Public Revenues

• In general, public revenue may be considered to

include any revenue flowing to the public budgets.
Among those public budgets there may be budgets
of governments, lower regional administration units
(districts and municipalities), parafiscal funds and
also budgets of health insurance funds. The most
substantial item on the revenue side of public
budgets are taxes. It further contains non-tax
public revenue (interest revenue, fees and fines,
and revenue from selling and renting out state or
municipal property).

1
A tax is

• a payment in money
• required by a government
• that is unrelated to any specific benefit
or service received from the government.

2
Other definition… A tax is …
• a financial, mandatory, nonequivalent,
non-specific charge or other levy
imposed on a taxpayer by a state.
• The tax is implemented by law.
• The failure to pay taxes is punishable by
law.
• The taxes can be paid regularly or
occasionally based on certain conditions
stipulated by the tax legislation. 3
The three criteria necessary to be a tax are
• the payment is required (by the law)
– free rider theorem of public goods

• imposed by a government
• not tied directly to the benefit received by
the taxpayer.
4
Sources of finance

– Tax = MAIN SOURCE

– User charges
• Prices charged for the delivery of certain public goods
and services
• Examples: Toll roads, public swimming pools
– Administrative fees
• Definition of service/benefit is broad & imprecise
• Examples: TV licences, parking tickets
– Borrowing

5
The Main Issues of Tax Theory
There are two main issues related to tax theory:
- Normative: How to design taxes to promote social welfare
in terms of the public interest in efficiency and equity
- Positive: The economic effects of the various taxes that
governments use
- What effects do taxes have on people’s desires
to consume, save, supply their labor, or on firms’
desire to invest?
- Who bears the burden of various taxes?
- Public officials need to be able to answer these questions
to design taxes that promote social welfare

6
Tax Principles
Economists believe that any broad-based tax should possess
five characteristics:

(1) Ease of collection

(2) Ease of compliance

(3) Flexibility

(4) Promotion of economic efficiency

(5) Promotion of end-results equity

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 Tax Principles

(1) Ease of Collection and

(2) Ease of Compliance
- To successfully implement a tax policy, it is necessary
to incur the costs associated with administering and
enforcing it
- Given that society must incur these costs, it wants to
get the most possible revenue at the least possible
cost
- Requires that individuals be able to calculate tax bills
fairly easily and that it be difficult for individuals to
hide information on taxable assets

8
 Tax Principles

(3) Flexibility
- Tax policy is a primary tool of macroeconomic policy (i.e.
economic stabilization)
- To be able to respond quickly to address potential
difficulties in the economy, tax authorities must be able to
change tax liabilities easily and quickly and those
changes must quickly be felt throughout the economy

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 Tax Principles

(3) Flexibility (II)

10
 Tax Principles
(4) Economic Efficiency
- Individuals must face same prices for economy to reach
Pareto-optimal outcome
- Broad-based taxes are distorting (i.e. drive wedge between
price paid by consumer and prices kept by firms) so they
violate this property
- The goal then is to design a tax that introduces the least
distortion and keeps society as close to the Pareto-
optimal outcome as possible

(5) End-Results Equity

- Tax policy is designed to work with redistribution programs
to achieve this goal

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Six Main Taxes (1)

(1) A personal income tax

- Tax on income received by individuals
- Typically collected from firms who withhold pay
- Tax liability calculated once a year and refund or extra
payment made depending on whether enough was
withheld
(2) A payroll tax
- Tax levied on the wage and salary component of
income
- Half tax collected from employers / half from workers
- Earmarked for Social Security in US
(3) A corporate income tax
- Tax levied on accounting profits of corporations
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Six Main Taxes (2)

(4) An excise tax

- Tax on the sale of a single product (e.g. gasoline,
alcohol, cigarettes)
- Designed to reduce consumption of good
(5) A property tax
- Tax on value of items of wealth – usually residential,
commercial and industrial properties
- Levied on owner of property
- Value assessed periodically by tax authorities
(6) A value-added tax
- Tax on value added of firms (which is the difference
between sales revenue and input purchases)
- Levied on firms
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 The Ability-to-Pay Principle

- Dates from Adam Smith and John Stuart Mill in late 1700s
and early 1800s
- Holds that people must be willing to sacrifice for the public
good
- Gave rise to view of taxes as necessary evil
- Key question: How to determine what people should
sacrifice?
- Two potential approaches based on ability to pay
- Horizontal Equity: Two people deemed equal in
every relevant economic dimension should pay
same tax
- Vertical Equity: It is permissible to tax unequals
unequally

14
 The Ability-to-Pay Principle continued

- Both principles raise important and difficult questions

- In what sense are people to be deemed to be equal or
unequal?
- How unequally can unequal be taxed?
- The issue of horizontal equity is the quest for the ideal tax
base (i.e. the item to be taxed)
- People with identical tax bases will pay identical tax bill
- The issue of vertical equity is the quest for the ideal tax
structure, as defined by chosen tax rates and deductions
- Differences in chosen tax rates and deductions make it
so that different people pay different tax bills

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Horizontal Equity: The Ideal Tax Base
(OPTIONAL)

- Robert Haig (1921) and Herbert Simons (1938) proposed a

method of thinking about optimal tax base that relied on three
principles:
(1) People ultimately bear the burden of taxation
(2) People sacrifice utility when they bear the burden of taxation
Horizontal equity: Two people with equal utility before tax
should have equal utility after tax
Vertical equity: If person has more utility than another before
tax they should also have more after tax
(3) The ideal tax base is the best surrogate measure of utility
- Because utility cannot be measured, society must rely on
something else, which should be best surrogate

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Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
Haig–Simons income
- Argues that the best surrogate for utility is the increase in
purchasing power during the year
YHS = consumption + change in net worth = C + ∆NW
- Concludes that people with the same YHS should be considered
equals and should pay the same tax because they will sacrifice the
same utility
- Once YHS is accepted as ideal tax base it implies that the optimal
tax structure is the broadest possible personal income tax
→ This requirement is never met in practice

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 Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
- Under the Haig–Simons definition of income, there are a number of
distinctions that should not matter (but usually do)
- Factors that should be treated the same, but usually are not
Sources of Income Uses of income
- Personal income and capital - Consumption and saving (saving
gains (portion of capital gains usually excluded)
usually excluded from tax base) - Various forms of consumption
- Earned and unearned income (medical care, mortgage interest
(receipt of transfer payments payments, etc. usually excluded)
usually excluded from tax base) - Form of capital gains (accrued
- Different sources of earned capital gains usually excluded,
income (interest earned on realized usually included)
savings and fringe benefits
usually excluded)

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Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)
- These differences usually exist because policymakers often use
tax policy to try to promote social ends which might run counter to
the concept of horizontal equity
- Business expenses should be excluded because they subtract
from purchasing power out of income
- Calculation of YHS must be indexed to inflation because increasing
prices reduces purchasing power
- Conclusion: Combined, these facts suggest that the ideal tax
base is (YHS - business expenses), indexed for inflation

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Horizontal Equity: The
Ideal Tax Base
Continued (OPTIONAL)

Haig-Simons income and utility

- Is this a good surrogate measure
of utility? Almost certainly not!
- Whether income is good measure
of utility depends on whether
people are identical
- People receive utility from
income and leisure
- Income comes from work and leisure comes from not working
- If every person has same preference for income and leisure and
same opportunities (i.e. same wage) they will choose same point
and have same utility
- In such a case, income would be a good surrogate for utility

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Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)

Consumption as the ideal tax base

- Recognizes that consumption is not a perfect surrogate measure
of utility but is likely better than income
- Consumption most directly generates utility
- Consumption changes over time are more directly tied to
utility changes over time than are income changes over time
- Implication is that to meet the concept of horizontal equity, two
people with equal lifetime consumption before tax should have
equal lifetime consumption after tax

21
Horizontal Equity: The Ideal Tax Base
Continued (OPTIONAL)

- This suggests that tax should be annual tax on consumption rather

than annual tax on income
- Two people with same lifetime income might have very
different lifetime consumption due to differences in annual
consumption/savings decisions
- Note that it would be possible to design an annual income tax that
would be equivalent to an annual consumption tax
- Would require allowing people to subtract saving from
income, which would actually make it a consumption tax

22
Horizontal Equity:
The Ideal Tax Base (OBLIGATORY)

Musgrave’s view of horizontal equity

- Argues that questioning whether income or consumption tax is
better is the wrong question
- Instead, believes that horizontal equity should only consider
whether taxes discriminated against people in inappropriate ways
- Either income or consumption tax is appropriate surrogate for
utility so long as people are not treated differently based on
gender, race, religion, etc.
- Society should just accept one type of tax and then worry
more about the specific tax structure (i.e. vertical equity)

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Vertical Equity

- This is the quest for distributive justice, which generates heated

debate without a satisfactory conclusion
- Key question: Should tax structure be progressive,
proportional, or regressive

- Let YhHS and Th be individual h’s income and tax burdens

→ If Th/ YhHS increases as YhHS increases, tax is progressive
→ If Th/ YhHS is constant as YhHS increases, tax is proportional
→ If Th/ YhHS decreases as YhHS increases, tax is regressive

- Societies tend to have a strong preference for proportional or

progressive taxes

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Progressive, Proportional, and
Regressive Taxes

• Proportional tax
– Percentage of taxpayers income

• Progressive tax
– Larger percentage of income as income rises

• Regressive tax
– Smaller percentage of income as income
rises
25
Progressive, Proportional, and
Regressive Taxes

26
Income and Consumption over
Life Cycle

27
Measuring of Consequences of
Taxation to Income Distribution I.
Lorenz Curve

28
Measuring of Consequences of
Taxation to Income Distribution II.
Gini‘s Coefficient

G is usually 0.2 to 0.5

Consequence of Linear or Progressive Tax:
Gini before tax > Gini after tax
29
Tax Incidence

• Two main concepts of how a tax is

distributed:
– Statutory incidence – who is legally
responsible for tax
– Economic incidence – the true change in
the distribution of income induced by tax.
– These two concepts differ because of tax
shifting.
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Tax Incidence: General Remarks

• Only people can bear taxes

– Business paying their fair share simply shifts
the tax burden to different people
– Can study people whose total income
consists of different proportions of labor
earnings, capital income, and so on.
– Sometimes appropriate to study incidence of
a tax across regions.
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Tax Incidence: General Remarks

• Both Sources and Uses of Income should

be considered
– Tax affects consumers, workers in industry,
and owners
– Economists often ignore the sources side

32
Tax Incidence: General Remarks

• Incidence depends on how prices are

determined
– Industry structure matters
– Short- versus long-run responses

33
Tax Incidence: General Remarks

• Incidence depends on disposition of tax

revenue
– Balanced budget incidence computes the combined
effects of levying taxes and government spending
financed by those taxes.
– Differential tax incidence compares the incidence of
one tax to another, ignoring how the money is spent.
• Often the comparison tax is a lump sum tax – a tax
that does not depend on a person’s behavior.

34
Tax Incidence: General Remarks

• Tax progressiveness can be measured in

a number of ways
– A tax is often classified as:
• Progressive
• Regressive
• Proportional
– Proportional taxes are straightforward: ratio
of taxes to income is constant regardless of
income level.
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Tax Incidence: General Remarks

• Can define progressive (and regressive)

taxes in a number of ways.
• Can compute in terms of
– Average tax rate (ratio of total taxes total
income) or
– Marginal tax rate (tax rate on last dollar of
income)

36
Tax Incidence: General Remarks
(optional)
• Measuring how progressive a tax system is
present additional difficulties. Consider two simple
definitions.
– The first one says that the greater the increase in
average tax rates as income rises, the more progressive
is the system.

T1
 T0

v1 
I1 I0

I1  I 0
37
Tax Incidence: General Remarks
(optional)
– The second one says a tax system is more progressive
if its elasticity of tax revenues with respect to income is
higher.
– Recall that an elasticity is defined in terms of percent
change in one variable with respect to percent change in
another one:

 T1  T0 
%T
v2  
T0

%I  I1  I0 
I0

38
Tax Incidence: General Remarks
(optional)

• These two measures, both of which

make intuitive sense, may lead to
different answers.
• Example: increasing all taxpayer’s liability
by 20%

39
Partial Equilibrium Models

• Partial equilibrium models only examine

the market in which the tax is imposed,
and ignores other markets.
• Most appropriate when the taxed
commodity is small relative to the
economy as a whole.

40
Excess Burden Review – Ad Valorem
Tax

41