Econ7008 Economics of Tax Policy
The major taxes: economic issues (1)
Income tax
Professor Stephen Smith
UCL Department of Economics
UK fiscal revenues, 2003-04
£ billion Percentage
of total
revenues
Income tax 122.1 30.0
Corporation tax 30.8 7.6
National Insurance contributions 74.5 18.3
Other Inland Revenue taxes 13.0 3.2
VAT 66.6 16.4
Excise duties - motor fuel 23.0 5.6
- tobacco 8.0 2.0
- alcohol 7.4 1.8
Other Customs and Excise 7.8 1.9
Business rates 18.6 4.6
Council tax 18.6 4.6
Vehicle excise duties 4.8 1.2
Other misc. taxes 11.9 2.9
Total taxes and NI contributions 407.1 100.0
Source: HM Treasury (2003) Financial Statement and Budget Report 2003. Table C7
Current receipts, outturn 2001-02
http://www.hm-treasury.gov.uk/budget/bud_bud03/budget_report/bud_bud03_repbc.cfm
(Personal) income tax
• 30% of total revenue from taxes and NI
contributions in UK Income tax bands and rates, 2003-04
• Paid by individuals on all earnings and
investment income Taxable income (£ per year) Rate of tax
• Progressivity stems from tax allowance 0-1,960 (starting rate band) 10
plus marginal rate structure 1,961-30,500 (basic rate band) 22
• Personal allowance of £4,615 for over 30,500 (higher-rate band) 40
2003/04
• Married couples' allowance (MCA)
reduces total tax liability of married
couples by £556.50 compared with
single taxpayers
• Savings and dividend income are taxed Taxpayers with highest marginal Percentage of Percentage of
at slightly different rates rate taxpayers revenue
• Savings income taxed at rates of 10%, 10% ("starting-rate taxpayers") 14% 0.8
20%, 40% in the starting, basic and
higher rate bands respectively. Dividend 22% ("basic rate taxpayers") 75% 45.6
income taxed at 10% up to the basic 40% ("higher-rate taxpayers") 11% 53.5
rate limit and 32.5% above the basic
rate limit, but a dividend tax credit
reduces effective rates to 0% and 25%.
Personal income tax: effect on labour supply
• PIT may affect various choices - labour
supply, saving, marriage, etc
• In the labour market, income tax alters labour :
leisure trade-off
• Income and substitution effects
– substitution effect is negative (reduces hours
worked)
– income effect may be positive or negative
– though normally the income effect of income
tax makes an individual work more (if leisure is
a normal good)
– net effect of the two is an empirical matter
– Labour supply curve may have backward-
bending sections, where income effect
dominates
Income tax and labour supply: empirical
evidence
• Quantitative impact is likely to vary across individuals in
different circumstances
– fixed hours of work, or freely-determined?
– hours worked by most working-age men relatively
insensitive to income tax (most work full-time)
– married women more responsive (easier to vary part-
time hours?)
Income tax and distributional equity
• Income tax is capable of substantial redistribution
– Large part of overall household tax burden
– Can be differentiated to take account of household circumstances
(family size, etc), unlike sales taxes
– Flexible functional form
• Principal alternative approaches to redistribution
(on expenditure side of public budget)
– Cash transfers
• Raise many similar issues to redistribution through income tax
– Free or subsidised provision of goods and services
• Less powerful redistributive targeting (if provided to all)
• Welfare effect is never superior to equivalent in cash (constrains
choices)
Income tax and distributional equity (cont.)
• Progressivity can be introduced
to income tax either by
– An initial income tax
“allowance” of tax-free
income
– Rising income tax rates on
successive tranches of
income (rising marginal rates)
• Both lead to average tax rate
rising with income
(=progressivity)
Marginal rate of income tax
• Equity : efficiency trade-off
– Greater progressivity typically requires higher marginal rates of tax
(for equal revenue yield)
– Higher marginal rates liable to have greater distortionary impact on
labour supply
• A similar equity: efficiency trade-off is encountered where redistribution
takes the form of direct cash payments to poorer households.
– If the cash payments are made to households with income below a
qualifying threshold level, the withdrawal of benefit when income
rises above this level will have similar economic effects to taxation
of marginal income.
– In addition higher taxes are needed on the non-poor, to cover the
cost of the cash benefits.
Integrating income tax and social security (cash
transfers to low-income households)
• UK has an extensive system of cash
transfers to households
• Payments are typically “contingent” on
certain characteristics (age, children,
sickness, disability, etc)
• Payments of some transfers are
“means-tested” (ie paid only if
household income and savings are
below an entitlement threshold)
• If means-tested benefits are fully-
withdrawn when household income
reaches the entitlement threshold, they
can create severe disincentive effects
• Possible poverty trap – “better off not
working”
• Gradual (“tapered”) withdrawal can
reduce disincentive to earn additional
income
• But in the taper range, households face
effective marginal rate equal to rate of
taper + income tax rate
• Integrates income tax and cash transfers to
Negative income tax poorer households
– Aim is partly to reduce “stigma” involved in
claiming cash transfers
– Aims also to achieve systematic structure of
marginal rates, without poverty trap problems
• Friedman (1962) “Capitalism and Freedom”
proposed one scheme
• At “break-even” level of income, household
pays no income tax
– Above this level, pays tax at rate t% on each
additional pound
– Below this level, receives payment of t% for
each pound by which income falls short of
breakeven level
• Can be implemented with a single marginal
rate
• But in order to provide adequate low-income
assistance, marginal rate would have to be
very high.
• Equivalent to a guaranteed basic income, with
all marginal income above this level taxed at
constant marginal rate
• George McGovern presidential campaign
(1972) proposed $1000 guarantee per person
(ie $4000 for family of 4), financed by 33%
income tax
Taxation of married couples - 1
• Independent taxation: Each person in a marriage is taxed wholly separately,
without reference to their partner’s income
• Advantages: tax burden is neutral with respect to marriage, and married and
unmarried couples treated the same
• Disadvantage: With a progressive income tax, the total tax burden of two
people, taxed separately, will depend on how their income is distributed
between them.
• For a given income, a married couple will pay more tax if only one of them
earns the income, than if each earn half the total income.
– eg income tax system with tax-free allowance of £4000, and marginal tax rate
above allowance of 25%.
– (a) Husband and wife earn £12000 each and are taxed separately. Each will pay
£2000 in tax.
– (b) Husband earns nothing, wife earns £24,000, and pays £5000 in tax.
– Same household income in (a) and (b), but £1000 more tax in (b).
– Reason is that the benefit of the allowance is lost if the husband earns nothing.
Taxation of married couples - 2
• A system of joint taxation (in which tax is assessed on the aggregate
income of the couple) ensures that households with the same income
are taxed the same, regardless of how the income is distributed
between husband and wife.
• Advantage:
• Most equitable tax treatment of married couples with different
distributions of income and working
• Problems:
• (1) May generate tax incentive or disincentive for marriage
• (2) Dictates loss of income confidentiality within marriage
• (3) Non-working partner pays tax at couple’s highest marginal rate on
first hour of work – so may have adverse effect on labour force
participation
Taxation of married couples - 3
• A system of transferable allowances has the same effect on total tax
burden as joint taxation in a progressive tax system based on a tax-
free allowance plus a single marginal rate.
• If, in the earlier example, the husband can transfer his "unused
allowance" to the wife, tax is reduced to £4,000
– Wife earns £24,000, but taxed on £16000 (income minus own and
husband’s allowances of 4k each). Income tax is £4000, same as total tax
with independent taxation
• Problems of transferable allowances
– administrative complexity: taxation of one partner depends on tax
treatment of the other
– possible impact on labour supply incentives for non-working spouse. Non-
working husband effectively pays tax at the full marginal rate from the first
pound of income.
Taxing families
• Many income tax systems take account of family size
(number of children) in computing income tax liability
• The UK used to do this – now pays a direct cash amount
to the mother instead (“Child Benefit”)
• Raises various questions:
– Why adjust income tax for family size?
– How large an adjustment per child?
– Tax allowance versus cash payment?
– Who should receive the benefit?
Treatment of household size in statistical analysis
• In analysing the distribution of income, and the distributional effects of different
taxes, we often base the analysis on the household, rather than the individual,
as the unit of analysis.
Reasons for this
• the living standards of household or family members may be more accurately
assessed by looking at total household income than at just their own income.
• hard to assess the distributional impact of some taxes (eg taxes on spending)
at the level of the individual.
– One person may do shopping for the household, or on behalf of other family
members, and so spending data is more meaningful analysed at the household level.
• But, the problem is that households come in different sizes. An income that is
adequate for one person may be insufficient to meet the needs of a larger
household.
• If we are to assess living standards accurately, we need to adjust household
income to reflect the number of people living from the household's income.
If we are to assess living standards accurately, we need to adjust household
income to reflect the number of people living from the household's income….
• Calculating equivalent income.
• No adjustment for household size:
– large households count as rich • Equivalence scales typically assign
households "weights" to households with different
numbers of members;
• Calculate per capita income:
single adult 0.64
– ignores household public goods (TV married couple 1.00
sets) and other economies of scale each child under 16 0.35
in households additional adult 0.64
– Individuals of different ages may
have different needs • We add up the appropriate weights for
each household to obtain the
"equivalisation factor" (W) for each
• Equivalence scales household, and then divide household
– to reflect differences in numbers and income by this equivalisation factor to
ages of household members, etc obtain the household's “equivalent
income”
– Choice of scale is, to some extent,
arbitrary • This income is the income of a two-adult
– “McClements” scale is widely used household with the same standard of
in the UK living.
• Consider three households:
A – one adult, income £12k
B – married couple, one adult child, income £30k
Adjusting household
C - married couple, two children under 16, income £36k income for household
• How do we judge the relative standard of living of the
three households? size: An example
• On the basis of total household income, C appears to have
the highest living standard, and A the lowest. Calculating equivalent household income.
• This takes account only of total income, and not of the
different "needs" of each household, in terms of the number • The weights can be interpreted as the
of mouths to feed, etc. income needed to maintain the same
standard of living as a married couple
• Per capita household income is
single adult 0.64
• A: 12k B: 10k C: 9k married couple 1.00
• With this adjustment, household A is "rich" and C is "poor". each child under 16 0.35
• This probably over-corrects for the additional costs of larger additional adult 0.64
households, and ignores any possible economies of scale in
joint living arrangements. • Procedure: Sum the weights for each
household to obtain the "equivalisation factor“
• Household equivalent income (see opposite) is for the household
• A: 18.75k B: 18.3k C 21.2k • Divide household income by the
equivalisation factor to obtain the household's
equivlaent income
• On this basis the household with the highest living standard is
C.
• This has a household income three times that of the singe-
person household, but four members.
• The calculation means that the additional income more than Equivalisation factor Equivalent income
compensates for the higher number of household members
A 0.64 18,75k
B 1.64 18.3k
C 1.70 21.2k
Personal income tax: effect on savings
• Again, income and substitution effects
– overall impact of income tax on saving is ambiguous
• Taxation of interest on savings without corresponding subsidy to
interest paid on borrowings leads to a kink in the budget line for the
allocation of resources between present and future consumption
• Income tax systems vary in terms of relative taxation of earned income
and "unearned" income (interest, dividends, etc)
• Until 1970s, UK system taxed unearned income at higher rates
– rationale: people with unearned income tend to be richer
• In last 20 years, UK and other countries have tended to reduce
taxation on certain categories of unearned income
– to encourage retirement savings
– and/or to compete with tax havens abroad
– PEPs TESSAs, ISAs, etc
Comprehensive income tax
Choice of tax base
– Broad definition of the tax base
– Covers wages and salaries, returns to the
ownership of capital (dividends, interest, capital
gains, rents from land and buildings, royalty
incomes, etc) and “mixed” income such as
The three main options: profits from small businesses, farms, etc
(combining labour and capital elements)
– Taxes all sources of income at the same rate
1. Comprehensive income tax – Tax rate is determined by aggregate income
Tax all sources of income
• Issues:
2. Direct expenditure tax
Tax income minus net savings 1. Taxation of capital gains on same basis as income is
essential to prevent simple schemes for income tax
avoidance
3. Tax earned income only requires valuations of wealth - even where no transactions
Capital income untaxed evidence
2. Taxation of investment incomes (rate of interest on
savings, etc) may distort intertemporal consumption
choices. ("double taxation of savings")
3. Common tax treatment of “wage” and “investment
income” elements in small business income is a
major attraction – because there is no real way of
distinguishing between these if they had to be taxed
differently
Taxation of capital gains
• Two possible approaches
– on "accrual" (ie when the value of the asset increases), or
– on "realisation" (ie tax gains only when asset is sold)
• Accrual basis faces problems:
• (i) How to value assets when no sale has been made?
• (ii) Taxpayer may have insufficient current income to pay the tax (a
major problem is asset is indivisible)
• Realisation basis has problems too:
• (i) It gets timing of tax payment out of line with change in wealth (a
particular problem if income-plus-capital-gains taxed at a non-linear
rate)
• (ii) It creates an artificial incentive to hold on to assets (since this
defers the tax).
Direct expenditure tax (Kaldor, 1955)
• tax base would be income minus net saving
– Based on an annual tax return, reporting income and transactions in assets
– effect would be to tax income when spent, not when earned
• Advantages compared with comprehensive income tax
– Avoids need for valuation of wealth
– Tax assessments need information on earned income, and net transactions in
registered assets
– Avoids "double taxation of saving" - distortion of intertemporal consumption
decisions due to taxation of interest
• Drawbacks
– Problem in the taxation of entrepreneurial incomes.
• Income from a small business consists partly of the proprietor's earned income,
and partly return on the proprietor's capital invested. CIT taxes both equally;
ExpT taxes earnings only (but proprietor controls division).
– Major problems concern the transition from income tax:
– (1) Initial asset registration at t=0. If assets can escape registration, expenditure
from subsequent sale of these assets would be untaxed.
– (2) The change of tax base redistributes the tax burden between generations.
• The current retired lose. They saved out of taxed income, but will also pay tax
on spending financed by dissaving.
Tax earned income only
• In absence of gifts and bequests
NPV (lifetime earnings) = NPV (lifetime consumption)
• So a tax on wages is equivalent in overall burden and economic effects
to a tax on consumption
– If there are gifts and bequests, tax on wages plus inheritances is equivalent to a tax
on consumption plus bequests.
• So a tax on earned income (wages) provides an alternative route to achieving
the economic outcomes of an expenditure tax
• Like expenditure tax, avoids double taxation of savings
– Investment incomes exempted from tax
• Has practical advantages, compared with expenditure tax. Avoids the need for
collecting information on net saving.
• Like expenditure tax, redistributes tax burden between generations when
introduced
– the old lose out, if it replaces a tax on incomes
• Major drawback is that it creates scope for avoidance through conversion of
earnings into investment incomes or capital gains
National Insurance Contributions
• payroll tax, levied (formally) both on employers and employees
• second largest source of fiscal revenue in UK (18% of total)
• No NI contributions are charged on unearned income (eg interest,
dividends, pensions)
• Lower rates apply to people "contracted out" of the State Second
Pensions scheme (ie members of a recognised private pensions
scheme).
Are NICs just another income tax?
– Social insurance v tax finance of pensions and unemployment
benefits
– Revenue from NICs paid into National Insurance Fund
– But is this “fund” just a fairy tale? Substantial revenues from
general taxation are also paid into the fund, and the link between
individual NI contributions and benefit entitlements is very weak.
Does the distinction between “employer” and
“employee” NICs have any economic significance?
• Who bears the burden of employer and employee
National Insurance Contributions?
– in the short run?
– in the long run? (ie in labour market equilibrium)
• The figures show labour supply and demand curves,
and the effect of imposing employer (top panel) and
employee (bottom panel) NICs.
– In the top panel, the curves are plotted with the net wage
rate on the vertical axis. Labour demand is a function of the
gross hourly labour cost (ie gross wage plus any employer
payroll tax). Imposition of an employer NIC shifts the labour
demand function downwards on this diagram, by the full
amount of the NIC.
– In the bottom panel, the effect of employee NIC on labour
supply is shown. Labour supply is a function of the net
wage (ie gross wage minus employee NIC), and the effect
imposing an employee NIC is to shift the labour supply
function upwards in this diagram.
• Employer and employee NICs shift the relative positions
of the two schedules by the same amounts - and have
the same effect on the labour market equilibrium (ie on
hours worked).