Taxes and Subsidies

Question 1

Canons of Taxation (the criteria for a good / effective tax system)

Answer 1

1) Equitable: the amount of tax paid should be based on the ability to pay, with the rich paying more tax than the poor.
2) Economic: the revenue from the tax should be greater than the cost of collection.
3) Certainty (transparency): the taxpayer should have full knowledge of the tax (i.e. how much to pay, when to pay, how to pay and why the tax is needed).
4) Convienient: Convenient: the tax should be easy to pay.

Question 2

Direct Taxes

Answer 2

tax imposed on the income of individuals (e.g. income tax) and firms (e.g. corporation tax/profit tax).

Question 3

Progressive Tax

Answer 3

A direct tax. Taxation takes a higher proportion of a person’s income as income rises.

Question 4

Regressive Tax

Answer 4

A direct tax. Taxation takes a higher proportion of a person’s income as income falls.

Question 5

Proportional Tax

Answer 5

A direct tax. Taxation takes the same proportion of a person’s income as income rises or falls.

Question 6

Average rates of taxation (direct tax)

Answer 6

the average percentage of total income that is paid in tax.

Question 7

Marginal rates of taxation (direct tax)

Answer 7

the additional tax rate paid as additional income is earned.

Question 8

Direct Tax advantages

Answer 8

1) Progressive system is usually used.

2) Tax revenue to the government (key source).

Question 9

Direct Tax disadvantages

Answer 9

1) Disincentive effects if tax rate is too high (high earning workers might move to different countries, unemployed people may not want to work).
2) Encourages tax avoidance and tax evasion.

Question 10

Direct Tax evaluation

Answer 10

An effective income tax system is one where:
It is difficult to avoid paying.
- Tax is paid “at source” (before your income goes into your bank account)
- The rates are not too high (or else people might try to avoid or evade tax)
- Where taxpayers generally feel like they get value for their tax (e.g. good quality public services).

Question 11

Indirect Tax

Answer 11

tax imposed on spending e.g. VAT (on most goods and services) and excise tax (on demerit goods like alcohol and cigarettes).

Question 12

Types of Indirect Tax

Answer 12

Specific Tax and Ad Valorem Tax

Question 13

Specific Tax

Answer 13

a fixed amount of tax added to the price of a product e.g. $1 tax is added to the price.

Question 14

Ad Valorem Tax

Answer 14

a percentage tax added to the price of a product e.g. VAT rate of 7%

Question 15

Advantages of Indirect Tax

Answer 15

1) Less consumption of demerit goods.
2) Tax revenue to the government (key source).
3) Market based measure (uses supply and demand).

Question 16

Disadvantages of Indirect Tax

Answer 16

1) Regressive.
2) Inflationary (higher prices).
3) Difficult to calculate correct size of tax that is needed.
4) Consumer surplus falls.
5) Producer surplus falls.
6) Deadweight welfare loss (economic inefficiency) occurs.
7) Encourages black markets.
8) Encourages tax avoidance and tax evasion.

Question 17

Indirect Tax Evaluation

Answer 17

• Agrees with most or all of the canons of taxation.
• Minimise tax avoidance and tax evasion.
• Minimises any negative impact on economic efficiency.
• Does not cause disincentive effects to occur.
• Is progressive.
• The tax revenue is spent appropriately (i.e. a hypothecated tax is where the tax revenue is used for a specific reason).
• A consideration of the overall winners and losers.
• The impact of PED and PES is taken into account to determine the incidence of tax (the amount of the tax that is paid by the consumer or producer).

Question 18

Subsidy

Answer 18

payments of money from the government to producers to lower costs of production and prices.

Question 19

Impact of elastic PED on subsidies

Answer 19

• PED is relatively elastic compared to PES

- causes large change in quantity from a relatively small price change.

Question 20

Impact of inelastic PED on subsidies

Answer 20

• PED is relatively inelastic compared to PES

- causes small change in quantity from a relatively large price change.

Question 21

Advantages of Subsidies

Answer 21

• More consumption of merit goods.

- Market based measure (uses supply and demand).

Question 22

Disadvantages of Subsidies

Answer 22

• Expensive for the government.
• Opportunity costs.
• Difficult to calculate the correct size of subsidy that is needed.
• Some producers will receive the subsidy when they do not need it.
• Producers might become reliant on the subsidy, which encourages inefficiency.
• Deadweight welfare loss (economic inefficiency) occurs.

Question 23

Subsidy Evaluation

Answer 23

• Need to compare the overall costs and benefits of the subsidy.
• Need to consider the opportunity cost of the subsidy.
• Government’s information problem regarding which firms need the subsidy and which firms do not.
• How the is subsidy funded: tax increases or diverted spending or borrowing?
• The impact of PED and PES is taken into account to determine the incidence of subsidy (the amount of the subsidy benefiting the consumer or producer).