• Three ways of raising government revenue:

  • Taxing

  • Borrowing

  • Create money

• The principles of taxation can be divided into two general categories:

  • Positive principles of taxation: analyze who bears the burden of taxes and what other economic effects can be expected to result from the imposition of taxes.

  • Normative principles of taxation: how tax policy can be used to design as desirable a tax system as possible.

• Unit tax: a tax charged per unit of a good exchanged.

  • Ad valorem taxes: based on the dollar value of the goods sold.

• Retail sales tax: taxes calculated as a percentage of retail sales, a type of ad valorem tax.

  • Excise tax: taxes placed on particular types of goods, can be either unit or ad valorem.

• Tax incidence: the ultimate burden of the tax, after shifting has taken place.

• The more elastic a supply or demand schedule is, the greater the proportion of the tax that can be shifted to the other side of the market.

• Welfare cost of taxation or excess burden or deadweight loss: all the exchanges that could be made, but are not made, because of a tax.

  • Arises because the tax payers not only must pay the tax to the government, but also will alter their behavior in response to a tax to avoid it to some degree.

  • For a tax to have no excess burden, there must be no substitution effect.

• Lump sum tax: a tax that completely eliminates the excess burden of taxation.

• Ramsey rule states that to minimize the excess burden of taxation, taxes should be placed on goods in inverse proportion to the elasticity of demand for the goods.

• Costs associated with the tax system:

  • Compliance costs: the costs imposed on taxpayers to comply with the tax laws, such as collecting and keeping records.

  • Administrative costs: home by the government to collect taxes.

  • Political cost: home by the taxpayers and the government as a result of taxpayers trying to influence tax laws.

• Earmarked taxes: taxes whose revenues are designated to a particular spending activity.

  • General fund financing: the tax revenues are placed in the general fund, from which government programs are financed. The alternative to earmarking.

Conclusion

• The principles of taxation can be divided into two general groups: positive and normative.

• Positive principles of taxation examine the effects of taxes on individuals and the economy.

• Two important positive principles of taxation are tax shifting and the welfare cost of taxation.

  • Tax shifting refers to who ultimately bears the burden of a tax.

    • Taxes initially placed on one group can be shifted through the market so that they end up being home by another group.

    • When a tax is placed on a particular market, the ratio of the tax ultimately home by the demanders or suppliers is equal to the ratio of the slope of the demand curve to the slope of the supply curve.

  • The welfare loss of taxation, also called the excess burden or deadweight loss of taxation, is the cost a tax places on the economy over and above the tax revenues collected.

    • In addition to collecting revenue, a tax gives people an incentive to alter their behavior to reduce the amount of tax they pay.

    • When people substitute out of taxed activities, this generates a welfare loss. The less people are willing to substitute out of a taxed activity, the smaller will be the excess burden of taxation.

    • Therefore, the excess burden of taxation can be minimized by placing higher taxes on goods with relatively inelastic supplies or demands.

• Other positive principles of taxation, such as earmarking of taxes and compliance, administration, and political costs, are also relevant to the evaluation of specific taxes.

  • Thus, these positive principles of taxation will be applied to the analysis of specific taxes when they are discussed in upcoming chapters.

  • The general principles of taxation discussed in this chapter serve as a foundation for understanding the details of particular taxes that are used in the economy.

  • The costs of raising tax revenues are significant as a percentage of the revenues raised, and one of the goals of the tax system is to be as efficient as possible by minimizing the welfare costs of taxation.

• Positive principles give us a good foundation for analyzing the tax system, but they only tell us about the effects of taxes.

• Tax systems are designed not only to raise revenue efficiently but also to raise it fairly. Thus, equity in taxation is an important issue.

• The fairness of a tax system can only be evaluated once the actual effects of a tax are understood.

  • For example, we might arrive at very different conclusions about the fairness of a tax if we did not take account of the fact that the group that bears the burden of a tax might not be the group upon whom the tax is initially placed.

• The next chapter extends the theme of this chapter by examining normative issues related to tax system is a product of human design, through our political institutions.