Public Finance Lecture 8 PDF

Public Finance Chapter Eight Taxation 1 Main points: 1. Defining Taxes 2. The Importance of Taxation: 3. Tax role in the reallocation of resources from private to public allocation: 4. Types of Taxes 5. Tax Base 6. Important Sources of Taxes 7....

Public Finance Chapter Eight Taxation 1 Main points: 1. Defining Taxes 2. The Importance of Taxation: 3. Tax role in the reallocation of resources from private to public allocation: 4. Types of Taxes 5. Tax Base 6. Important Sources of Taxes 7. General and Selective Taxes: 8. Tax Rate 9. Tax Rate Structure 10. How should the burden of government finance be distributed? 11. Horizontal and vertical equity: 12. Tax Evasion and Tax Avoidance 2 1. Defining Taxes:  Taxes are pecuniary burden laid upon individuals or property owners to support the government, a payment exacted by legislative authority. It is levied on a product, income, or activity.  Taxes are compulsory payments associated with certain activities.  Revenues collected through taxation are used to: - Purchase the inputs necessary to produce government-supplied goods and services, or - To redistribute purchasing power among citizens 3 2. The Importance of Taxation:  The taxation process can benefit the society, and the business. 1. The Society: Taxation is important to the society for the following reasons: - The government use the tax collected to fund projects related to health care systems, education systems, and public transports. - The money collected can be used to provide unemployment benefits, pensions, and so on. 4 - Funding the essential projects and services that people need. - The government would allocate part of the tax to provide the essential services required for rural areas and to improve the standards of such places. - Taxation can affect the rate of economic growth of a country. - Tax revenues discourage certain undesirable activities such as; tobacco and gambling. On such activities the government imposes excise tax, discouraging individuals from selling such commodities. - Taxes provide information about the total price for the government projects. 5 2. Businesses: - Taxes help business through the government funding the money back into the economy as: i) long term loans and/or funding. Or ii) In case of an economic recession or turmoil. - Taxes help develop the country as a whole, and the more developed the country is; the better the prospects for the business's as it increases the well being of the country's society. 6  3. Tax role in the reallocation of resources from private to public allocation: Taxation reallocates resources from private to government use in two distinct steps:  First, the ability of individuals to command resources is reduced, because taxation reduces income for spending on market goods and services.  Second, the revenues collected by government then are used to bid for resources necessary to provide government goods and services and to provide income support payments to recipients of government transfers such as Social Security pensions. 7  4. Types of Taxes Direct Taxes Indirect Taxes - A Direct tax is a kind of charge, -An indirect tax is a tax collected by an which is imposed directly on the intermediary (such as a retail store) from taxpayer and paid directly to the the person who bears the ultimate government by the persons economic burden of the tax (such as the (juristic or natural). customer). - A direct tax is one that cannot be -An indirect tax is one that can be shifted shifted by the taxpayer to by the taxpayer to someone else. someone else. -An indirect tax may increase the price of a good. 8 5. Tax Base  An item or economic activity upon which the assessment or determination of tax liability is based.  Most commonly used tax bases: - Income - Consumption - Wealth 9  Income Consumption Wealth (Y= C+S) (C=Y-S) (W = S+I) - Is the sum of the value of the annual A person’s annual Wealth represents the consumption of goods and services consumption is his annual value of a person’s and annual saving. income less the amount of accumulated savings - Total annual income in a nation is that income saved that year. and investments at any equal to the value of the total point in time. consumption and saving of all people and organizations in the country. - Income is often regarded as a good index of the ability to pay taxes. 10 Notes:  The three major tax bases are related. Consumption is the portion of income that is not saved,  Wealth is the net value of a person’s stock of accumulated savings or investments  Many economists use income as a benchmark for evaluating the fairness of taxes. 11 6. Important Sources of Taxes: 1. Income taxes:  An important source of tax revenue in most industrialized countries is the income or payroll tax, also known as the personal income tax.  Income taxes are imposed on labor or activities that generate income, such as wages or salaries.  In the United States, income taxes account for about half of the total revenue of local, state, and federal governments combined. 12 2. Capital tax:  Capital includes items or facilities that generate profits, such as factories, business machinery, and real estate. Some types of capital taxes are known as “profits” taxes.  One kind of capital tax used by the federal government in the United States is the corporate income tax.  A property tax is a capital tax used by state and local governments.  Property taxes are levied on items such as houses or boats. 13 3. Sales and excise taxes:  Many state and local governments levy a sales tax on the purchase of certain items.  Consumers usually pay a percentage of the sales price as the tax.  An excise tax is levied on a specific product, such as alcohol, cigarettes, or gasoline. 4. Federal Income Tax: A tax levied by a national government on annual income. 14 5. Payroll Tax:  A tax an employer withholds or pays on behalf of their employees based on the wage or salary of the employee.  In the United States, Medicare and Social Security, make up the payroll tax. 6. Unemployment Tax:  A federal tax that is allocated to state unemployment agencies to fund unemployment assistance for laid-off workers. 15 7. Sales Tax:  A tax imposed by the government at the point of sale on retail goods and services.  Sales tax is based on a percentage of the selling prices of the goods and services and is set by the state.  Technically, consumers pay sales taxes, but effectively, business pay them since the tax increases consumers costs and causes them to buy less. 8. Foreign Tax:  Income taxes paid to a foreign government on income earned in that country. 16 9.Value-Added Tax:  A national sales tax collected at each stage of production of a good.  Depending on the political climate, the taxing authority often exempts certain necessary living items, such as food and medicine from the tax. 17  7. General and Selective Taxes: General Tax Selective Tax  Is one that taxes all of the components  Is one that taxes only certain portions of the economic base, with no of the tax base, or it might allow exclusions, exemptions, or deductions from the tax base. exemptions and deductions from the general tax base.  For example, a general income tax would tax all sources of income and  For example, an excise tax is a tax on would not allow any sort of deduction the manufacture or sale of a particular from total income in computing tax good or service. liability.  Similarly, a tax on real estate is an  Similarly, a general wealth tax would tax example of a selective tax on a all forms of holding wealth. particular form of wealth. 18 8. Tax Rate  A tax rate is the percentage of an individual's taxable income or a corporation's earning that is owed to the state.  The tax rate is the percentage of the tax base that must be paid in the form of taxes.  Examples include sales tax on goods and services, real property tax, short-term capital gains tax rate and long-term capital gains tax rate. 19 9. Tax Rate Structure:  The tax rate structure describes the relationship between the tax collected during a given accounting period and the tax base.  In evaluating taxes there are two ratios: A) The average tax rate (ATR):  It is simply the total dollar amount of taxes collected divided by the dollar value of the taxable base: ATR = Total Taxes Paid ÷ Value of the Tax Base 20 B) The marginal tax rate (MTR): Is the additional tax collected on additional dollar value of the tax base as the tax base increases: MTR =∆Total Taxes Paid ÷ ∆Value of the Tax Base 21  There are three tax rate structures: 1. Proportional taxes (flat-rate tax): Apply the same tax rate to any income level, or for any size of the tax base. Proportional tax is one for which the ATR does not vary with the value of the tax base. Under proportional taxation, the ATR, but not the amount of tax, is independent of the size of the base. 22 2. Regressive Taxes:  Is one that is inversely proportional to income — the lower the income, the higher the tax in relation to income.  The ATR declines as the size of the tax base increases.  In a regressive tax rate structure, the MTR < ATR for all those brackets above the lowest. 23  More productive individuals would be rewarded with lower tax rates as they produced and earned more.  However, the opposition to such a method of taxation is strong because it violates the widely held belief that ability to pay increases with income. 24 3. Progressive Tax: A progressive tax applies a higher tax rate to higher incomes. The portion of the tax base that is subject to a particular tax rate, is known as a tax bracket, which always has lower and upper limits, except for the top tax bracket, which has no upper limit.  The ATR increases with the size of the base.  The larger the tax base, the larger the ATR applied.  The tax bracket gives the increment of annual income associated with each MTR. 25 26  10. How should the burden of government finance be distributed? The benefit principle The ability-to-pay principle  Argues that the means of financing  Argues that taxes should be distributed government-supplied goods and services according to the capacity of taxpayers to should be linked to the benefits that pay them. citizens receive from government.  Citizens with greater ability to earn  From the point of view of those who income, should be taxed more heavily favor the benefit approach, fees and than those with less capacity to earn. charges are ideal forms of government finance. 27 Advantage: Disadvantage:  Is that it links the cost per unit of government-provided  The problem of distributing services with the marginal benefits of those services. tax shares is viewed as  The free-rider problem does not exist. independent of individual Disadvantage: marginal benefits received  The only way to determine such benefits would be to from government activities. ask individual citizens how much extra units of the good or service are worth to them. If individuals know that their share of the financial burden depends on their declaration of benefits, they might have little or no incentive to declare their true benefits. 28 11. Horizontal and vertical equity: Horizontal Equity Vertical Equity  Is achieved when individuals  Is accomplished when of the same economic individuals of differing capacity (measured, for economic ability pay example, by income) pay the annual tax bills that differ same amount of taxes per according to some year (or over their lifetimes). collectively chosen notion of fairness. 29  12. Tax Evasion and Tax Avoidance: Tax Evasion Tax Avoidance  Is noncompliance with the tax laws by failing to pay taxes that are due.  Is a change in behavior to reduce tax  The incentives for evasion by individuals liability. depend on the costs and benefits expected  Taxpayers respond to the changes in prices from noncompliance. caused by taxes by rearranging their  The benefits of evasion tend to increase with personal affairs. the amount of tax, or money in general, saved  High taxes on labor income might induce by not complying with the rules. workers to refuse overtime work.  The costs of tax evasion vary with the  Tax avoidance is not illegal. penalties involved and the probability of being caught by the authorities.  Tax evasion is illegal 30