The Economics Of Taxation

The Economics of Taxation Definition

What is the definition of the economics of taxation? The economics of taxation is the design of an efficient tax system that would be fair, equitable, and simple to understand. Economists design such systems based on certain principles, such as the benefit principle and the ability-to-pay principle. Principles are essential to developing a tax system as various people would have different opinions on what the tax system should be like.

There are different types of taxes that are often used. These are progressive, regressive, and proportional taxes. All of them are broadly classified into direct and indirect taxes.While the payment of direct taxes cannot be transferred to someone else, indirect taxes allow for that possibility. Progressive taxes put a higher burden on those who have a more considerable income, while regressive taxes do the opposite. Proportional taxes are when everyone pays the same flat rate of tax.

The Economic Importance of Taxation

The economic importance of taxation cannot be overstated. Governments need to raise revenue to provide essential goods and services that would otherwise not be provided by the free market mechanism.Furthermore, various taxes are designed to encourage or discourage the consumption of certain goods. For example, a sin tax is intended to raise the price of a product, the consumption of which can lead to undesirable effects, such as an increased risk of diabetes.

The Economics of Taxation Principles

The Economics of taxation has certain principles designed to provide a solution for differing opinions on the tax system.Let's go over the two most essential principles of taxation:

• benefit principle
• ability-to-pay principle

Benefit principle

The benefit principle is backed by the idea that taxes should be paid in proportion to the number of benefits someone receives irrespective of their income.

All looks good, right? The difficulty with this principle is that benefits are often quite tricky to measure. An individual may not benefit directly from the use of a car. Still, the roads built and maintained from the tax revenue raised from this tax are used to transport essential goods you may consume without even realizing it!

Ability-to-pay principle

The ability-to-pay principle promotes the idea that regardless of the benefits received, taxes should be paid in proportion to the income level.

This principle complements the benefits principle well, as the benefits consumed from government expenditure are difficult to quantify. In addition, it supports a reasonable assumption that higher-income people can pay their fair share without suffering as much as a low-income family would.

The Economics of Taxation Policy

The economics of tax policy is concerned with designing a tax system. Initial ideas were proposed by Adam Smith in the four canons of taxation, which included fairness, certainty, convenience, and efficiency principles. Modern-day principles largely maintain these doctrines with some adaptations.

The criteria that are often used in tax policy design are:

• efficiency principle
• equity principle
• simplicity principle

Efficiency principle

The administration is a high cost when it comes to collecting taxes. There is also a cost arising from those who do not pay taxes on time or do not pay altogether. The efficiency principle ensures that the tax collection is relatively easy to administer and that evasion is fairly tricky. If evasion is difficult, the tax would be somewhat successful at generating revenue. Furthermore, the economic benefits of raising tax revenue should outweigh the costs.

Equity principle

All taxes should be fair, but what does that even mean? People may not always agree on who should pay how much. It may be that a flat tax rate is desirable in one case. In contrast, a proportional tax rate is more desirable in another. Even then, there may be supporters of both types of taxes in each case, and it would be difficult for them to agree. However, what is universally agreed upon in terms of equity is that there should be no tax loopholes. Tax loopholes would mean that some individuals or businesses will manage to avoid paying taxes where they actually should. That sounds pretty unfair for a diligent taxpayer like yourself, right?

Simplicity principle

There is nothing worse than a tax that is so complicated that even accountants would struggle to get their heads around it. Tax laws should be simple to understand, not only for those who wrote them but also for the taxpayers like yourself. A sales tax is a great example of a tax that satisfies this principle. It is levied as a percentage of a good's price and paid in every transaction by the purchaser. The sellers can also relatively easily report those figures when filing their tax forms.

The Economics of Taxation Impact

The economics of taxation has a measurable impact on the economy in terms of resource allocation, productivity and growth, tax incidence, and behavior adjustment.

Resource allocation

Taxation affects resource allocation by affecting factor markets. If a particular item is taxed more heavily and used as an input in the production chain, then the price of the final product will rise. Consumers can then divert their purchases from such items, depending on the elasticity of demand. This can affect the firms that produce the said item and they will have to find better use of their resources due to potential losses. The factors of production will then have to be re-allocated between competing uses, and the resulting allocation may not necessarily be the most efficient.

Productivity and growth

Individuals decide to work, save, invest and spend their income as they desire. However, taxation can impact these decisions, affecting productivity and growth for the whole economy! Suppose an individual is earning an income just below the tax threshold for higher income tax. In that case, they will be incentivized to continue making the same income. How so? It may be that by working more, they will actually be worse off than they currently are as they will have to pay more in income tax. By reducing their desire to work more, the income tax threshold reduces the productive potential that could have been achieved if they did work more. Now suppose that many individuals decide to do the same on an aggregate level. In that case, total productivity, real output, and economic growth will stumble.

Tax incidence

Tax incidence is defined as the actual burden of a tax. In other words, it simply means who actually pays the tax. Imagine that a producer needs to pay a higher tax and decides to pass down the costs to the consumer in the form of higher prices. The extent to which the producer can pass on the tax burden to the consumer depends on the consumer's price elasticity of demand.Let's consider a case where consumer demand is relatively price elastic.

Figure 1. Tax incidence with price elastic demand, StudySmarter Originals

As seen in Figure 1 above, the tax imposed on a producer increases their production costs. This shifts the supply curve from S₀ to S_tax by the amount of tax charged. Initial equilibrium was at price P₀ and quantity Q₀. However, as the demand for this product is price elastic, an increase in price causes the quantity demanded to drop significantly from Q₀ to Q_tax. The new market equilibrium is at price P_tax and quantity Q_tax. Consumer burden is the purple highlighted area, whereas producer burden is the yellow highlighted area. It can be seen that in the case of more price elastic demand, the producer bears more incidence of the tax.Let's consider a case where consumer demand is relatively price inelastic.

Figure 2. Tax incidence with price inelastic demand, StudySmarter Originals

As seen in Figure 2 above, the tax imposed on a producer increases their production costs. This shifts the supply curve from S₀ to S_tax by the amount of tax charged. Initial equilibrium was at price P₀ and quantity Q₀. However, as the demand for this product is price inelastic, an increase in price causes the quantity demanded to drop by very little from Q₀ to Q_tax. The new market equilibrium is at price P_tax and quantity Q_tax. Consumer burden is the purple highlighted area, whereas producer burden is the yellow highlighted area. It can be seen that in the case of more price inelastic demand, the consumer bears more incidence of the tax.

Behavior adjustment

As long as the taxes are uniformly implemented, their effect on behavior is fairly significant. There are taxes on certain goods that come with significant adverse effects when consumed. For example, sugary drinks and tobacco have taxes hidden in their prices to discourage consumption due to adverse health effects. Moreover, there are taxes on certain pollution emissions that factories throw into the environment. On the other hand, tax deductions are designed to encourage certain behaviors. For example, first-time home buyers get a tax deduction on their mortgage interest repayments. This is designed to stimulate young people to invest upfront to have their own place to live, thereby relying less on government support in the future.