Lump Sum Tax

Lump Sum Tax: Efficiency

Lump sum taxes are widely considered the form of taxation that promotes the most economic efficiency. With a lump sum tax rate, producers are not "punished" for increasing their production by being subject to a higher tax bracket if they increase their revenue. Producers are also not taxed on each additional unit they produce as is the case with a per unit tax. The lump sum tax encourages efficiency because it does not affect how people behave since the lump sum tax does not change like a revenue-based or per unit tax.

This increased economic efficiency eliminates deadweight loss, which is the loss of combined consumer and producer surplus resulting from the misallocation of resources. As economic efficiency increases, deadweight loss decreases. Lump sum taxes also require minimal administrative attention on behalf of the government and the taxpayer. Because the tax is a straightforward value that does not vary depending on income or production, the focus lies on whether or not the tax has been paid rather than having to keep receipts and calculate if the correct amount has been paid.

Lump Sum Tax vs Proportional Tax

What is the difference between a lump sum tax vs proportional tax? A lump sum tax is when all those who pay the tax pay the same amount across the board. With a proportional tax, everyone pays the same percentage of tax, regardless of income.

With a proportional tax, everyone pays the same proportion of their income in tax whereas with a lump sum everyone pays the same amount of tax. Maybe an example for each type of tax would help.

If we compare how much Mary and Jamie each spend in taxes, we can see how the lump sum tax is often criticized as unfair, especially by those lower income or smaller producers who end up paying a larger percentage of their income in tax. However, this example also demonstrates how a lump sum tax may encourage economic efficiency. Jamie's tax burden does not increase nor even remain constant the more they produce. Their tax burden actually decreases the more they produce, which incentivizes businesses to become more efficient in their production because they can keep more of their profits.

Lump Sum Tax: Proportional Tax

Now, let's have a look at a proportional tax so that we can better understand how it differs from a lump sum tax. Where a lump sum tax is the same quantity at all income levels, a proportional tax is the same percentage rate across all income levels.

Fig. 2 - How a proportional tax affects income

In Figure 2 we see how a proportional tax affects different levels of income. Regardless of low, middle, or high income, the tax required is the same portion of income. This method of taxation is often seen as more fair than a lump sum tax since it takes income or production into consideration and the tax burden is the same at varying levels of income.

The downside to a proportional tax is that it is less efficient since it produces deadweight loss when large producers are not driven towards economic efficiency as heavily as with the rewards of a lump sum tax.

Examples of Lump Sum Tax

Let's have a look at some examples of lump-sum taxes. One thing about lump-sum taxes is that they usually come paired with per-unit taxes or strict requirements to qualify.

The example above shows how lump sum taxes can be unfair to smaller producers.

An example of lump sum taxes being used is the Swiss lump sum tax applied to foreign nationals living in but are not employed in Switzerland.

Disadvantages of Lump Sum Tax

Let's look at some disadvantages of lump sum taxes. Although they might be beneficial for eliminating deadweight loss, increasing efficiency, and reducing administrative tasks, lump-sum taxes are not widely employed. The main disadvantage of lump-sum taxes is that they are unfair to smaller businesses and those with lower incomes. The tax burden is higher for those with a lower income since they pay a greater portion of their income in tax than wealthier people.

Tax systems typically weigh the trade-off between efficiency and equity. With any tax, it is difficult to have a tax that is both fair and encourages efficiency. A fairer tax like a proportional tax usually discourages people from producing at their highest potential since they are taxed on their level of production, making them less efficient. A lump sum tax is on the other end of promoting efficiency but is unfair.

Lump Sum Tax Formula

Another disadvantage of a lump sum tax is that it can be arbitrary, meaning that there is no formula or guide for setting them. For the taxpayers, it is not always clear why the tax is the amount that it is since it is not based on their production capabilities or income. Again, this might not matter to wealthier producers but it can be problematic for those with a lower income, especially if the taxes are adjusted every year and the amount of tax is subject to change, like how Switzerland adjusts its lump sum tax annually.