Chapter 13 The Theory of Income Taxation

Transcription

1 Chapter 13 The Theory of Income Taxation Comprehensive Income: The Haig-Simon Definition Income Tax = tax on personal s income. It represent the dominant source of revenue for the government. Comprehensive income = the sum of a person s annual consumption expenditures and the increment in that person s net worth in a given year: I = C + NW It is also called the Haig-Simons definition of income Net worth = the value of a person s assets held at any point in time less the value of a person s liabilities, or debts. at any point in time, NW can be either positive or negative. Capital gains = increases in the value of assets over the accounting period. The sources and uses of income are as follow: 1) Sources = Earnings + Transfers + Net Capital Gains Cost of Acquiring Income Net capital gains are capital gains minus capital losses 2) Uses = Consumption + Gifts and Donations + Savings Cost of Acquiring Income In Equilibrium, Sources = Uses Chapter 13 The Theory of Income Taxation Page 1

2 Income-in-Kind Income in the form of goods and services rather than cash Payments E.g. Home production of goods and services Occupations allowing workers flexible hours and freedom from pressures Serious problem involved in administering income tax is treatment of nonmonetary transactions. Taxation of all types of income-in-kind is infeasible. Some easy to tax, such as fringe benefits provided by employers (medical and life insurance, vehicles, etc.) Economic Effect of A Flat-Rate Income Tax Reformers suggest that Canadian tax system would be more efficient with a flat-rate income tax because: 1) it will not distort choices in the income-producing activities in which individuals engage (all income regardless of the source is taxed by the same rate) 2) it will not distort the pattern of consumption of taxpayers in ways that prevent attainment of efficiency. (it does not change the relative price of consumption goods and services) The tax, however, is likely to distort choices made concerning allocation between work and leisure and between consumption Chapter 13 The Theory of Income Taxation Page 2

3 and saving or productive investment. Impact of a Flat-Rate Tax on the Work-Leisure Choice Case 1: I L Where: L: leisure consumption = 24 in a day I: income; I N : net income & I G : gross income W: wage rate; W N : net wage & W G : gross wage T: tax At E: w: slope of the BL = MRS LI : slope of IC I = w (24 L) At E : W N = W G (1 t) I = W G (1 t) (24 L) W G (1- t): slope of BL = MRS LI : slope if IC T: T = I G I N = E A Chapter 13 The Theory of Income Taxation Page 3

4 Impact of tax on work effort depends on income and substitution effects of tax-induced reduction in wages. Tax lowers implicit price of leisure by reducing the return from work effort. IE: it reduces worker s earned income; leisure is a normal good, thus worker will decrease leisure consumption. SE: it reduce the relative price of leisure, therefore tends to increase consumption of leisure. TE: net effect on work-leisure choices depends on which effect is stronger. In this diagram: SE > IE. Case 2: I L Chapter 13 The Theory of Income Taxation Page 4

5 At E: w: slope of the BL = MRS LI : slope of IC I = w (24 L) At E : W N = W G (1 t ) I = W G (1 t) (24 L) W G (1- t): slope of BL = MRS LI : slope if IC T: T = I G I N = E B TE: net effect on work-leisure choices depends on which effect is stronger. In this diagram: SE < IE. Labour Market Analysis of Income Taxation Tax-induced distortion in work-leisure choice used to measure excess burden of tax must be based only on change in work hours due to substitution effect caused by tax. Labor supply response must be adjusted to remove income effect of tax-induced wage change. Compensated Labour Supply curve: Curve showing how hours worked per day vary with wages when income effect of wage changes is removed. Chapter 13 The Theory of Income Taxation Page 5

6 Case 1: Perfectly Inelastic Labour Supply Income tax on labor reduces wages by full amount of tax per hour when supply of labor is perfectly inelastic: Excess burden of the income tax is not zero because substitution effect of tax reduces labor hours supplied per year. Excess burden of the income tax = Chapter 13 The Theory of Income Taxation Page 6

7 Case 2: The Elasticity of Labour Supply Exceeding Zero Take the IE into consideration: With tax, wage received by employees reduces from W to W N ; Wage paid by employers increased from W to W G and worked hour reduces from Q 1 to Q 2. Excess burden of the income tax = Take out IE: With tax, holding the wage received by employees and wage paid by employers the same as above, worked hour reduces from Q 1 to Q 3. Excess burden of the income tax = Chapter 13 The Theory of Income Taxation Page 7

8 When the supply of labour is not perfectly inelastic, workers can shift the tax to other groups. In addition, the excess burden of the tax will be greater than when the supply of labour is perfectly inelastic. Empirical Evidence on Labor Supply For males between ages of 25 and 55, income effect of wage changes roughly equal to substitution effect. May be that substitution effect of wage reductions caused by income tax is large, but offset by equally large income effect very little effect on labour supply. Example: Payroll Tax The total tax deducted from workers labour earning = The portion of the tax collected from employers = Chapter 13 The Theory of Income Taxation Page 8

9 If the supply of labour is perfectly inelastic, a payroll tax collected from both employers and employees would be fully borned by workers as the wage falls by the full amount of the tax per labour hour. This result is independent of how the nominal collection of the payroll tax is split between employers and employees. Studies conclude that income taxes have little effect on labor supply decisions of workers who provide main source of income to household but have much greater effect on labor supply of other household members. Taxation of Interest Income and Its Effect On Saving Taxation of interest income lowers return to saving but can either increase or decrease actual amount of saving observed. again, it depends on the magnitude of IE and SE. Indifference curve analysis can be used to analyze one s choice between consumption and saving. Marginal rate of time preference (MRTP) is the slope of an indifference curve for present and future consumption multiplied by 1. MRTP measures the willingness of saver to forgo current consumption in exchange for future consumption. E.g. MRTP = 10 means a saver is willing to give up 10 units of future consumption goods for 1 unit of current consumption good. (impatient) Chapter 13 The Theory of Income Taxation Page 9

10 Income Taxation and Intertemporal Choice Without tax: With tax: In this case, SE > IE, current consumption increases and saving decreases. Chapter 13 The Theory of Income Taxation Page 10

11 Market Analysis of Taxation on Interest and Investment Income Excess burden: An income tax reduces annual saving and investment when the supply of saving is responsive to changes in net interest. If IE of tax-induced interest charges is negligible, the area ABC can be used to approximate the excess burden of the tax. Incidence of tax on interest income If annual amount of saving is responsive to tax-induced declines in net interest payments, tax can be shifted from savers to borrowers through increase in market rate of interest - Higher interest offsets some tax burden on savers, but increases production costs, resulting in tax being shifted to consumers in form of higher prices Chapter 13 The Theory of Income Taxation Page 11

12 Decreased investment results in slower growth of nation s capital stock Lower ratio of capital to labor decreases labor productivity, implying that, in competitive labor markets, wages would be lower than if there were no tax on interest income Chapter 13 The Theory of Income Taxation Page 12