Tax Inefficiencies: Implications for Optimal Taxation

1. Tax Inefficiencies and Their Implications for Optimal Taxation Chapter 20 20.1 Taxation and Economic Efficiency 20.2 Optimal Commodity Taxation 20.3 Optimal Income Taxes 20.4 Tax-benefit Linkages and the Financing of Social Insurance Programs 20.5 Conclusion

2. Taxation and Economic Efficiency 20 . 1 Graphical Approach

3. Taxation and Economic Efficiency 20 . 1 Elasticities Determine Tax Inefficiency

4. Taxation and Economic Efficiency 20 . 1 Elasticities Determine Tax Inefficiency Theinefficiency of any tax is determined by the extent to which consumers and producers change their behavior to avoid the tax; deadweight loss is caused by individuals and firms making inefficient consumption and production choices in order to avoid taxation.

5. Tax Avoidance in Practice 1. The British boat designer Uffa Fox lived in a home he constructed from a floating bridge. When the Inland Revenue (Britain’s tax collectors) attempted to collect property tax on the home, Fox began sailing it up and down the river. By the time he was done, Fox had collected so many different addresses that the Inland Revenue gave up their attempts. 2. An Englishman visiting Cyprus in the early 1980s asked a tour guide why so many of the houses seemed to have steel reinforcement bars jutting out from their top floors. The guide informed him that Cyprus had a building tax that applied only to finished structures. Owners of those houses could thus claim that they were still in the process of finishing the roof. 3. The Thai government levies a tax on signs in front of businesses. The tax is levied only on external signs and the rate depends on whether the sign is completely in Thai (low), in Thai and English (medium), or completely in English (very high). A walk around Bangkok thus reveals many businesses hanging English signs with a small amount of Thai writing in the upper-right-hand corner. Some businesses manage to avoid the tax entirely by printing the message on curtains that are hung in the front window, rendering the sign “internal” and thus tax-exempt.

6. Taxation and Economic Efficiency 20 . 1 Determinants of Deadweight Loss The formula for DWL is marginal deadweight loss The increase in deadweight loss per unit increase in the tax.

7. Taxation and Economic Efficiency 20 . 1 Determinants of Deadweight Loss

8. Taxation and Economic Efficiency 20 . 1 Deadweight Loss and the Design of Efficient Tax Systems A Tax System’s Efficiency Is Affected by a Market’s Preexisting Distortions preexisting distortions Market failures, such as externalities or imperfect competition, that are in place before any government intervention.

9. Taxation and Economic Efficiency 20 . 1 Deadweight Loss and the Design of Efficient Tax Systems A Tax System’s Efficiency Is Affected by a Market’s Preexisting Distortions

10. Taxation and Economic Efficiency 20 . 1 Deadweight Loss and the Design of Efficient Tax Systems Governments Should “Smooth” Tax Rates Over Time Just as individual utility is maximized by full consumption smoothing, government efficiency in taxation over time is maximized by tax smoothing, by having a relatively constant tax rate over time rather than high taxes in some periods and low taxes in others.

11. The Deadweight Loss of Taxing Wireless Communications Hausman (2000) estimated the deadweight loss from a particularly dynamic sector of our economy: wireless communications services. • In 1999, the state and federal tax burden on wireless communication in the typical state was 14.5%, although the rate was 25% in high-tax states. • Hausman estimated that for every dollar the government raised in taxes, social welfare was reduced by 53¢. This figure is high for three reasons: • Demand for wireless communications is fairly price sensitive. • There is already a large preexisting distortion in this market. • The taxes are fairly high, and the marginal deadweight loss rises with the tax rate. • Hausman estimated that the marginal deadweight loss caused by an additional tax on wireless services ranged from 72¢ to 90¢ per dollar raised.

12. Optimal Commodity Taxation 20 . 2 Ramsey Taxation: The Theory of Optimal Commodity Taxation optimal commodity taxation Choosing the tax rates across goods to minimize deadweight loss for a given government revenue requirement. Ramsey Rule Tominimize the deadweight loss of a tax system while raising a fixed amount of revenue, taxes should be set across commodities so that the ratio of the marginal deadweight loss to marginal revenue raised is equal across commodities. value of additional government revenues The value of having another dollar in the government’s hands relative to its next best use in the private sector.

13. Optimal Commodity Taxation 20 . 2 Inverse Elasticity Rule If we assume that the supply side of commodity markets is perfectly competitive (elasticity of supply is infinite), then the Ramsey result implies that: This formulation of Ramsey’s rule shows that two factors must be balanced when setting optimal commodity taxes: • The elasticity rule: When elasticity of demand for a good is high, it should be taxed at a low rate; when elasticity is low, the tax rate should be high. • The broad base rule: It is better to tax a wide variety of goods at a moderate rate than to tax very few goods at a high rate. Because the marginal deadweight loss from a tax rises with the tax rate, the government should spread taxes across a large number of commodities and not tax any one commodity at a very high rate.

14. Optimal Commodity Taxation 20 . 2 Equity Implications of the Ramsey Model Imagine that the government had only two goods it could tax, cereal and caviar. • The elasticity of demand for caviar is much higher than that for cereal, so the inverse elasticity rule would suggest that the government tax cereal much more highly than caviar. • This would mean imposing a tax on a good consumed exclusively by higher-income groups that was much lower than the tax imposed on a good consumed by all. This outcome, while efficient, might violate a government’s sense of tax fairness across income groups (vertical equity).

15. Price Reform in Pakistan Angus Deaton (1997) studied the demands for commodities in several developing nations. He used variation in prices encountered by consumers of rice, wheat, and other commodities to estimate their elasticities of demand.

16. Price Reform in Pakistan

17. Optimal Income Taxes 20 . 3 optimal income taxation Choosing the tax rates across income groups to maximize social welfare subject to a government revenue requirement.

18. Optimal Income Taxes 20 . 3 A Simple Example It is helpful to begin with a simple example that makes the following assumptions: 1. Everyone in society has the same utility functions (U1 = U2 = . . .). 2. These utility functions exhibit diminishing MU of income. 3. The total amount of income in society is fixed (so incomes are not determined by individual choices that might respond to tax rates). 4. Society has a utilitarian social welfare function (V = U1 + U2 + . . .) under which each individual’s utility is weighted equally in determining social welfare. Under these assumptions, the optimal income tax system is one that leaves everyone with the same level of post-tax income. Any individuals with incomes below this level would receive a transfer from the government that would increase their incomes to the average amount. With this system, each additional dollar of earnings either reduces one’s transfer by $1 (if below the average income level) or raises one’s tax by $1 (if above the average income level).

19. Optimal Income Taxes 20 . 3 General Model with Behavioral Effects

20. Optimal Income Taxes 20 . 3 General Model with Behavioral Effects The optimal income tax system meets the following condition: In the case of income taxation, the optimal tax system reflects a different balancing: • Vertical Equity: Social welfare is maximized when those who have a high level of consumption, and thus a low marginal utility, are taxed more heavily, and those who have a low level of consumption, and thus a high marginal utility, are taxed less heavily. • Behavioral Responses: As taxes rise on any one group, individuals in that group may respond by earning less income.

21. Optimal Income Taxes 20 . 3 An Example

22. Optimal Income Taxes 20 . 3 The Structure of Optimal Income Tax Rates:A Simulation Exercise simulation exercises The numerical simulation of economic agents’ behavior based on measured economic parameters in an attempt to determine optimal tax rates or other outcomes of interest.

23. Optimal Income Taxes 20 . 3 The Structure of Optimal Income Tax Rates: A Simulation Exercise

24. Tax-benefit Linkages and the Financing of Social Insurance Programs 20 . 4 tax-benefit linkages Direct ties between taxes paid and benefits received.

25. Tax-benefit Linkages and the Financing of Social Insurance Programs 20 . 4 The Model

26. Tax-benefit Linkages and the Financing of Social Insurance Programs 20 . 4 Issues Raised by Tax-benefit Linkage Analysis If There Is No Inefficiency to Providing a Benefit, Why Doesn’t the Employer Just Do So Without Government Involvement?

27. Tax-benefit Linkages and the Financing of Social Insurance Programs 20 . 4 Issues Raised by Tax-benefit Linkage Analysis When Are There Tax-benefit Linkages? The tax-benefit linkage is strongest when taxes paid are linked directly to a benefit for workers. What Is the Empirical Evidence on Tax-benefit Linkages? The existing literature suggests that the cost of social insurance financing is borne by workers in the form of lower wages and not lower employment.

28. E M P I R I C A L E V I D E N C E A GROUP-SPECIFIC EMPLOYER MANDATE Gruber (1994) examined the impact on wages and labor supply of a group-specific mandated benefit. Before the mid-1970s, health insurance plans provided very little coverage for the costs associated with normal pregnancy and childbirth. This was viewed as discriminatory by some state governments, leading to the state laws mandating that pregnancy costs be covered as completely as other medical costs. These laws significantly increased the insurance costs for women of childbearing age in those states, thereby raising the costs of employing a specific group of workers (treatment group). There were two possible control groups: similar workers in other states that did not pass these laws, or other groups of workers within the states that did pass these laws. Gruber’s study compared the changes in wages and labor supply of the treatment group around the time of the passage of these laws to the changes in both of these control groups. The results show that the cost of this new mandate was fully passed on to the wages of the affected groups, with little effect on their labor supply.

29. Conclusion 20 . 5 • The fundamental issue in designing tax policy is the equity-efficiency trade-off. • Understanding tax efficiency really comes down to remembering two key principles. • The more elastically supplied or demanded the good, the larger the deadweight loss from the tax. • The higher the tax rate, the larger the incremental deadweight loss of taxation. • Trading off these two considerations is the key to understanding the efficiency aspects of the tax policies.