Imagine you receive your first paycheck for the first month you worked on a new job… and the amount of money on it is less than you expected. This is highly frustrating! Where did that money go? You reach out to the accountant at your company and find out that you have paid a certain percentage of your earnings to the government. You are still not convinced. Why did the government just take the money away from me, you ask?
Income tax and other forms of taxes are essential sources of government revenue. The government doesn’t just take your money with nothing provided in return. Public goods and services like street lighting, roads and railways, defense, and even education, in some cases, are funded from this revenue. The economics of taxation is the design of an efficient tax system that would be fair, equitable, and simple to understand. Eager to dive deeper into the depths of the economics of taxation? Keep scrolling!
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.
The economics of taxation is the design of an efficient tax system that would be fair, equitable, and simple to understand.
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.
To learn more about different types of taxes, check out our article - Types of Taxes.
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.
In 2017 Philadelphia became one of the first cities in the United States to introduce a tax on sugary drinks. The result was a more than 20% reduction in consumption of sugary drinks.1
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.
Taxes on gas are a great example of the benefit principle. Why should someone who doesn't even have a car pay this tax while someone who uses the car daily pollutes the environment? The average gas tax rate in the U.S. was about 28 cents per gallon in 2020.2
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!
The benefit principle states that taxes should be paid in proportion to the number of benefits received, irrespective of income.
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.
Income tax is an excellent example of the ability-to-pay principle. Income tax in the U.S. is progressive, meaning that high-income earners pay more tax than low-income earners. The 2022 Federal income tax rate for single filers in the U.S. is 10% for income under $10,275 but is 24% for income between $89,076 and $170,050.3
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 ability-to-pay principle states that taxes should be paid in proportion to the income level, regardless of the benefits received.
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 Stax 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 Qtax. The new market equilibrium is at price Ptax and quantity Qtax. 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 Stax 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 Qtax. The new market equilibrium is at price Ptax and quantity Qtax. 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.
Tax incidence for a consumer is reflected by how much the market price changes after the imposition of tax.
Tax incidence for a producer is reflected by how much their revenue decreases after the imposition of 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.
The Economics Of Taxation - Key takeaways
- The economics of taxation is the design of an efficient tax system that would be fair, equitable, and simple to understand. The criteria that are often used in tax policy design are: the efficiency principle, the equity principle, and the simplicity principle
- The benefit principle of taxation states that taxes should be paid in proportion to the number of benefits received, irrespective of income. The ability-to-pay principle states that taxes should be paid in proportion to the income level, regardless of the benefits received.
- The economics of taxation has a measurable impact on the economy in terms of resource allocation, productivity and growth, tax incidence, and behavior adjustment.
- Tax incidence for a consumer is reflected by how much the market price changes after the imposition of tax. Tax incidence for a producer is reflected by how much their revenue decreases after the imposition of tax.
- In the case of price elastic demand, the producer bears more incidence of the tax. In the case of price inelastic demand, the consumer bears more incidence of the tax.
References
- Reuters, First U.S. soda tax cuts consumption beyond expectations, 2016, https://www.reuters.com/article/us-health-soda-tax-idUSKCN12S200
- Statista, Gas tax and price of leading states based on highest effective gasoline tax in the United States as of March 2022, https://www.statista.com/statistics/509649/us-states-with-highest-gas-tax-and-prices/
- Nerdwallet, 2021-2022 Tax Brackets and Federal Income Tax Rates, https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets
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