TAXES ON GOODS AND SERVICES

1. General Taxes on Goods and Services Specific Excises TAXES ON GOODS AND SERVICES

2. IN THEORY • A comprehensive consumption tax would reach the same base as the income tax, where the latter is adjusted for personal saving

3. injections leakages The Circular Flow Diagram • Macro equilibrium means that the flow of expenditures on goods & services (top loop) is equal the flow of income to resources owners (bottom loop). • Under this condition the (government purchases • investment, & exports) into the circular flow … equal the(saving, taxes, and imports) from it. • Hence, Macro equilibrium obtains where injections equal leakages, i.e. equilibrium obtains in the loanable funds and foreign exchange markets,

4. = Capital Inflow Capital Outflow + + Exports Imports Net Capital Inflow - = Exports Imports = Budget Deficit Net Capital Inflow + + Net Saving Investment = + Budget Deficit Net Saving Investment - + Exports Imports Leakages and Injections from the Circular Flow of Income • Given the following exchange market relationship: • Since net capital inflow is (capital inflow - capital outflow) the equation may be re-written as: • Equilibrium in the loanable funds market implies: • Substituting for net capital inflow from above:

5. - + = + Budget Deficit Exports Imports Investment Net Saving GovernmentPurchases - - = + + Taxes Exports Imports Investment Net Saving GovernmentPurchases + = + + + Investment Taxes Imports Exports Net Saving Leakages Injections Leakages and Injections from the Circular Flow of Income • Budget deficit = (government purchases - taxes): Which may be re-written as: Therefore, when the loanable funds and foreign exchange markets are in equilibrium, leakages from the circular flow of income (savings + taxes + imports) are equal to injections into it (investment + government purchases + exports).

6. General Consumption Taxes Could be Direct or Indirect A Direct Consumption Tax would reflect Individual Incomes less Savings Indirect Consumption Taxes apply to Transactions at a given level of Economic Activity. The two most common types are: • Value-Added Tax or VAT • Retail Sales Taxes

7. VALUE-ADDED TAXES Apply to the increment in Value contributed by firms and individuals at each stage in the process of Production and Distribution. Are equal to the difference between an entity’s sales or gross receipts and its purchases of inputs from other entities. That is: rent to land, wages and salaries to employees, earnings before interest, depreciation, and taxes.

8. Two Kinds of VAT • The Subtraction Method: entities subtract purchases from gross receipts and pay tax on the remainder. • The Credit-invoice method: entities receive refund from government for taxes paid on earlier transactions in the product flow.

9. Both Kinds of VAT • Discourage Tax Evasion by encouraging entities to demand receipts for purchases in order to reduce their tax obligations -- VATS do not administer themselves, but they encourage a trail of invoices • Insure that some revenue will be collected even if some entities cheat • Discourage exclusion of specific consumption categories from the Tax base (the subtraction method actually requires the state to refund the VAT to the buyer) and prevent taxation of business purchases, thereby avoiding cascade effects

10. Imposes less of an accounting and reporting burden on entities Discourages removal of consumption items from tax base Makes it easier for government to exclude specific items or sales to specified individuals (exports, say) from tax base Required for membership in EC Subtraction vs. Credit-Invoice System

11. GENERAL PURPOSE SALES TAXES Retail Sales Taxes would be same as VATs, except they are: • Easier to evade • More likely to include some (or a lot of) business purchases, although they all have some method for suspending taxes on items purchased for resale • More likely to be added on after purchase • More likely to exclude a variety of goods and most services from tax base

12. Example • Consider the manufacture and sale of any item, which in this case we will call a widget .

13. Without any sales tax • A widget manufacturer spends $1 on raw materials and uses them to make a widget. • The widget is sold wholesale to a widget retailer for $2.20, making a profit of $0.20 for the manufacturer. • The widget retailer then sells the widget to a widget consumer for $3.00, making a profit of $0.30

14. With a U.S.-style sales tax With a 10% sales tax: • The manufacturer pays $1.00 for the raw materials, certifying it is not a final consumer. • The manufacturer charges the retailer $2.20, checking that the retailer is not a consumer, leaving the same profit of $0.20.

15. With a U.S.-style sales tax With a 10% sales tax: • The retailer charges the consumer $3.30 ($3.00 + 10%) and pays the government $0.30, leaving the same profit of $0.30. So the consumer has paid 10% ($0.30) extra, compared to the no taxation scheme, and the government has collected this amount in taxation.

16. With a VAT With a 10% VAT: • The manufacturer pays $1.10 ($1 + 10%) for the raw materials, and the seller of the raw materials pays the government $0.10. • The manufacturer charges the retailer $2.42 ($1.10 + [$1.20 + 10%]) and pays the government $0.12 ($0.22 minus $0.10), leaving the same profit of $0.20.

17. With a VAT With a 10% VAT: • The retailer charges the consumer $3.30 ($2.42 + [$.80 + 10%]) and pays the government $0.08 ($0.30 minus $0.22), leaving the same profit of $0.30. So the consumer has paid 10% ($0.30) extra, compared to the no taxation scheme, and the government has collected this amount in taxation, the same as under the comprehensive retail sales tax.

18. AS A PRACTICAL MATTER: BROAD-BASED or GENERAL CONSUMPTION TAXES • Can Provide a lot of Revenue • Provide a means of extracting Payment from Individuals with high capacity to pay taxes, but low current income, including those successfully evading the Income Tax • Help to diversify/broaden the Tax Base • Tax what people take from the economy, not what they contribute to it, and they encourage saving

19. SELECTIVE EXCISES • Luxury Excises • Sumptuary Excises: Tobacco, Booze, Prostitution, Gambling, Narcotics, etc. • Inelastic demand • Regressive, also violate horizontal equity • Especially regressive where a specific (rather than ad valorem) per unit excise is charged (although easier/cheaper for state to enforce) • Cost-Base Excises: Regulatory and Environmental taxes • Benefit-Base Excises: e.g., Auto fuel taxes

20. Sumptuary Excises

23. Income/Substitution Effect: BBT