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					PRINCIPLES OF TAXATION
Purposes and Consequences of
    Government Finance
• The method of financing government expenditures
  affect a number of important economic variables.
• The political equilibrium: the distribution of tax
  shares impacts voting choices.
• The overall market equilibrium and the efficiency
  with which resources are employed in private uses:
  government financing methods can distort prices
  and reduce market efficiency.
• The distribution of income: the method of financing
  government expenditures can impact the
  distribution of income.
What Are Taxes?
• Taxes are compulsory payments associated
  with certain activities. The revenues collected
  through taxation are used to purchase the
  inputs necessary to produce government
  supplied goods and services or to redistribute
  purchasing power among citizens.
• Essentially taxation reallocates resources
  from private to government use.
What is the Tax Base?
• The tax base is the item or economic activity
  in on which the taxes levied. The most
  commonly used tax bases can be grouped
  into three broad categories: income,
  consumption, and wealth.
• A person’s income is the sum of the value of
  his/her annual consumption of goods and
  services and annual savings. Income is often
  regarded as a good index of the ability to pay
  taxes.
• A person’s annual consumption is his/her
  annual income less the amount of that income
  saved that year.
• Wealth represents the value of a person’s
  accumulated savings and investment at any
  point time.
• The three major tax bases are related.
  Consumption is the portion of income that is
  not save, while wealth is the net value of a
  person’s stock of accumulated savings or
  investments.
• Because income is believed to be a good
  index of the ability to pay taxes, many
  economists use this broad economic base as a
  benchmark for evaluating the fairness of
  taxes. The amount of taxes paid is generally
  computed as a percentage of annual income.
  The way a particular tax varies as a
  percentage of income per year is often used to
  make judgments about the fairness of the
  distribution of taxes among taxpayers.
• Taxes on economic basis can be general or
  selected.
• A general tax is one that taxes all of the
  components of the economic base with no
  exclusion, exemptions or deductions or
  deductions from the tax base. For example, a
  general wealth tax would tax all forms of
  holding wealth.
• A selective tax is one that taxes only certain
  portions of the tax base, or it might allow
  exemptions and deductions from the general
  tax base. For example, an excise tax is a tax
  on the manufacture or sale of a particular good
  or service.
Tax Rate Structure
• The tax rate structure describes the
  relationship the between the tax collected
  during a given accounting period and tax
  base.
• The average tax rate(ATR) is simply the total
  dollar amount taxes collected divided by the
  dollar value of taxable base.
• The marginal tax rate (MTR) is the
  additional tax collected on an additional
  dollar value of the tax base as the tax
  base increases.
• A proportional tax rate structure is one from
  which the average tax rate expressed as a
  percentage of the value of the tax base, does
  not vary with the value of the tax base. For
  example, an income tax of 20% would tax all
  income at 20%. A tax with a proportional rate
  structure is sometimes referred to as a flat tax.
• For proportional tax rate structure, both the
  average and marginal rates of taxation are the
  same.
Tax Rate




                 MTR = ATR




           Tax Base
• A progressive tax rate structure is one for
  which the average tax rate increases with the
  size of the base. The larger the tax base, the
  larger the average tax rate applied. The tax
  bracket gives the increment of annual income
  associated with each marginal tax rate.
• For progressive taxation, the marginal rate
  eventually exceeds the average rate of
  taxation as the marginal tax rate increases.
                  Progressive Rate Structure

Tax Rate




                                               MTR

                                               ATR




           4000   29000       70000
                                                     Tax Base
• A regressive rate structure is one where the average tax rate
  declines as the size of the tax base increases. In a regressive
  rate structure the marginal rate is less than the average rate. A
  regressive income tax results in a lower annual average tax
  rate as income rises. An example of a tax with a regressive
  rate structure is the payroll tax used to finance Social security
  pensions and Medicare – 15.3 % to the maximum earnings
  and 2.9 % thereafter.
        Regressive Rate Structure
15.3%




11.0%


                                    ATR

 2.9%                               MTR


        72, 200   100,000
How Should the Burden of Government
      Finance be Distributed?
Tax Incidence: Some Definitions
• Statutory incidence of a tax indicates who is
  legally liable for a tax.
• Economic incidence of a tax is the change in the
  distribution of private real income brought about
  by the tax.
• Tax shifting represents the extent to which the
  statutory and economic incidence differ.
• Forward Shifting is a transfer of the tax burden
  from the sellers who are liable for the tax to the
  buyers as a result of an increase in the price of the
  taxed good.
• Backward Shifting of a tax is a transfer of its
  burden from the buyers who are liable for its
  payment to sellers through a decrease in the
  market price of the taxed good.
                Some Observations

• Tax incidence is concerned with determining who
  bears the real burden of taxation.
• The incidence of a tax refers to its effect on the
  distribution of income.
• In analyzing the incidence of a tax we may want
  to consider the disposition of the tax revenues as
  well as the source of the expenditures.
Balanced-Budget Incidence
Balanced budget incidence refers to the distribution
  effects of a tax combined with the expenditures it
  finances.
• That is, how the opportunity cost of a given
  spending policy is distributed among the public by
  the tax.
• Balanced budget incidence tells us how the cost of
  spending programs are divided among the
  population. However, it has the defect of making
  the incidence of a tax depend on how the revenue
  is spent.
• In addition, it is usually impossible to say that a
  particular tax finances a particular spending
  program when the government has so many
  different taxes.
• That is, there are few truly earmarked taxes.
Differential Incidence
° Differential tax incidence assumes government
  expenditure are held constant and then compares
  the distributional effects of substituting one tax for
  another.
° Differential incidence avoids the necessity of
  considering the effects of the expenditure program
  -- expenditures remain unchanged.
• However, the differential incidence is not entirely
  unambiguous because the differential incidence
  of a tax depends on what other tax it is compared
  to.
• The typical case is to compare the tax to a lump-
  sum tax which in a sense is the least disruptive of
  individual decisions.
Significance of Tax Incidence
•Tax incidence is important because knowing where
 the burden of a tax actually falls allows us to evaluate
 its “fairness” or at least to discuss it intelligently
What is fairness in this context?
Benefits Received Principle
• The benefits principle argues that the means of
  financing government- supplied goods and
  services should be linked to the benefits that
  citizens receive from the government.
• Under this approach fees and charges are ideal
  forms of government financing.
• If successfully implement the benefits approach
  links the cost per unit of government-provided
  services with the marginal benefits of those
  services.
• The benefits received principle holds that
  people should be taxed according to the
  marginal benefits they receive from government
  spending -- Pigou/Dalton approach -- Based
  on market principles.
• Voluntary Exchange: applies market criteria to
  the public sector, but is essentially applicable
  only where the “exclusion principle” applies to
  economic goods.
Ability- To - Pay
• The ability-to-pay principle maintains that
  taxes should be distributed according to the
  capacity of taxpayers to pay them.
• Citizens with greater ability to earn income,
  for example, should be taxed more heavily
  than those with less capacity to earn.
• Using this approach, the problem of
  distributing tax shares is viewed as being
  independent of the individual marginal
  benefits received from the government
  activities.
• The implementation of the tax system based
  on the ability to pay approach requires some
  collective agreement concerning an equitable
  distribution of the taxes among citizens.
• Individual evaluations of the ability to pay are
  likely to differ among citizens whose
  preferences differ.
• In the United States, the general consensus
  holds that ability to pay varies with income.
• The ability-to-pay principle holds that taxes should
  be levied in accordance with the taxpayer’s ability
  to pay. It suggests that those who have an equal
  ability to pay should bear the same tax burden and
  those who have greater ability should bear a
  heavier tax burden.
Approaches to Determining
     Ability to Pay
• Absolute Equity determines equity by equal
  monetary contributions.
• Equal sacrifice implies that all taxpayers
  should bear the same tax burden in terms of
  the disutility of the tax. The sacrifice
  imposed on a low income individual would
  be the same as that imposed on a high
  income individual in terms of utility
  forgone.
• Proportional sacrifice proposes that the
  sacrifice incurred by individuals in the payment
  of taxes should be proportional to their incomes.
• A higher income person should bear a greater
  sacrifice (disutility) than a lower income
  individual in paying taxes.
• Minimum aggregate sacrifice suggests that
  government revenues should be collected first
  from the highest income individuals and then
  from successively lower income groups as
  additional revenues are needed.
              Ability to Pay Principle

Approach                    Characteristics and Limitations
Absolute equity             Generally viewed as too extreme.

Equal sacrifice              Provides no tax recommendations or
                             indicator of taxpaying ability.

Proportional sacrifice      Suggests progressive taxation and
                            income as the indicator of taxpaying
                            ability
Minimum aggregate sacrifice Suggests extreme tax progression and
                            income as an indicator of taxpaying
                            ability, but is generally considered
                            too extreme.
             Other Definitions
• Horizontal equity means “equals should be
  treated equally”. Individuals with the same
  amount of “tax paying ability” should bear equal
  tax burdens.
• Vertical equity means that “unequals should be
  treated unequally”. Persons with different tax
  paying circumstances or abilities should pay
  different amounts of tax.
Measures of Tax Progressiveness
• Average tax rate is the ratio of taxes paid to
  income.
• Marginal tax rate is the ratio of the change in
  taxes paid to change in income.
• Proportional tax is a tax in which the ratio of
  taxes paid to income is constant regardless of the
  level of income; the average rate is constant
• Progressive tax is a tax whose average rate
  increases with income.
• Regressive tax is a tax whose average rate
  decreases with income.
AVERAGE RATE VS MARGINAL
RATE AND PROGRESSIVENESS
               Tax         Average     Marginal
     Income    Liability   Tax Rate    Tax Rate
      2000     - 200       -0.10        0.20
      3000         0           0        0.20
      5000       400        0.08        0.20
     10000     1400         0.14        0.20
     30000     5400         0.18        0.20

Structure of Tax: Subtract $3000 from income and
                  pay 20% of the remainder as a tax.
Two Measures of Tax
  Progressiveness
 The greater the increase in average tax rates as
 income increases, the more progressive the
 system.

                 T1 T 0
                    
            v1  I1 I 0
                 I1  I 0
T0 and T1 are actual tax liabilities at the given
income levels.

I0 and I1 are the given income levels where I1 > I0

The tax system with the highest value of v1 is said to
be more progressive.
 One tax system can be said to be more
progressive than another if its elasticity of tax
revenues with respect to income is higher.


       (T 1  T 0) ( I 1  I 0)
  v2             
           T0            I0
 EXAMPLE OF v1 AND v2 MEASURES

Suppose that everyone’s tax liability is to be
increased by twenty percent of the amount of tax
the individuals current pay.
T0 goes to 1.2T0
T1 goes to 1.2T1
What happens to v1 and v2?
              .       .
     T 1 T 0 12T 1 12T 0
                  
v1  I1 I 0  I1        I0
     I1  I 0   I1  I 0

 v1 increases by 20 percent; thus by this measure
 progressiveness increases.
      ( T 1  T 0) ( I 1  I 0)
v2               
           T0            I0
  (12T 1  12T 0) ( I 1  I 0)
    .          .
                   
          .
         12T 0              I0
 v2 remains unchanged; thus no change in
 progressiveness by this measure. Both the
 numerator and the denominator are multiplied by
 1.2.
Lump-sum Taxes, Price-Distorting
   Taxes, and Excess Burden
• A lump-sum tax is a fixed sum that a person
  would pay per year, independent of that
  person’s income, consumption of goods and
  services or wealth – Head tax is an example.
• A price-distorting tax is one that causes the
  net price received by the sellers of a good or
  service to diverge from the gross price paid
  by the buyer. Wedge effect.
Other Goods
                  A
      Tax     {                                 Tax
                  L
         Y*

                       E'
        YT
                                                E
        Y1
                                 E''
                                            U2             U3
                                            U1


                                       B'             L'        B
              0       QT    QL              Q
                                                            Gasoline
• The loss of well-being of the taxpayer when she
  pays T in taxes under the price –distorting tax
  instead of under the lump-sum tax is the
  individual’s excess burden of taxation.
• The excess burden measures the loss in well-being
  to a taxpayer caused by the substitution effect of a
  price-distorting tax.
• The excess burden of the price-distorting tax is the
  reduction in well-being of the taxpayer from U2 to
  U1 in the diagram when the price-distorting tax is
  used instead of the lump-sum tax.
Partial Equilibrium
     Analysis
INCIDENCE OF AN EXCISE TAX
    AND EXCESS BURDEN
Increasing Marginal Cost
                                               ST = MSC + $0.25
                     Tax Revenue = PNPG CA
Price
                                                       S = MSC



                                   C
   1.15 = PG                                         Excess Burden

                   T = $0.25
        1.00
                                          B
  0.90 = PN
                                      A

                                                  D = MSB
                                   Q
               0                 Q1       Q*         Gasoline
• When the excise is imposed the marginal cost
  of selling gasoline increases by 25 cents per
  gallon because of the tax.
• In addition to covering all other variable cost
  of production, sellers must also cover the tax
  to avoid losses in selling gasoline.
• The decrease in supply results in a new after-
  tax equilibrium at point C where the price is
  $1.15. This is the gross price received by the
  seller. The seller must pay $.025 of the gross
  price as a tax. Thus, the net price is only
  $0.90 per gallon after the tax.
• PN = PG –T
• The total excess burden of a tax is an additional
  cost to society over and above the amount of
  dollars that citizens pay in a tax. The excess
  burden measures the loss in net benefits from
  private use of resources that results when a
  price-distorting tax prevents markets for taxed
  goods and services from attaining efficient
  output levels.
• The total excess burden of an excise tax is the
  loss in well-being to buyers and sellers in a
  market compared to what they would suffer if a
  lump-sum tax were used to collect the revenues.
• When the excess burden is positive, the total
  burden of a tax on buyers and sellers in a
  market exceeds the tax revenues collected.
• Note that even if the total tax revenues were
  returned to the buyers and sellers of gasoline
  as a lump-sum payment of TQ1 ( or area
  PNPGCA) , the excess burden ( dead-weight
  loss) would not be recovered.
• W = .5 T Q
Excess Burden and Price
       Elasticity
• The excess burden actually varies more than
  proportionally with excise tax.
• The dead-weight loss can be calculated as
• W = .5 T2 (Q* / P*) (ESED / ES – ED)
• Note according to this expression the excess
  burden varies quadratically ( T2) with the
  excise tax.
• If the excise were doubled from $.25 to $.50,
  the loss in well-being from the excess burden
  of the tax could be expected to increase
  fourfold.
• Other things equal the greater the price
  elasticity of supply, the greater is the loss due
  to the excess burden of a tax.
• For either ES = 0 or ED = 0, the excess burden
  is zero.
• The efficiency loss ratio is defined as the
  excess burden of a tax divided by the tax
  revenues collected by the tax for a given
  period of time.
             W   Excess Burden
               
             R   Tax Revenue
• An efficiency-loss ratio of 0.2 means that the
  excess burden of a tax is 20 cents for each
  dollar of revenue raised. The efficiency-loss
  ratio of a tax is sometimes called the
  coefficient of inefficiency of the tax.
                      D             S+t
Price
                                          S




        0             Q                  Quantity

            Perfectly Inelastic Demand
                       S
Price




                                             D

                                         Net Price After Tax


        0              Q                 Quantity

            Perfectly Inelastic Supply
Ad Valorem Tax
• Ad valorem taxes are levied as a percentage
  of the price of a good or service.
• Retail sales taxes are ad valorem taxes levied
  as a certain percentage of the price received
  by sellers of a good.
• Payroll taxes are ad valorem taxes because
  they are levied as a percentage og wages paid
  by employers.
• The economic analysis of an ad valorem tax is
  basically the same as for the excise or unit
  tax.
Ad Valorem Tax on Labor
Wages                                   S
                          A
WG = 5.20                                   Excess burden

                                    E
        5.00

WN = 4.16                     E'
               Tax
               Revenue


                                                    D = Gross wage
                                                   Net Wage = WG (1-t)
                         Q1        Q*             Labor Hours
• Suppose that workers are subject to a flat
  20% tax on wages.
• The tax can be thought as a reduction in
  gross wages received by workers for each
  hour of work.
• In the figure, the actual demand curve for
  labor indicates the gross wage that
  employers would pay for each amount of
  labor hours.
• The pretax equilibrium is point E at $5.00
  per hour of labor and a Q* .
• A tax of 20% would reduce the net wage to 80% of
  the gross wage that employers actually pay.
• The net wage is the actual wage received by the
  workers.
• The wedge between the gross wage and the net
  wage is the tax.
• WN = WG (1 – t)
• As the gross wage increases, the actual tax per
  labor hour paid, tWG, increases.
• This is why the difference between the gross wage
  curve and the net wage curve increases as the gross
  wage increases.
• The posttax equilibrium is at point E’.
• The quantity of labor hired declines from Q* to Q1
  hours.
• At the post-tax equilibrium the market wage is
  $5.20 per hour but the net wage received by the
  worker is only 80% of that amount or $4.16.
• Because workers decrease the quantity of labor
  hours supplied as a result of the tax, they succeed in
  shifting part of its burden of payment forward to
  employers as the market wage rises to $5.20 per
  hour.
• The excess burden in this case is represented by the
  area AEE’.
Constant Marginal Cost
P        S



         D

    Q1
Incidence of an Excise Tax

    Consumer
    Surplus
P                       S



                        D

               Q1
Incidence of an Excise Tax
       Consumer
       Surplus

P2                         S+t
                       t
P1                         S



                           D

        Q2        Q1
Incidence of an Excise Tax
                Consumer
                Surplus     Dead-Weight Loss


P2                                        S+t
     Tax Revenues                    t
P1                                        S



                                          D

                Q2         Q1
• With a constant cost industry, the price to the
  consumer ultimately rises by the amount of the tax
  per unit.
• In this case the tax is shifted forward to the
  consumer because they bear the burden of the tax
  in the form of a higher price.
   Excess Burden or
Welfare Cost of Taxation
EXAMPLE
• The additional burden of taxation called
  the welfare cost of taxation or the excess
  burden is a cost above the direct burden
  as measured by the dollar tax revenues
  raised.
Incidence of an Excise Tax
                      Indirect (Excess) Burden
                      or Welfare Cost

75                                         S+t
     Direct Burden                   t
50                                         S



                                            D

               1200   1500
At 75: Total Spending = 75 * 1200 = 90,000
       Firms Get      = 50 * 1200 = 60,000
       Gov’t Gets      = 25 *1200 = 30,000
      No Body Gets = ½ (300)(25)= 3750
 WELFARE COST OF TAX
      K
100                                     S + t’
      R 1       B                  t’
75                                      S+t
        2                      t
      L     3       4     D
50                                      S
            A


                                        D

      900   1200        1500
                  NOTE
Doubling the tax per unit quadruples the
welfare cost .

 Area BAD: ½ (300)(25) = 3750
 Area KLD: ½ (600)(50) = 15000
 4 * 3750 = 15,000
INCREASING COST INDUSTRY        S+t

                                       S




P2                         Excess Burden
                           of the Tax
P1




                                   D


              Q2    Q1
EXCISE TAX IN A MONOPOLY MARKET
            STRUCTURE
     EXCISE TAX IN A MONOPOLY MARKET
                               MC
                                    ATC

P1




                                       D
                          MR

                Q1
     EXCISE TAX IN A MONOPOLY MARKET
                               MC
                                    ATC

P1




                                       D
                          MR

                Q1
     EXCISE TAX IN A MONOPOLY MARKET
                                 MC
                                      ATC

P1
     Monopoly Profit




                                       D
                            MR

                       Q1
     EXCISE TAX IN A MONOPOLY MARKET
                                     MC
                                          ATC

P1




                                 T
                                          D
                            MR            D+T
                       MR
                Q1
     EXCISE TAX IN A MONOPOLY MARKET
                                 MC
                                      ATC

P1
P2




                                       D
                            MR         D+T
                       MR
           Q2   Q1
     EXCISE TAX IN A MONOPOLY MARKET
                                 MC
                                      ATC
P2
P1
Pn




                                       D
                            MR         D+T
                       MR
           Q2   Q1
     EXCISE TAX IN A MONOPOLY MARKET
                Monopoly Profits       MC
                After the Excise Tax
                                            ATC
P2
P1
P2




                                            D
                                 MR         D+T
                            MR
           Q2     Q1
TAX INCIDENCE AND ASSET VALUES
Suppose that a tax is place on land. Who
bears the burden of the tax.
Assume the following:
$R0, $R1, ... $Rn represent the annual rental
rate on land.
Value of the land before the imposition of the
tax is equal to the present value of the rental
income.
             $R 1    $R 2               $Rn
 PR  $R 0                  . . .
             1  r (1  r) 2          (1  r) n

Now suppose a tax of $u0, $u1, $u2 , ..., $un is
place on the land each year.
Because the land is fixed in supply, the annual
rental received by the owner falls by the full
amount of the tax. So the net return stream
looks like the following:
$(R0 - u0) , $(R1 - u1) , ... $(Rn - un) ,
Prospective purchasers of the land take into
account the after tax flow of rental income; i.e.,
they purchase the land plus a tax liability on
the land.
So what value would they place on the land?
                      $(R 1  u1) $(R 2  u2)
P' R  $(R 0  u0 )                         
                        1 r       (1  r) 2

       $(Rn  un)
. . .
        (1  r) n
The difference in the before tax value and the
after tax value is the discounted value of future
tax payments or tax liabilities.
        u1       u2                 un
 u0                    . . .
      (1  r) (1  r) 2
                                 (1  r) n




At the time the tax is imposed , the price of
the land falls by the present value of all future
tax payments. The tax becomes capitalized into
the value of the land.
Due to the capitalization of the tax , the
individual who bears the full burden of the tax
forever is the landlord at the time the tax is
levied.
Future landlords make tax payments to the
government, but such payments are not really a
burden because they just balance the lower price
paid at the time of purchase.
General Equilibrium Analysis of the Excess
     Burden and Incidence of Taxes
• An economy is composed of complex inter- related
  markets. This implies that the effect of a tax in any one
  market is not likely to be confined to that market
  alone. Instead, repercussions are likely in related
  markets, along with possible feedback effects in the
  market initially taxed.
• For example, a tax on the consumption of electric
  power affects not only the price of electricity but also
  the demand for various electrical appliances and for
  natural gas for cooking and heating. These secondary
  shifts in demand affect the prices of the substitutable
  and complementary activity. This in turn might result
  in feedback effects on both the demand and supply of
  electricity
Minimizing the Excess Burden of
    Sales and Excess Taxes
• Supposed tax authorities wish to minimize the
  excess burden associated with a system of
  sales and excise taxes. Surprisingly, they must
  tax this is an differing rates rather than at
  uniform rates to accomplish this.
• Assume that demand for food is more in the
  last the than demand for clothing and that the
  demand for each of these goods is independent
  of the price of the other.
• Accordingly, when the price of either good
  changes, the demand curve for the other does
  not shift.
Price of
Food
                        E2
                                     S'
Pf (1+t)
                         E1
                                     S
      Pf
                    A

               Q             Df

           0        Qf2 Qf1
                                   Food
Price of
Clothing
                    E2
                                     S'
Pc(1+t)
                           E1
                                     S
     Pc
                    B
                                Dc
               Q

           0        Qc2   Qc1
                                Clothing
• Because the demand for food is more a
  inelastic than the demand for clothing, the
  excess burden in the clothing market exceeds
  that in the food market.
• The excess burden in the food market is the
  triangular area AE2E1.
• The excess burden in the clothing market is
  the triangular area BE2E1 .
• The excess burden is higher in the clothing
  market because the substitution effect of the
  tax is a greater there than in the food market.
• This analysis suggests that to minimize the
  excess burden associate with any system of
  sales or excise taxes. The total excess burden
  associated with the sales tax could be reduced
  if the tax will raise in the food market and
  lowered in the clothing market.
• By adjusting the tax rates in the two markets
  until the marginal reduction in excess burden
  in the clothing market is balanced by the
  marginal increase in excess burden in the
  food market, the total excess burden can be
  minimized.
• The more inelastic the demand, the higher the
  to tax rate necessary to ensure minimization
  of the efficiency loss.
• For any two goods F and C, the following
  conditions minimizes the total access burden.
• tFEF = tCEC where t is the tax rate for each
  good and E is its price elasticity of demand.
• This relationship is referred to as a Ramsey’s
  rule which states that the percentage
  reduction in the quantity demanded of each
  of the goods must be equal.
Note that tF and tC are the percentage changes
in the prices of food and clothing, respectively.
Therefore,

         QF      QC
         QF       QC
      tF      tC
          tF       tC
 Therefore,


        QF QC
           
        QF   QC
Given EC and tC, the lower EF, the higher the
tax rate on food necessary two achieve this
 condition.
Multimarket Analysis of
      Incidence
• Assume that the economy produces only two
  goods, food and clothing, and that a taxes
  levied on the sale of clothing but not on food.
• The tax on clothing acts to decrease the supply
  of clothing with a consequent increase in its
  market price from P* to PG and a reduction in
  quantity demanded from Q* to Q*.
• The reduction in production of clothing cause
  by the tax frees productive resources from
  clothing production for alternative uses.
                       S = MC + T
                                                       S
Price                      S        Price
                                                                S'
            E2
                                                  E1
    PG
                                            PF
    P*            E1                        PF'            E2


    PN
                               D                                     D


        0   QC' QC*      Clothing             0   QF   QF'
                                                                Food
• The determination of the incidence of the tax
  is now more complex.
• Although the tax causes the price of clothing
  to increase, it indirectly causes the price of
  food to decrease.
• From point of view of consumers, the increase
  in clothing prices is balanced to some extent
  by a corresponding decrease in the price of
  food.
• If the impact of the increase in the price of
  clothing is exactly offset by the decrease in
  the price of food, consumers are made no
  worse off the tax.
• The tax is borne by owners of all specialized inputs
  in clothing production as a reduction in income.
• In addition, consumers who spend relatively more
  on clothing than on food suffer a decrease in real
  income.
• The extent to which the results of the multimarket
  analysis differ from a single market analysis
  depends on the degree to which tax induced
  resource flows are concentrated in particular
  markets and the extent to which displaced inputs
  have specialized uses in the taxed industry
Budget and Expenditure
 Incidence: Revisited
• Budget incidence evaluates the effect of both
  government expenditure and tax policies on the
  distribution of income in the private sector.
• Expenditure incidence evaluates the effects of
  alternative government expenditure projects on
  distribution income.
• Differential tax incidence is the resulting change in
  the distribution of income when one type of tax is
  substituted for some alternative tax, or set of taxes,
  yielding an equivalent amount of revenue in real
  terms, while both the mix and the level of
  government expenditures are held constant.
• An analysis of the differential tax incidence
  attempts to delineate all direct and indirect
  effects of the substitution of one tax for
  another. This includes all secondary shifts in
  relative prices that result from tax shifting, as
  well as direct transfer of income.
• However, the concept of differential
  incidence ignores the interdependence
  between the revenue and expenditures sides
  of the budget.
The Lorenz Curve
• A Lorenz curve gives information on the
  distribution of income by size brackets.
• And economy whose income distribution is
  measured along line 0E has a perfectly
  uniform distribution of real income.
• Income is equally distributed along line 0E.
• No mention has a Lorenz curve like 0E.
• Significant degrees of income inequality exist.
• The actual Lorenz curve might look like 0xyE.
• Along this curve the top decile of households
  has 40% of the nation’s a real income at point
  y.
The Gini Coefficient
• A summary index of the information
  contained in the Lorenz curve is the Gini
  coefficient, which measures the degree of
  inequality for any income distribution by
  calculating the ratio of the area between the
  Lorenz curve corresponding to that
  distribution and the 45-degree line to the total
  area under the 45-degree line.
• G = Area A / (Area A + Area B)
• If the Gini coefficient were equal to zero, the
  Lorenz curve would be the 45 degree line.
• A study of the incidence of the overall 1980
  tax structure in the United States concluded
  that, except for those with very high incomes
  and very low incomes, the overall distribution
  the tax burden in roughly proportional to
  income.
• Recent analysis of the effect of changes in the
  federal tax structure in 1990 and 1993 by the
  Congressional Budget Office indicates that
  reforms, particularly those enacted under the
  Clinton administration, will make the U.S. tax
  system more progressive.
Percentage                                                                              E
                 100
of Real Income



                                                                             y




                           Line of Equal Distribution           Area A

                                                                         Area B




                                        x

                       0                                50                        100
                                              Percentage of Households

				
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posted:11/1/2011
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