taxation

Taxation

• Why are taxes imposed?

• What are the effects of the tax on welfare?

• Incidence (or burden) of taxation

• The importance of the elastic of demand

 

Why do we tax goods

  • Governments need money to sustain public goods and services

  • Tax on goods (eg, VAT ) is usually more difficult to avoid than income tax.

  • On top of generating revenue, the government may want to discourage the consumption of some goods such as cigarettes, sweets ECT.

  • Sometimes goods have externalities and their consumption is subsidised ( eg good appearance of a building façade.

 

 

Which good can we tax

  • Taxing goods with inelastic demand will not dissuade their consumption too much.

  • On the other hand taxing goods with Elastic demand will not generate high tax revenue.

 

 

        

Deadweight loss

  • Essentially, what the tax will do is

cause a lower level of

consumption

  • This will lead to a welfare loss

 

 

Taxation

  • The tax can be seen as a wedge between the price consumer pays and the amount the producer receives

 

 

Imposing a tax on the supplier

  • A tax on the supplier essentially shifts the supply curve upwards

  • The supplier now faces higher cost per unit sold, which makes them want a higher price in order to supply the good.

 

Imposing tax on the buyer

  • A tax of the buyer essentially shifts the demand curve to the left

  • The buyer now needs to subtract the tax from their WTP for the good.

 

In simple terms:

 

When the government puts a tax on buyers, the product becomes effectively more expensive for them.

 

So buyers think like this:

 

“I was willing to pay £10 for this product, but if I have to pay £2 tax, then I can only pay £8 to the seller.”

 

This means buyers are willing to pay less to the seller, so overall demand decreases.

 

What happens in the graph

 

The demand curve shifts left (or downward).

 

Buyers want less of the product at every price because part of the price is now tax.

 

Simple example

 

Before tax:

 

You are willing to pay £10 for a concert ticket.

 

After £2 tax:

 

Total price becomes £12.

 

You may decide not to buy it or only buy if the seller charges £8.

 

So the tax reduces demand.

 

 

 

Example green apples

Supply schedule

P= 20  + Qs

Demand before schedule

P= 60-4Qd

 

 

 

Now, assume that a tax of 10 is

imposed on the supplier

What happens to social welfare?

 

New supply schedule (with taxation)

𝑃 = 30 + 𝑄𝑆

 

 

 

 

 

 

 

 

Incidence or burden of taxation

 

Who actually pays the tax

Seller is taxed

Tries to raise the prices

Buyer might pay higher prices.

 

 

Taxation

• Direct costs of taxation

e.g. paying salaries at the Inland Revenue

• Deadweight Loss

• Consumer and producer surpluses fall

• Quantity traded is less

• Buyers pay higher prices

• Sellers obtain lower prices

 

 

 

On the left, mainly price increases, here the consumption level slightly falls, essentially consumers pay the tax, on the right, consumption falls here price increases only slightly, essneitally consumers pay the tax

 

 

 

Types of tax.

 

Sin taxes: primary focus reducing consumption

  • Different to a Pigouvian tax (see Externalities)

• Pigouvian or Pigouvian tax: tax on activities which have a negative effect on others

• In practice, sin taxes and Pigouvian taxes are often part of the same political debates

 

 

Sin taxes

• Recent examples

Sugar Tax

Tobacco

Alcohol

• Not necessarily concerned with revenue-raising

• Regressive?

• Black Market

 

 

Tax on sugary soda drinks

  • Soda tax of 2018 (uk)

  • Tax on sugary drinks

 

  • Pooper consumers drink more soda than wealthier people

  • Would cutting out soda help the poor?

 

Only one product in a larger junk food category

Limited time for food preparation

Super-sizing and tight family budgets

Food deserts

Lack of access to exercise facilities

 

 

Black Markets

Transfers funds to criminal gangs

They then use those funds for other activities as well

 

Undermines the rule of law

Seen as an acceptable or victimless crime

 

Lack of oversight: consumer rights

 

The product is still being consumed

The underlying health issue is not being tackled

 

 

 

 

 

Indoor smoking ban

• Particularly aimed at passive smoking

• Drop in hospital admissions for childhood asthma

• Drop in hospital admissions for heart attacks

• Drop in cigarette sales

 

 

Taxation

• Tariffs

Taxes on imports or exports

• Is it better to buy domestically produced goods?

Ricardian Comparative Advantage

 

 

 

Tariffs

  • Protectionism

  • Trade wars

  • (Autarky: self-sufficient economy)

 

Economic arguments for:

Infant industry argument

Strategic industry argument

 

 

Gains from trade

• Avoids trade wars (and actual wars)

• Transfer of knowledge

• Effect of competition on innovation

 

• Absolute Advantage

Adam Smith

 

• Comparative Advantage

David Ricardo

Counter-intuitive

 

 

What is absolute advantage

  • Producer can make a product at a lower cost per unit (or more efficiently) than others.

  • Different producers with different absolute advantages gain from trade

  • Specialisation

  • Division of labour

 

 

Comparative advantage

• Opportunity costs

• Country with lowest opportunity cost makes that product

• Trade occurs even if one country has an absolute advantage

in all products

 

 

 

Autarky (No Trade) – Simple Definition

 

Autarky means a country produces everything it needs by itself and does not trade with other countries.

 

Simple Example

 

Imagine two countries: England and Portugal. Both want to make 1 cloth and 1 wine.

 

England needs 220 labour hours to make both.

 

Portugal needs 170 labour hours to make both.

 

If they are in autarky (no trade):

 

England makes its own cloth and wine.

 

Portugal makes its own cloth and wine.

 

 

 

How Trade Can Help (Specialisation & Comparative Advantage)

 

Instead of both countries making both goods, countries can focus on what they are better at producing, then trade.

 

Step 1: Compare Efficiency

 

We have two countries:

 

England → Needs 220 labour hours to make 1 cloth + 1 wine

 

Portugal → Needs 170 labour hours to make 1 cloth + 1 wine

 

Portugal uses fewer hours overall, so it is more efficient.

 

 

+ specialisation from each county means that they can make a competitive  advantage as they can produce what they are good at

 

 

 

Tariffs

• Often politically motivated

e.g. US Car Industry

• Trade wars

• Gains from trade

Ricardo’s comparative advantage

• Tariffs for:

infant industries

strategic industries

 

 

 

Tax havens

• Tax competition

• Tax avoidance (legal and illegal)

• Tax havens and Dutch disease

 

 

What is tax competition

  • Different jurisdictions have different rules on tax

• The ability to tax is curtailed by outside options

• Implicit assumption

Governments do not allocate resources as efficiently as

private consumers and firms do

• Free-riding problems

 

 

What is tax avoidance

• Legally acceptable tax avoidance

Reduces tax revenue

Diverts resources into financial sector aimed at reducing

tax payments

• Cash economy and under-reporting

Post Covid?

• Money laundering

Creates compliance costs for everyone