• Neither approach is easy to interpret or implement.

• For the benefit principle to be operational, expenditure benefits for particular taxpayers must
be known. For the ability-to-pay approach to be applicable, we must know just how this
ability is to be measured.
• These are formidable difficulties and neither approach wins on practicality grounds.
Moreover, neither approach can be said to deal with the entire function of tax policy.
• The benefit approach will ideally allocate that part of the tax bill which defrays the cost of
public services, but it cannot handle taxes needed to finance transfer payments and serve
redistribution objectives.
• For benefit taxation to be equitable, it must be assumed that a ''proper'' state of distribution
exists to begin with.
• This is a serious shortcoming since in practice, there is no separation between the taxes
used to finance public services and the taxes used to redistribute income.
• The ability-to-pay approach better meets the redistribution problem but it leaves the
provision for public services undetermined.
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• The issuance of licenses, the financing of municipal transportation, and the provision of
airport facilities, toll tax are more or less in this category.
ABILITY TO PAY: VERTICAL EQUITY AND RATE STRUCTURE

• Now we have made some decision regarding tax base let us assume it as income level.
• People with equal income should then pay the same tax.
• Now question to be considered now is how the taxes payable by people with different incomes
should differ.
• Equal Sacrifice Rules
• With equity in distribution consideration in mind people should pay tax with equality in sacrifice.
• Taxpayers are said to be treated equally if their tax payments involve an equal sacrifice or loss of
welfare.
• The loss of welfare in tum is related to the loss of income, as measured by the taxpayer's marginal
utility of income schedule.
• That schedule is assumed to be known and the same for all people.
• Given this premise, the equal sacrifice rule calls for people with equal income (or ability to pay) to
contribute equal amounts of tax. Furthermore, people with different incomes should pay different
amounts.
• The more difficult question is how these amounts should differ.
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• The more difficult question is how these amounts should differ.

• To answer it, one must know the shape of the marginal utility of income schedule, and even
then the answer differs, depending on how the term ''equal'' is interpreted.
• In particular, does equal sacrifice call for a progressive tax or proportional or regressive tax.
• The answer depends on both the shape of the income utility schedule and the rule that
"equality of sacrifice" is defined by.
• It may be interpreted to mean, equal absolute, equal proportional, or equal marginal .
• These concepts may be explained with the help of Figure.
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Absolute Sacrifice

• Under the equal absolute sacrifice rule, L, with income OB, pays CB, while H, with
income OB', pays C'B', where CB + C'B' is the needed revenue T. The loss of utility or
sacrifice incurred by L equals CBDE while the loss to H equals C'B'D'E', and This is distributed
such that CBDE = C'B'D'E'.
• If marginal utility were constant (MU parallel to the horizontal axis), equal absolute sacrifice
would require tax liabilities to be the same for all incomes.
• Equal sacrifice would call for a head tax/ lump sum tax
• But with a declining MU schedule, tax liability must rise with income. This much is clear, but it
does not follow that a progressive tax will be called for.
• The required tax distribution will be progressive, proportional, or regressive, depending on
whether the elasticity of the marginal income utility with respect to income.
• Even though it seems reasonable to assume that the MU schedule falls, there is no intuitive
answer about its rate of decline.
Proportional Sacrifice

• If the tax burden is distributed in line with equal proportional sacrifice, L will pay PB and H
will pay P'B', with PB + P'B' again equal to T.
• The tax is divided between the two so that the fraction of pretax utility lost for L (or
PBDK/OBDM) is the same as that for H (or P'B'D'K‘/O'B'D'M').
• Under this rule, it is evident that a constant MU schedule will call for proportional taxation.
• It can also be seen that a declining but straight-line MU schedule calls for progression, but
generalizations become difficult if the MU schedule falls at a decreasing rate, as is usually
assumed.
• The result in any particular case depends on the level and slope of the MU schedule, as
well as on the initial distribution of income and the amount of revenue that is to be raised.
Marginal Sacrifice

• Under the equal marginal sacrifice rule, L pays FB and H pays F'B', where FB + F'B' is the
required revenue T. The marginal sacrifice is the same, since FG = F'G'.
• After-tax incomes are equalized at OF= O'F'.
• If the marginal utility of income were constant, the distribution of the tax bill under equal
marginal sacrifice would be indeterminate.
• Given a declining MU schedule, equal marginal sacrifice calls for "maximum progression"; i.e.
, the leveling down of income from the top until the required revenue is obtained.
• The rate of decline does not matter in this case.
• The equal marginal sacrifice rule may thus be viewed as an efficiency rule or equity rule.
Tax incidence:

• What is meant by impact , burden and incidence of taxation, backward and forward shifting of
tax.
• What is meant by incidence of tax.
• Why it is that who ultimately bear the burden of tax may differ from those upon whom tax is
legally imposed.
• What determines who bears the burden of tax. And how it is dependent of elasticity of supply and
demand and structure of market.
• Why is in case of competitive market incidence of tax is independent on whether it is imposed on
producer and consumer.
• Why in case of competitive market specific and ad valorem tax produces same effect on quantity
is same amount of revenue is to be collected by government.
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Tax incidence and elasticity
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Producers bear the full burden
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Taxation in perfect competition
Tax incidence in monopoly/ imperfect competition market
Constant elasticity of demand
Effect of specific tax on monopolist
Effect of Ad valorem tax on monopolist.
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Taxation and economic efficiency:
• How is the efficiency loss associated with taxation measured.
• On what does its magnitude depends.
• What is meant by income and substitution effect of tax.
• How do they work in case of commodities and labour supply.
…
• All taxes effect economic behaviour. They transfer resources from individuals to government. As a
result individuals alter their behaviour in some way, like reduction in consumption , working more
enjoying less leisure.
• No matter how individuals adjust, an increase in taxes must make them worse off.
• But some taxes reduce individual welfare less than other for each unit of revenue generated.
• Best taxation policy is one which minimises this welfare loss for given amount of revenue raised.
Income and substitution effect of taxation:
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Deadweight loss.

• Lump-sum taxation was described as the perfect tax instrument because it does not cause any
distortions.
• The absence of distortions is due to the fact that a lump-sum tax is defined by the condition that no
change in behaviour can affect the level of the tax.
• Commodity taxation does not satisfy this definition. It is always possible to change a consumption
plan if commodity taxation is introduced.
• Demand can shift from goods subject to high taxes to goods with low taxes and total consumption
can be reduced by earning less or saving more.
• The introduction of a commodity tax raises tax revenue but causes consumer welfare to be
reduced.
• The deadweight loss of the tax is the extent to which the is reduction in welfare exceeds the
revenue raised.
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Measuring deadweight loss using compensated demand curve
Deadweight loss and rate of tax
Deadweight loss and elasticity of demand
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• Where t = tax rate

• έ is elasticity of demand.
• X is quantity demand.
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Optimal taxation:

• Imposition of tax leads to deadweight loss and revenue raised to government.

• Optimal tax is that tax that gives minimum deadweight loss for given amount of revenue.
• Ramsey rule or Ramsey tax; in absence of any income or profit taxes and with all individuals
identical , raising revenue so as to minimise deadweight loss requires imposing taxes in inverse
relationship to the elasticity of demand and supply.
Deadweight loss
Laffer curve

• Laffer curve depicts the relationship between tax rate and tax revenue.
Laffer curve explanation

• Supply-side economics/ reaganomics.

• The Laffer Curve describes how changes in tax rates affect government revenues in two ways.
One is immediate, which Laffer describes as "arithmetic." Every dollar in tax cuts translates
directly to one less dollar in government revenue.
• The other effect is longer-term, which Laffer describes as the "economic" effect. It works in the
opposite direction. Lower tax rates put money into the hands of taxpayers, who then spend it. It
creates more business activity to meet consumer demand. For this, companies hire more workers,
who then spend their additional income. This boost to economic growth generates a larger tax
base. It eventually replaces any revenue lost from the tax cut.
• Reaganomics is a popular term referring to the economic policies of Ronald Reagan, the 40th U.S.
president (1981–1989). His policies called for widespread tax cuts.