5 Tax Flashcards
Lump-sum tax
A tax that is the same amount for every individual, regardless of income or wealth. Lump-sum taxes are efficient because they do not distort behaviour but are inequitable as they disproportionately affect low-income individuals.
Distortionary taxes
Change economic behaviour by altering incentives
Direct vs. indirect taxes
Direct taxes are levied directly on individuals or organizations, such as income or corporate taxes. Indirect taxes are applied to goods and services, such as sales or value-added taxes (VAT).
Economic incidence
Who ultimately bears the buden of the tax, depending on price elasticities of supply and demand. Eg. cigarettes addictive and inelastic hence consumers bear burden. Vs luxury car purchase can be foregone
Average vs marginal tax rate
average tax rate is the total taxes paid as a percentage of total income. The marginal tax rate is applied to the last dollar of income earned, influencing labor and investment decisions
Inequality
uneven distribution of income, wealth, or opportunities among individuals or groups within a society
Gini coefficient
Measure of inequality, ranging from 0 (perfect equality) to 1 (maximum inequality). It is calculated by comparing the cumulative distribution of income or wealth to perfect equality (represented by the Lorenz curve)
Measures of inequality
- Lorenz Curve
- Gini coefficient
- 90:10 ratio
- Share of income of top 1% of earners
Vertical equity
principle that individuals with higher incomes should pay more in taxes, ensuring fairness in tax systems
Social Welfare Function
tool to evaluate social outcomes, balancing equity and efficiency by aggregating individual utilities. A utilitarian SWF focuses on maximizing total welfare, while other SWFs may prioritize reducing inequality
Ramsey Rule
Minimizes the deadweight loss of a commodity tax system while raising a fixed amount of revenue
Rule: To minimize distortions, goods with inelastic demand or supply should be taxed more heavily than those with elastic demand or supply
The optimal tax causes every good to have the same proportional reduction in compensated demand
- broad tax base rule (meaning it’s better to tax a wide variety of goods at a moderate rate than a few at a high rate)
- an inverse elasticity rule: when elasticity of demand for a good is high it should be taxed at a low rate (and vice versa)
Limitations to Ramsey rule
- Customers care about their own individual welfare not social welfare
- Those with less elastic demand may need the good more
- Regulators may limit the ability to adopt Ramsey prices
Optimal income taxation
A framework for designing tax schedules that balance equity (redistribution) with efficiency (minimizing economic distortions)
Progressive taxation
Higher-income individuals pay a larger percentage of their income, reducing inequality
Lump Sum
A single tax rate applied to all incomes. Are very efficient (it is very complicated for you to change your behaviour to evade it)
But simple, flat taxes are less equitable. Example: The UK Poll Tax (Community Charge) required all adults to pay the same fixed amount, regardless of income
Proportional tax
Taxes with a constant rate across all levels, applied not just to income but also to consumption or property - eg. VAT which is regressive because lower-income households spend more of their income on taxed goods
Proportional when average tax rates do not rise with income
Ways to modify proportional tax
To solve inequity
1. establish a minimum income threshold under which no taxes are paid
2. keep some tax credits, such as the Child Tax Credit
3. allow a small number of deductions, such as those for donations to charity or home mortgage interest
Regressive taxation
Taxes where lower-income individuals pay a higher proportion of their income
Deadweight loss in tax
The reduction in social efficiency from preventing trade where benefits exceed costs
When a tax is imposed, the supply curve shifts upward by the tax amount, creating a price wedge between what consumers pay and what producers receive. This reduces the quantity traded and results in a deadweight loss (DWL), represented by the shaded area in the graph. DWL occurs because some transactions that would have benefited both buyers and sellers no longer occur due to the tax.
the more elastic, the higher the deadweight loss
marginal deadweight loss rises with the tax rate (because transactions made close to the equilibrium are not the ones that generate a lot of social surplus)
Elasticity of demand/supply
A measure of responsiveness to price changes
Efficiency vs equity
Vertical equity (equity) vs behavioural responses to taxes (efficiency)
Progressive tax promotes equity but may reduce work or investment incentives, creating deadweight loss. Balancing requires analyzing economic incidence, elasticities, and societal preferences for redistribution
Flat tax pros and cons
Pros:
1. Administratively simple
2. Avoids high marginal rates that discourage productivity
3. Attract investment and reduce avoidance
Cons:
1. Inequitable and imposes heavier relative burden on low-income
2. Fail to redistribute wealth
Five most common types of taxes (Gruber)
- Taxes on Earnings
- Taxes on Individual Income (wider set of sources than in 1, includes benefits, pensions)
3 Taxes on Corporate Income
4 Taxes on Wealth (includes property taxes and estate taxes)
5 Taxes on Consumption (sales taxes, incl. VAT and excise taxes)
The first four are often called direct taxes and the last indirect taxes.
Tax on market activities with negative externalities
Pigouvian tax - to correct for market inefficiencies by aligning the private costs of a good or service with the social costs. Eg. tax on carbon is intended to solve an externality problem by changing firm behaviour. In this case changing behaviour is intended and good-distortionary
Piketty quote
A ‘racing away’ of top incomes
VAT
OECD countries have relied increasingly on consumption taxes - higher proportion of total tax
Mankiw, Weinzierl and Yagan (Mankiw et al)
- Only final goods ought to be taxed (keeps distortions away from intermediate inputs for production efficiency) - and avoids cascading effect
- Typically, final goods ought to be taxed uniformly (follows from some technical assumptions and an income tax system)
Equity-efficiency trade-off
equalising slices of the economic pie may shrink the overall size of the economic pie
Mirrlees
Balance:
- Vertical equity: individuals with a high level of consumption (the ‘rich’) should be taxed more heavily, and individuals with a low level (the ‘poor’) should be taxed less heavily.
- Behavioural responses: as taxes rise on any one group, individuals in that group may respond by earning and/or declaring less income (Laffer curve!)
Why do economists disagree?
- Number of potential high income earners, and how responsive they are to tax (labour supply elasticity) → importance of behavioural response.
- Choice of social welfare function → importance of vertical equity
