7.

0 TAX INCIDENCE

General objective

By the end of the lesson the learner should be able to explain the meaning and implications
of tax incidence

Specific objectives

By the end of the lesson the learner should be able to

a) explain the meaning tax incidence

b) explain tax incidence in the case of inelastic supply and elastic demand

c) explain tax incidence in the case of elastic supply and elastic demand

d) explain tax incidence in the case of inelastic demand and elastic supply

e) graphically illustrate tax incidence

f) explain the macroeconomic perspective on tax incidence

7.1 Introduction

In economics, tax incidence is the analysis of the effect of a particular tax on the distribution of
economic welfare. Tax incidence is said to "fall" upon the group that, at the end of the day, bears
the burden of the tax. The key concept is that the tax incidence or tax burden does not depend on
where the revenue is collected, but on the price elasticity of demand and price elasticity of
supply.

Initially, the incidence of all labour related taxes such as income tax contributions falls on
employers. This must be so at the margin since the employee must receive more net of tax ie
take-home than they can receive from the alternative, such as welfare benefit payments. The tax
surcharge may be as high as 80%.

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In that all business taxes reduce profitability, and in accordance with the principles set out by the
Physiocrats, they reduce the amount of rent that the business can pay and thus the incidence falls
on the landowner. The land owner may be the business itself but the effect is to cut into that part
of the revenue stream that consists of land rental value. A secondary effect is that locations,
where, in the absence of tax land values would be low, become sub-marginal when the taxes are
imposed ie viable economic activity cannot take place at those locations.

7.2 Illustration of tax incidence

Imagine a sh1 tax on every barrel of apples an apple farmer produces. If the product (apples) is
price inelastic to the consumer (whereby if price rose, a small demand loss would be accounted
for by the extra revenue), the farmer is able to pass the entire tax on to consumers of apples by
raising the price by sh 1. In this example, consumers bear the entire burden of the tax; the tax
incidence falls on consumers. On the other hand, if the apple farmer is unable to raise prices
because the product is price elastic (if prices rose, more demand would be lost than extra revenue
gained), the farmer has to bear the burden of the tax or face decreased revenues: the tax
incidence falls on the farmer. If the apple farmer can raise prices by an amount less than sh 1,
then consumers and the farmer are sharing the tax burden. When the tax incidence falls on the
farmer, this burden will typically flow back to owners of the relevant factors of production,
including agricultural land and employee wages.

Where the tax incidence falls depends (in the short run) on the price elasticity of demand and
price elasticity of supply. Tax incidence falls mostly upon the group that responds least to price
(the group that has the most inelastic price-quantity curve). If the demand curve is inelastic
relative to the supply curve the tax will be disproportionately borne by the buyer rather than the
seller. If the demand curve is elastic relative to the supply curve the tax will be born
disproportionately by the seller. If PED = PES the tax burden is split equally between buyer and
seller.

7.2.1 Inelastic supply, elastic demand

Because the producer is inelastic, he will produce the same quantity no matter what the price.
Because the consumer is elastic, the consumer is very sensitive to price. A small increase in price

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leads to a large drop in the quantity demanded. The imposition of the tax causes the market price
to increase from P without tax to P with tax and the quantity demanded to fall from Q without
tax to Q with tax. Because the consumer is elastic, the quantity change is significant. Because the
producer is inelastic, the price doesn't change much. The producer is unable to pass the tax onto
the consumer and the tax incidence falls on the producer. In this example, the tax is collected
from the producer and the producer bears the tax burden. This is known as back shifting.

7.2.2 Elastic supply and demand

Most markets fall between these two extremes, and ultimately the incidence of tax is shared
between producers and consumers in varying proportions. In this example, the consumers pay
more than the producers, but not all of the tax. The area paid by consumers is obvious as the
change in equilibrium price (between P without tax to P with tax); the remainder, being the
difference between the new price and the cost of production at that quantity, is paid by the
producers.

7.2.3 Inelastic demand, elastic supply

Because the consumer is inelastic, he will demand the same quantity no matter what the price.
Because the producer is elastic, the producer is very sensitive to price. A small drop in price
leads to a large drop in the quantity produced. The imposition of the tax causes the market price
to increase from P without tax to P with tax and the quantity demanded to fall from Q without
tax to Q with tax. Because the consumer is inelastic, the quantity doesn't change much. Because
the consumer is inelastic and the producer is elastic, the price changes dramatically. The change
in price is very large. The producer is able to pass (in the short run) almost the entire value of the
tax onto the consumer. Even though the tax is being collected from the producer the consumer is
bearing the tax burden. The tax incidence is falling on the consumer, known as forward shifting.

7.2.4 Graphical illustration of tax incidence

Inelastic supply, elastic demand: the burden is on producers

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Inelastic supply, elastic demand: the burden is on producers

Similar elasticities: burden shared

Inelastic demand, elastic supply: the burden is on

consumers

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7.3 Macroeconomic perspective of tax incidence

The supply and demand for a good is deeply intertwined with the markets for the factors of
production and for alternate goods and services that might be produced or consumed. Although
legislators might be seeking to tax the apple industry, in reality it could turn out to be truck
drivers who are hardest hit, if apple companies shift toward shipping by rail in response to their
new cost. Or perhaps orange manufacturers will be the group most affected, if consumers decide
to forgo oranges to maintain their previous level of apples at the now higher price. Ultimately,
the burden of the tax falls on people—the owners, customers, or workers.

However, the true burden of the tax cannot be properly assessed without knowing the use of the
tax revenues. If the tax proceeds are employed in a manner that benefits owners more than
producers and consumers then the burden of the tax will fall on producers and consumers. If the
proceeds of the tax are used in a way that benefits producers and consumers, then owners suffer
the tax burden. These are class distinctions concerning the distribution of costs and are not
addressed in current tax incidence models. The US military offers major benefit to owners who
produce offshore. Yet the tax levy to support this effort falls primarily on American producers
and consumers. Corporations simply move out of the tax jurisdiction but still receive the
property rights enforcement that is the mainstay of their income.

Summary of The Topic

Illustration of tax incidence
Inelastic supply, elastic demand
Elastic supply and demand
Inelastic demand, elastic supply
Graphical illustration of tax incidence
Macroeconomic perspective of tax incidence

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 Revision Questions
i. Explain the meaning tax incidence
ii. Explain tax incidence in the case of inelastic supply and elastic demand
iii. Explain tax incidence in the case of elastic supply and elastic demand
iv. Explain tax incidence in the case of inelastic demand and elastic supply
v. Graphically illustrate tax incidence
vi. Explain the macroeconomic perspective on tax incidence

Further References
i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P
Limited, Delhi India Pages 45-56
ii. H.L Bhatia (2004) Public Finance. Vikas Publishing Housepvt Limited, New Delhi India
Pages 90-121
iii. Musgrave (2005) Public Finance In Theory And Practice, Tata McGraw-Hill New Delhi
Pages 249-270

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 8.0 TAXATION AND EFFICIENCY

General objective

By the end of the lesson the learner should be able to explain efficiency in taxation

8.1 Introduction

Adam Smith was the first economist who laid down four important canons of taxation which are
the efficiency principals/canons of taxation to which were added few more by subsequent
economists.

8.2 The efficiency principals of taxation

1. The canon of equality

2. The canon of certainty
3. The canon of convenience
4. The canon of economy
5. The canon of productivity
6. The canon of elasticity
7. The canon of flexibility
8. The canon of simplicity
9. The canon of diversity

1. The canon of equality

The canon of equality, equity or justice is the most important canon of taxation. Smith explained
it thus: "The subjects of every state ought to contribute towards the support of the government, as
nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue
which the respectively enjoy under the protection of the State." It means that every person should
pay the tax according to his ability and not he same amount. It also means that everybody

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should not pay at the same rate. Rather, every taxpayer should pay the tax in proportion to his
income. The rich should pay more and at a higher rate than the other person whose income is
less. Thus this canon implies equality of sacrifice or ability to pay the tax n proportion to the
income of the taxpayer.

2. The canon of certainty

According to smith, there should be certainty in taxation because uncertainty breeds corruption.
By the canon of certainty he mans that "the tax which each individual is bound to pay ought to be
certain, and quantity to be paid ought all to be clear and plain to he contributor and to every other
person." Thus this canon requires that there should be no element of arbitrariness in a tax. It
should be clear to every taxpayer as to what, when, and where the tax is to be paid. Nothing
should be left to the direction of the income tax department. Certainly also means that the state
should also be certain about the amount of tax revenue and the time when it is expected to flow
in the exchequer.

3. The canon of convenience

This canon lays down that both the time an manner of payment should be convenient to the
taxpayer. In the words of smith, "Every tax ought to be levied at the time or in the manner in
which it is most likely to be convenient for the contributor to pay." In India, the payment of land
revenue is in keeping with this canon because it is to be paid after harvesting. Similarly, the
payment of sales tax and excise duty by the consumer is also convenient because he pays these
taxes when he buys commodities and at a time when he has the means to buy. The manner of
payment is very convenient to him because these taxes are included in the prices of commodities.

4. The canon of economy

Every tax should satisfy the canon of economy in two ways. First, it should be economical for
the state to collect it. if the cost of collection in the form of salaries of tax officials is more that
what the tax brings as revenue, such a tax is uneconomical, and hence it should not be levied.
Second, it should be economical to the taxpayer. It means that he should have sufficient money
left with him after paying the tax. A very heavy tax on incomes will discourage saving and
investment, and thus adversely affect the productive capacity of the community. Smith states

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this canon in these words: "Every tax ought to be so contrived as both to take out and to keep out
of the pockets of the people as little as possible, over and above what it brings into the public
treasury of the state."

5. The canon of productivity

According to this canon, a tax should be productive in the sense that it should bring large
revenue which should be adequate for the government. But it does not mean that in its efforts to
raise more revenue, the government should tax the people heavily. Such an effort would
adversely affect the productive capacity of the economy. Further, this canon implies that one tax
which brings large revenue is better than a number of taxes which bring small revenue. Many
taxes may not be productive. They may also be uneconomical

6. The canon of elasticity

This canon is closely related to that of productivity. The canon of elasticity requires that the
government should be able to raise the rates of axes when it is in need of more revenue. In other
words, taxes should be elastic. The best example is excise duties. They can be levied on any
number of commodities and their rates can be increased every year in order to raise more
revenue. But care has to be taken that the rates of excise duties should not be so raised that they
may encourage inflationary pressures in the economy.

7. The canon of flexibility

Flexibility in taxation is different from elasticity. Flexibility means that there should be no
rigidity in taxation. The tax system can be changed to meet the revenue requirements of the state.
On the other hand, elasticity in taxation means that the revenues can be increased under the
prevailing ax system. But there cannot be any elasticity in taxation without flexibility because
some change is required in the rates and structure of taxes if the state wants to increase revenue.

8. The canon of simplicity

The tax system should be simple, plain and intelligible to the common taxpayer. The tax system
should not be complicated. It should be simple to understand as to how is it to be calculated and

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how much is it to be paid. The form/forms to be filled up for calculation and payment of a tax
should be simple and intelligible to the taxpayer. This canon is essential in order to avoid
corruption and oppression on the part of the tax department.

9. The canon of diversity

There should be diversity or variety in taxation. A single or a few taxes would neither meet the
revenue requirements of the state nor satisfy the canon of equity. There should, therefore, be a
variety of taxes so that all citizens should contribute towards the state revenues according to their
ability to pay. There should be a variety of direct and indirect taxes. But a large multiplicity of
taxes will be difficult to administer and hence uneconomical.

Summary Of The Topic

The efficiency principals of taxation

Revision Question
i. Explain taxation and efficiency
ii. Explain the efficiency principals of taxation

Further Refernces

i. M. L Jighan ( 2006), Public Finance And International Trade, Vrinda Publications P

Limited, Delhi India Pages 32-35

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 9.0 OPTIMAL TAXATION

General objective

By the end of the lesson the learner should be able to explain the various aspects of
optimal taxation

Specific objectives

By the end of the lesson the learner should be able to

a) explain the meaning of optimal taxation

b) Define optimal taxation theory

c) explain excess burden of taxation

d) explain factors determining the taxable capacity

e) explain the measurement of taxable capacity

10.1 Optimal tax Theory

Optimal tax theory is the study of how best to design a tax to minimize distortion and
inefficiency subject to raising set revenues through distortionary taxation. A neutral tax is a
theoretical tax which avoids distortion and inefficiency completely. Other things being equal, if a
tax-payer must choose between two mutually exclusive economic projects (say investments) that
face the same pre-tax risk and returns, the one with the lower tax or with a tax break would be
chosen by the rational actor. With that insight, economists argue that generally taxes distort
behavior.

For example, since only economic actors who engage in market activity of "entering the labor
market" get an income tax liability on their wages, people who are able to consume leisure or
engage in household production outside the market by say providing housewife services in lieu
of hiring a maid are taxed more lightly. With the "married filing jointly" tax unit in U.S. income
tax law, the second earner's income is placed on top of the first wage earner's taxable income and

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thus gets the highest marginal rate. This type of tax creates a large distortion disfavoring women
from the labor force during years when the couple have great child care needs.

The incidence of sales taxes on commodities also leads to distortion if say food prepared in
restaurants are taxed but supermarket bought food prepared at home are not taxed at purchase. If
the taxpayer needs to buy food at fast food restaurants because he/she is not wealthy enough to
purchase extra leisure time (by working less) he/she pays the tax although a more prosperous
person who say enjoys playing at being a home chef is more lightly taxed. This differential
taxation of commodities may cause inefficiency (by discouraging work in the market in favor of
work in the household).

9.2 Optimal taxation theory

Most governments take revenue which exceeds that which can be provided by non-distortionary
taxes or through taxes which give a double dividend. Optimal taxation theory is the branch of
economics that considers how taxes can be structured to give the least deadweight costs, or to
give the best outcomes in terms of social welfare.

The Ramsey problem deals with minimizing deadweight costs. Because deadweight costs are
related to the elasticity of supply and demand for a good, it follows that putting the highest tax
rates on the goods for which there is most inelastic supply and demand will result in the least
overall deadweight costs.

Some economists sought to integrate optimal tax theory with the social welfare function, which
is the economic expression of the idea that equality is valuable to a greater or lesser extent. If
individuals experience diminishing returns from income, then the optimum distribution of
income for society involves a progressive income tax.

9.3 Excess burden of taxation

In economics, the excess burden of taxation, also known as the distortionary cost or
deadweight loss of taxation, is the economic loss that society suffers as the result of a tax, over
and above the revenue it collects. It is assumed that distortions occur because people or firms
change their behaviour in order to reduce the amount of tax they must pay. Excess burdens can

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be measured using the average cost of funds or the marginal cost of funds (MCF). Excess
burdens were first discussed by Adam Smith.

An equivalent kind of inefficiency can also be caused by subsidies (that are actually taxes with
negative rates).

9.4 Measures of the excess burden

The cost of a distortion is usually measured as the amount that would have to be paid to the
people affected by its supply, the greater the excess burden. The second is the tax rate: as a
general rule, the excess burden of a tax increases with the square of the tax rate.

The average cost of funds is the total cost of distortions divided by the total revenue collected by
a government. In contrast, the marginal cost of funds (MCF) is the size of the distortion that
accompanied the last unit of revenue raised (ie, the rate of change of distortion with respect to
revenue). In most cases, the MCF increases as the amount of tax collected increases.

The standard position in economics is that the costs in a cost-benefit analysis for any tax-funded
project should be increased according to the marginal cost of funds, because that is close to the
deadweight loss that will be experienced if the project is added to the budget, or to the
deadweight loss removed if the project is removed from the budget.

9.5 Distortion and redistribution

In the case of progressive taxes, the distortionary effects of a tax may be accompanied by other
benefits: the redistribution of dollars from wealthier people to poorer people who could possibly
obtain more benefit from them.

In fact almost any tax measure will distort the economy from the path or process that would have
prevailed in its absence (land value taxes are a notable exception). For example a sales tax
applied to all goods will tend to discourage consumption of all the taxed items, and an income
tax will tend to discourage people from earning money in the category of income that is taxed
(unless they can manage to avoid being taxed). Some people may move out of the work force (to

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avoid income tax); some may move into the cash or black economies (where incomes are not
revealed to the tax authorities).

For example, in Western nations the incomes of the relatively affluent are taxed partly to provide
the money used to assist the relatively poor. As a result of the taxes (and associated subsidies to
the poor), incentives are changed for both groups. The relatively rich are discouraged from
declaring income and from earning marginal (extra) income, because they know that any
additional money that they earn and declare will be taxed at their highest marginal tax rates. At
the same time the poor have an incentive to conceal their own taxable income (and usually their
assets) so as to increase the likelihood of their receiving state assistance. It can be argued that the
distortion of incentives (the move away from a fiscally neutral stance that does not affect
incentives) does more harm than good.

Deliberate distortion

Here, the fiscal distortion is deliberate, so as to compensate for externalities. "Sin taxes" on
alcohol, tobacco, pornography, etc. may be levied so as to discourage their consumption. Such an
approach is often preferable to outright prohibition, since prohibition incites trafficking, often
resulting in crime and other social costs, but no revenue. Similarly, taxes such as a carbon tax,
may be levied on emission of pollutants, in order to encourage corporations to adopt cleaner
methods of production.

Fiscal Illusion

Fiscal Illusion is a public choice theory of government expenditure first developed by the Italian
economist Amilcare Puviani. Fiscal Illusion suggests that when government revenues are
unobserved or not fully observed by taxpayers then the cost of government is perceived to be less
expensive than it actually is. Since some or all taxpayers benefit from government expenditures
from these unobserved or hidden revenues the public's demand for government expenditures
increases, thus providing politicians incentive to expand the size of government.

Fiscal Illusion has been used to explain the flypaper effect often seen when a higher level of
government provides a grant to a lower level of government. Here, instead of reducing taxes in

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order to pass on the benefits of the grant to local taxpayers, the grant-receiving body increases
expenditures in order to expand local services in some way. Fiscal Illusion is invoked as an
explanation because the local taxpayers are under the mistaken perception that the grant is to
local government and not, in fact, to them.

Another example of fiscal illusion can be seen in local property tax politics. Here renters, who
pay local property taxes indirectly, may vote for an expansion of local government services.
Fiscal illusion theory suggests they support this policy because its cost is masked by its
roundabout nature (through an increase in their rent payments

9.6 Factors Determining Taxable Capacity

The taxable capacity of a country depends on the following factors.

Size of national income. Taxable capacity depends on the size of national income or wealth or
natural resources of a country and the extent to which they are developed. The higher the
national income, the higher the taxable capacity of a country, and vice versa.

Distribution of national income. In a country where there is inequality of income, taxable

capacity is high because the few rich can be taxed heavily. On the other hand, if there is equality
of income, the taxable capacity is relatively low because the government expenditure to uplift the
poor will be less.

Stability of income. In developed countries, the incomes of individuals are stable, the taxable
capacity is high. But where incomes are subject to fluctuations and are unstable, as in
underdeveloped countries, the taxable capacity is low.

Size and growth of population. If the size and growth rate of population are high, the per capita
income will be low. So the taxable capacity will also be low, and vice versa.

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Standard of living. If the standard of living of the people is high, it means that people are
spending more on comforts and luxuries. So their capacity to pay taxes is also high, and vice
versa.

Tax system. The type of tax system affects the taxable capacity. A progressive tax system has a
higher taxable capacity because it falls on higher income groups, as in the case of direct taxes on
incomes. On the other hand, regressive indirect taxes which fall heavily on low income groups
have low taxable capacity.

Sources of Revenue. Taxable capacity depends on the number of sources of revenue available to
the government. The greater the number of revenue sources that are productive, the higher the
taxable capacity, and vice versa.

Public expenditure. If public expenditure is meant to increase the welfare of the people, people
do not mind paying taxes. If the government spends money on unnecessary and unproductive
projects, people will not be willing to pay taxes. Thus taxable capacity is high for productive
public expenditure which increases national income, and vice versa.

Taxing and spending income. Taxable capacity depends on the manner and timing of both
taxing and spending income by the government. This involves compensatory spending and
compensatory taxation. Compensatory spending compensates for the fall in private investment
and increases output, employment and income. Compensatory taxation compensates for the fall
in private expenditure, compensates for the fall in private expenditure, saving or investment by
taxing the people. Both tend to increase economic activity and national income thereby raising
the taxable capacity.

Price situation. Taxable capacity is determined by the price situation in the country. If prices are
rising, the real income of the people falls and their taxable capacity declines. The converse is the
case when prices are falling.

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Organization of the economy. If the economy s primarily agricultural, the taxable capacity will
be low because the income from agricultural operations is uncertain. On the other hand, an
industrial economy has high taxable capacity because the industrial sector generates larger
income than the agricultural sector.

Psychology of the people. Taxable capacity also depends upon the psychology of the people.
People are prepared to more pay taxes honestly and willingly during a war and natural calamities
like floods, earthquakes, etc. As pointed out by Findlay Shirras, "the psychology of the people
has much to do with the extent of taxable capacity. People are often willing to bear heavier
taxation on patriotic or sentimental grounds. On the other hand, adverse psychology of the
people has much to do with the extent of taxable capacity. People are often willing to bear
heavier taxation patriotic or sentimental grounds. On the other hand, adverse psychology of the
people towards the payment of the taxes lowers down the taxable capacity.

Political conditions. What should be the level of taxation is a political factor these days. A
country with has political stability, its taxable capacity will be high if there is political instability
or the government is unsympathetic and repressive, the taxable capacity will be low.

Conclusion. Thus the taxable capacity of a country depends upon a number of factors. These
factors change from time to time and so does the taxable capacity.

9.7 Measurement Or Limit Of Taxable Capacity

Colin Clark gives a limit of taxable capacity of a country. According to him, "The safe upper
limit of taxation is 25 per cent of national production. "Thus he takes 25 per cent of national
income. If the level of taxation exceeds this limit, it will adversely affect production and
incentive to work, save and invest. Further, a high level of taxation will lead to increase in wages
and to a rise in prices. All these factors will reduce national income. Colin Clark places this limit
for advanced counties.

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Taxable capacity
But Kaldor does not agree with Colin Clark. He suggests a different limit for different types of
taxes. According to him, a particular tax up to 10 per cent of national income may be a heavy
burden on people and another tax of 25 per cent may not be a burden. For instance, and income
tax up to 10 per cent of national income may adversely affect incentive to work, save and invest.
On the other hand, an expenditure tax of 10 per cent or more will increase production rather than
retard it. People will not spend extravagantly. They will reduce wasteful expenditures. They will
save and invest and productions will not e adversely affected.

However, most governments have accepted Clark's 25 per cent limit of taxable capacity. But the
followers of Kaldor persist that 25 per cent should not be the limit for taxes on incomes.

Summary of The Topic

Optimal tax Theory
Optimal taxation theory
Excess burden of taxation
Measures of the excess burden
Distortion and redistribution
Factors Determining Taxable Capacity
Measurements Or Limit Of Taxable Capacity

Revision Questions
i. Explain the meaning of optimal taxation
ii. Explain the meaning of optimal taxation theory
iii. Explain excess burden of taxation
iv. Explain factors determining the taxable capacity
v. Explain the measurement of taxable capacity

89
Further References
i. Musgrave (2005) Public Finance In Theory And Practice, Tata Mcgraw-Hill New Delhi
Pages 277-295
ii. David N Hyman (2005) Public Finance, A Contemporary Application Of Theory To
Policy Thomson Learning,Ohio Usa Pages 427-460
iii. John Quigley, E. Smolensky (1994) President And Fellows Of Havard University Usa
Pages 247-280
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