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           Frederick University
Taxation and Government
   For government to provide goods and services such
    as national defense, social security, national parks,
    etc. it must have money.
   The Government raises money several ways including
    user fees and taxes.
   User Fees are fees paid by those that use the good
    or service: it is a price.
   Taxes may be paid by everyone or only those that
    use a good or service: who pays depends on the type
    of tax.
        What is the Role of Government?

   The level of taxes is determined by the amount of government
    services and goods provided.
   The Government’s roles include:

       Providing a stable set of institutions, laws and rules.
       Promoting effective and workable competition.
       Correcting for externalities.
       Creating an environment that fosters economic stability and
       Providing public goods.
       Adjusting for undesirable market results.
How Much Should
Government Tax?
The government must raise revenues
equal to the cost of providing the
amount of goods and services that its
citizens demand.
Types of Taxes

   There are many types of taxes:
       Personal Income taxes
       Corporate Income taxes
       Excise Taxes
       Value Added Taxes (VAT)
       Property Taxes
       Social Security Taxes
Types of Taxes
   Direct taxes (income taxes, property
   Indirect taxes (VAT, excise taxes)
The Costs of Taxation
   The costs of taxation include:
       The direct cost of the revenue paid to
       The loss of consumer and producer surplus
        caused by the tax
       The cost of administering the tax codes.
    The Costs of Taxation
       When government institutes taxes,
        there is a loss of consumer and
        producer surplus that is not gained by

   This is known as deadweight loss.
    The Costs of Taxation
       Graphically the deadweight loss is
        shown on a supply-demand curve as
        the welfare loss triangle.

   The welfare loss triangle – a
    geometric representation of the welfare
    loss in terms of misallocated resources
    caused by a deviation from a supply-
    demand equilibrium.
                          Consumer Surplus Before Tax: A + B + C
                          Consumer Surplus After Tax: A
                          Producer Surplus Before Tax: D + E + F
                          Producer Surplus After Tax: F
                          Deadweight Loss: C + E

Price   Consumer                        S1
  P1                              tax
        B             C                 Deadweight
 P0                                        loss
        D             E

            Producer                     Demand
                     Q1      Q0               Quantity
The Costs of Taxation
    There are other costs of taxation.
   Resources must be devoted by the
    government to administer the tax codes
    and by citizens and businesses to
    comply with it.
The Costs of Taxation
 Payroll accounting has become so
 onerous, businesses large and small
 often pay payroll-accounting firms to
 keep up with changing municipal and
 state payroll rules and actually issue
 paychecks for their clients’ employees.
The Benefits of Taxation
  The benefits of taxation are the goods
   and services that government provides
 Some of these benefits are part of the

   basic institutional structure of a market
   economy that allows it to work
- the basic legal system is an example.
The Benefits of Taxation
 Still other benefits take on the qualities
 of a public good – national defense, for
The Benefits of Taxation
 Other benefits are provided for reasons
 of equity or because they provide
 positive externalities.
The Benefits of Taxation
   The policy debate about the benefits of
    taxation generally focuses on goods
    that could be supplied by the market
    but are publicly supplied.
       Education and health care are examples.
The Benefits of Taxation
 Measuring the benefits of these goods
 is difficult since they are not provided in
 a market setting.
Principles of Taxation

    Benefits received
    Ability to pay
Principles of Taxation
   The benefit principle states that the
    individuals who receive the benefit of
    the good or service should pay the tax
    necessary to supply the good.

       Examples are gasoline taxes and airport
        taxes, both paid by travelers.
Principles of Taxation
       The ability-to-pay principle states that
        individuals who are most able to bear the
        burden of the tax should pay the tax. Those
        who have higher incomes can afford to pay a
        greater proportion of their income in taxes,
        regardless of the benefits

       The best example of this is a progressive
        tax, such as the income tax in Cyprus.
  Difficulty of Applying the
  Principles of Taxation

The principles of taxation are difficult to
apply because, among other reasons, the
two principles often conflict.
 Difficulty of Applying the
 Principles of Taxation

In funding health care, for example, the
poor should pay because they benefit the
most, while under the ability-to-pay
principle, the rich should pay.
Difficulty of Applying the
Principles of Taxation

 The elasticity concept helps us to
 understand the tradeoffs as well as who
 is likely to bear the burden of a tax.
Burden Depends on Relative
   Elasticity is a measure of how easy it
    is for the supplier and consumer to
    change their behavior and substitute
    other goods.
   Consequently, the more one group
    (consumers or suppliers) is able or
    willing to change its behavior relative to
    the other group the more likely it is to
    avoid the tax burden.
Burden Depends on Relative
   The person who physically pays the tax
    is not necessarily the person who bears
    the burden of the tax.
   The burden of the tax is rarely shared
    equally since the elasticities are rarely
Burden Depends on Relative
 The relative burden of the tax dictates
 that the more relatively inelastic the
 behavior of one’s group (supply or
 demand), the larger the tax burden one
 will bear.
Burden Depends on Relative
 If demand is more inelastic than
 supply, consumers will pay the higher
 share. If supply is more inelastic than
 demand, suppliers will pay the higher
Burden Depends on Relative
    Who pays a tax is not necessarily who
     bears the burden.
   The person who actually pays the tax
    does not matter, and the person who
    bears the burden can differ from the
    person who pays.
      Difficulty of Applying the
      Principles of Taxation
   Since the free market system is very
    efficient, Governments with free market
    economies desire to change the behavior
    of suppliers and buyers as little as possible.
   Hence, Governments should tax inelastic
    goods or services.
   In the language of consumer and producer
    surplus, if the government seeks to
    minimize welfare loss, it should tax goods
    with inelastic supplies and demands.
            Who Bears the Burden of a
                                         Supplier Pays Tax
Price of luxury boats

                                  Consumer pays
                         50,000   Supplier pays
                         40,000                           Demand
                         10,000                    510

                                   200     400    600 Quantity of luxury boats
            Who Bears the Burden of a
                                       Demand is inelastic
Price of luxury boats

                                  Consumer pays       tax
                                  Supplier pays
                         20,000                         Demand
                         10,000                        590
                                   200    400     600 Quantity of luxury boats
            Who Bears the Burden of a
                                      Consumer Pays Tax

Price of luxury boats

                         60,000   Consumer pays

                         50,000   Supplier pays
                         40,000                                D0
                         30,000                          D1
                         10,000                    510

                                   200    400     600 Quantity of luxury boats
 Tax Incidence and Current
 Policy Debates

The analysis of tax incidence is helpful
when discussing current policy debates.
Social Security Taxes
   Social Security taxes are payroll taxes
    for a government-run retirement
   Both employer and employee contribute
    a percentage of before-tax wages to
    the Social Security fund.
Social Security Taxes
 On average, labor supply tends to be
 less elastic than labor demand, so the
 Social Security tax burden is primarily
 on employees.
Value Added Tax
   VAT is paid by retailers on the basis of
    their sales revenue.
   Demand is inelastic so consumers bear
    the greater burden of the tax.
 Government Intervention as
 Implicit Taxation
Government intervention can be seen as a
combination tax and subsidy.
The Difference Between Taxes and
Price Controls

   The effects of taxation and price
    controls are similar.
   They are different in that price ceilings
    create shortages and taxes do not.
   Shortages also create black markets.
   Both taxes and price controls create
    deadweight loss.
Rent Seeking, Politics, and
   An enormous amount of time and
    money is spent in the political arena to
    increase one’s surplus at the expense of
    another group.

   This activity is called rent seeking
    behavior – the effort to transfer
    surplus from one group to another.
What is the
average tax rate?

Total tax due divided
 by total taxable
What is the
marginal tax rate?

The change in taxes
 due divided by the
 change in taxable
What is a
progressive tax?

   A tax that charges a
  higher percentage of
  income as income rises
What is a
regressive tax?

 A tax that charges a lower
 percentage of income as
 income rises
What is a
proportional tax?

 A tax that charges the same
  percentage of income,
  regardless of the size of
What is a flat rate tax?

Same as a proportional tax
VAT, excise, and flat-rate taxes
are examples of a regressive tax
because each results in a
greater burden on the poor than
the rich.

Progressive income taxes follow
the ability-to-pay principle
because there is a direct
relationship between the average
tax rate and income size.

 Which principle dominates in Cyprus?

The ability-to-pay principle dominates the
benefits-received principle

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