Tax Incidence and the Efficiency Cost of

Taxation
Chapter 7-8

1. The Role of Taxation

One potential classification of government functions from
an economic perspective would be
Efficiency
To reduce distortions in competition.
To alleviate the problems of incomplete markets

1. The Role of Taxation

One potential classification of government functions from
an economic perspective would be
Efficiency
To reduce distortions in competition.
To alleviate the problems of incomplete markets
Equity
To provide merit goods
To alleviate poverty.

1. The Role of Taxation

One potential classification of government functions from
an economic perspective would be
Efficiency
To reduce distortions in competition.
To alleviate the problems of incomplete markets
Equity
To provide public goods
To alleviate poverty.
Stabilization (Macroeconomic Management)
Macroeconomic stabilization

Taxation has a role in each of these

1. Efficiency
Controls externalities.
Raises revenue for the provision of public goods.
2. Equity
Can redistribute income
Can generate revenues that provide other forms of
poverty alleviation.
3. Stabilization
A key instrument in controlling aggregate demand
And the balance of trade

Principles of Taxation
Tax base is a measure or value upon which a tax is levied.
Three categories of tax bases:
- income
- consumption
- wealth
Types of Tax Rate Structure:
- Regressive
- Progressive
- Proportional

Approaches to Tax Equity

Tax system should be equitable, i.e. that each taxpayer
should contribute his or her fair share to the cost of the
government.
Benefit principle: each taxpayer contributes in line with the
benefits which he or she receives from public services.
Ability-to-pay: each taxpayer is asked to contribute in line
with his or her ability to pay.

What are the criteria for a good tax system?

1. Fairness
Horizontal Equity
Vertical Equity

What are the criteria for a good tax system?

1. Fairness
Horizontal Equity
Vertical Equity
2. Efficiency
Minimize the excess burden
Poll tax
Fiscal neutrality
The correction of externalities

What are the criteria for a good tax system?

1. Fairness
Horizontal Equity
Vertical Equity
2. Efficiency
Minimize the excess burden
Poll tax
Fiscal neutrality
The correction of externalities
3. Compliance and Administration Costs
Compliance Costs = time, money inconvenience
Administration costs

Indirect Tax

2. Economic Analysis of Taxation

 Price Distorting Tax

- alters the relative price of the goods
- causes the net price received by sellers to diverge from
the gross price paid by buyers.
Excess burden of tax
The loss of well-being of the taxpayer when he pays
taxes under the price-distorting tax instead of under
the lump-sum tax.

Price-Distorting Tax vs a Lump Sum Tax

3. Tax Incidence

Statutory vs Economic Incidence (Tax Burden)

Statutory tax burden is the amount of tax collected from a
person.
Economic tax burden is the amount of tax paid by a person.
Example:
- With no taxes, the price of petrol is RM3 per litre.
- The govt. imposes a 50 sen per litre tax.
- The tax is collected from the seller.
- In response to the tax, the seller raises the price to RM3.50
Who bears the statutory and economic burden of the tax?
Statutory burden is on the seller, but economic burden is
on the consumer.

Statutory vs Economic Incidence (Tax Burden)

Example:
- With no taxes, the price of petrol is RM3 per litre.
- The govt. imposes a 50 sen per litre tax.
- The tax is collected from the seller.
- In response to the tax, the seller does not change the
price of petrol.
Who bears the statutory and economic burden of the tax?
Both statutory and econ. burden is on the seller.

The Effect of a Sales Tax on a Market

Some Obvious Consequences

1.
2.
3.
4.

Consumers are paying more for each unit. (bad)

Government is earning taxes. (might be good)
Consumers are buying fewer units. (bad)
Firms are making fewer units. (Neutral here as perfect
competition implies they make zero profit)

How do these costs and benefits add up?

This gain and loss exactly cancel

The tax revenue
=
The extra paid by the consumers who still buy the
taxed commodity.
This is just a redistribution of income not an inefficiency.
Summary:
One effect of taxes is to transfer resources to the
government.
This reduces taxpayers disposable incomes.

The Substitution Effect

The price of this commodity has risen relative to other
commodities.
This affects the incentives of the private sector.
It distorts markets.

The Substitution Effect

The price of this commodity has risen relative to other
commodities.
This affects the incentives of the private sector.
It distorts markets.
It generates rents
A tax on tobacco makes growing it less attractive,
therefore land prices fall.
Tobacco machinery manufacturers lose as do tobacco
workers.
(Any input into a taxed commodity suffers.)

The Excess Burden

This inefficiency is called
An Excess Burden
A Deadweight Loss

The Excess Burden

This inefficiency is called
An Excess Burden
A Deadweight Loss
A poll tax (or any non-price related tax) will not have these
costs.

The Excess Burden

Marginal Excess Burden := The excess burden of an extra
RM raised in taxes.
(This is generally higher than the average burden, as should
tax least distorting commodities first.)

The Excess Burden

Marginal Excess Burden := The excess burden of an extra
RM raised in taxes.
(This is generally higher than the average burden, as should
tax least distorting commodities first.)
A good tax system should impose taxes with least excess
burden first.

The Excess Burden

Marginal Excess Burden := The excess burden of an extra
RM raised in taxes.
(This is generally higher than the average burden, as should
tax least distorting commodities first.)
A good tax system should impose taxes with least excess
burden first.
Then move on to those taxes with higher excess burden.

The Excess Burden

Marginal Excess Burden := The excess burden of an extra
raised in taxes.
(This is generally higher than the average burden, as should
tax least distorting commodities first.)
A good tax system should impose taxes with least excess
burden first.
Then move on to those taxes with higher excess burden.
Optimally, the marginal excess burden of each tax
instrument should be the same.

Tax Incidence

Tax Incidence

Shifting of Taxes
Forward Shifting is the transfer of the burden of a tax
from the seller, who is legally obligated to pay it, to a
buyer.
Backward Shifting is the transfer of the burden of a tax
from the buyer, who is legally obligated to pay it, to a
seller.

General Equilibrium Analysis and

Shifting
When one good is taxed and another good is not
taxed, the impact of the tax is not confined to the
taxed good.
Because a tax on one good lowers the profit that can
be made to firms producing it, they may shift their
productive resources to the other good so as to
maximize their after-tax rate-of-return in both markets.
This has the effect of equalizing the after-tax rate-ofreturn.

Multimarket Analysis of Excess Burden

Multi-market Analysis Incidence

Questions:
Who pays the taxes on
(1)
(2)
(3)
(4)

Cigarettes
Alcohol
Petrol
Labour?

4. Taxation and Equity

IF policy maker care about equity they will care about the
winners and losers associated with tax changes.
Recall
A tax is progressive if payment as a % of income increases as
income rises.
A tax is regressive if payment as a % of income decreases as
income rises.
A tax is neutral if payment as a % of income constant as
income rises.

Government Taxes and Expenditures

and the Distribution of Income
The Tax Incidence is who bears the burden of a tax.
The Expenditure Incidence is who receives the benefits
of a government program.
The Budget Incidence is the net analysis of a programs
tax and expenditure incidence.
The Differential Tax Incidence is the change in the tax
incidence that results from substituting one equal yield
tax for another.

The Lorenz Curve

The Lorenz Curve maps the cumulative percentage of

households against their cumulative percentage of
income.

LORENZ CURVE

The Gini Coefficient

The Gini Coefficient is the ratio of the area between the
Lorenz curve and the perfect equality line (Area A in the
previous slide) to the area under the perfect equality line
(Areas A and B).