Definition: An excise tax is a per unit tax levied on the sale of specific goods or services.
Examples:
- Gasoline: federal excise tax of $0.10 per liter.
- Fuel-inefficient automobiles: excise tax of $4,000 for cars consuming 16 liters or more per 100 km.
Effects of Excise Taxes on Prices and Quantities
Excise taxes lead to:
- An increase in the price paid by buyers.
- A decrease in the price received by sellers.
- The creation of a wedge between the price buyers pay and the price sellers receive.
- A reduction in the equilibrium quantity supplied and demanded.
Supply and Demand Graph
Understand the concept through a supply and demand graph:
- S = Supply Curve
- S₁: Original supply curve before the tax indicates the quantity producers are willing to supply at various prices.
- S₂: New supply curve after tax, shifted upward, requiring a higher price to supply the same quantity due to the tax per unit.
- D = Demand Curve
- D₁: Original demand curve before tax indicates the quantity consumers are willing to buy at various prices.
- D₂: New demand curve after tax, shifted downward, as consumers effectively face a higher price due to the tax.
Tax Incidence
Definition: Tax incidence measures who ultimately bears the burden of the tax.
Principles of Taxation:
- The incidence depends inherently on the shapes of the supply and demand curves, specifically their elasticities, rather than who officially pays the tax.
- When the price elasticity of demand is higher than the price elasticity of supply, consumers bear more of the burden.
- Conversely, when the price elasticity of supply is higher than the price elasticity of demand, producers bear more of the burden.
Payroll Taxes in Canada
Payroll taxes are deducted from employee paychecks for social programs like the Canada Pension Plan (CPP) and Employment Insurance (EI).
Employers also contribute equal amounts to employee CPP and 1.4 times the amount contributed to EI.
The burden of payroll taxes typically falls on workers, leading to lower wages, rather than increasing employer profits.
Revenue from Excise Tax
The general principle states that total revenue from an excise tax equals the area of the rectangle formed by the tax wedge (height) multiplied by the quantity sold (width).
Question: Does doubling the excise tax rate double revenue?
- Conclusion: Usually no, because an increase in tax raises prices and reduces the quantity sold, potentially lowering overall revenue.
The Laffer Curve
Theoretical Proposition: Initially, increasing tax rates raises revenue, but beyond a certain point, additional increases can lead to a decline in revenue due to reduced transaction volume.
As tax rates rise excessively, the reduction in transactions will diminish tax revenue.
Effects on Surplus: Higher prices decrease consumer surplus, while lower prices increase it—taxation decreases both consumer and producer surpluses, leading to a net loss in total surplus.
Deadweight Loss and Efficiency Costs of Taxes
Taxes create deadweight loss, representing the loss in total surplus within society that arises from reduced transactions, as some trades that would have occurred in a tax-free environment do not take place.
Administrative Costs: The costs associated with collecting taxes are incurred both by the government and taxpayers, exceeding the net amount collected.
Total Inefficiency: Calculated as the sum of deadweight loss and administrative costs. Tax systems should aim to minimize these inefficiencies.
Minimization of Efficiency Costs
Minimize inefficiencies by targeting taxes towards goods with relatively inelastic demand or supply.
- Extreme Cases:
- A perfectly inelastic demand curve results in no deadweight loss.
- A perfectly inelastic supply also avoids deadweight loss.
Principles of Tax Fairness:
- Benefit Principle: Those who benefit from public spending should also bear the tax burden corresponding to that benefit (e.g., gas taxes for infrastructure improvements).
- Ability to Pay Principle: Taxpayers should contribute according to their ability to pay.
- Lump-sum taxes are considered efficient but unfair as they are uniform irrespective of individuals' circumstances.
A well-designed tax system represents a trade-off between equity and efficiency.
Federal Tax Philosophy
The income tax constitutes approximately half of federal revenue, with government transfer payments functioning similarly to a negative tax rate (e.g., old age security, child benefits).
Structure of Tax Systems
Components:
- Tax Base: The value of assets over which a tax can be applied.
- Tax Structure: Defines how tax rates are computed based on the tax base.
Major types of taxes:
- Income Tax: Based on individual or family income.
- Payroll Tax: Based on wages paid by employers to employees.
- Sales Tax: Based on the value of goods sold.
- Profits Tax (Corporate Income Tax): Based on firm profits.
- Property Tax: Based on the value of owned property.
Tax Rate Types
Proportional Tax: Fixed tax rate.
Progressive Tax: Increases with income, taking a larger share from high-income earners.
Regressive Tax: Decreases with income, resulting in low-income earners paying a larger share.
Marginal Tax Rate: The percentage of an increase in income that will be taxed.