Transcript Lecture 1: Introduction

L11200 Introduction to Macroeconomics 2009/10
Lecture 21:
Taxation
Reading: Barro Ch.13
18 March 2010
Summary
• Last time: introduced topic of government
expenditure
– Large proportion of GDP and employment
– Spent on transfer payments and activities
– Offsets private consumption
• Today: understanding tax structures
– More realistic structures than a lump-sum tax
Lump-Sum Taxation
• Last week modelled taxation as a lump-sum
transfer to the government
C1  C2 / (1  r1 )  ...  (1  r0 )  ( B0 / P  K0 )  (w / P)1  L  (w / P)2  L / (1  r1 )  ...
s
1
s
2
(Vt  T1 )  (V2  T2 ) / (1  r1 )  (V3  T3 ) /[(1  r1 )  (1  r2 )]  ...
• Each period households paid T and (maybe)
received V, irrespective of current income or
wealth
Forms of Taxation
• In reality, taxation takes two forms: income tax
and asset income tax
• Income tax: tax paid on earned income from
employment
• Asset income tax: tax paid (per annum) on
value of asset income gained by the
household
• Two forms have different implications for
household behaviour
Income Taxation
• IFS SLIDE ON MARGINAL TAX RATES
Modelling Income Tax
• Household budget constraint:
C  (1/ P)  B  K  (w / P)  Ls  r  ( B / P  K )  V  T
• Now assume that tax is taken in proportion to
income.
• Tax rate τ, so every extra unit of income
earned raises net income by (1-τ)
Substitution and Income Effects
• Taxing income affects labour supply decision
– Hour of work now yield less income, so negative
substitution effect (encourages leisure)
– Less overall income causes negative income effect,
households demand less leisure / consumption
and so work more
– Plus, income effect is offset if additional tax is
used to increase transfer, V
– So net effect likely to increase leisure
Effect on factor inputs
• Less labour supply means MPK also falls
– Labour and capital combined in production via
Cobb-Douglas production function
– So fall in labour supply causes MPL to increase
(wage increase)
– But causes MPK to fall as capital-labour ratio now
increased
– Fall in MPK reduces demand for capital services
Effect on Output
• Income tax reduces supply of labour and
demand for capital services
– So overall production in the economy falls
– Lower output produced in current and future
periods
– Hence taxation isn’t neutral (as in the case of a
lump-sum tax), it does influence the production
decision.
Tax on Asset Income
• Tax levied on income arising from asset
returns
C  (1/ P)  B  K  (w / P)  Ls  r  ( B / P  K )  V  T
• Now income earned from bond / capital
holdings is taxed at rate τ
• So after-tax real interest rate is (1   )  r
• So households have incentive to defer
consumption
Effect on factor inputs
• But does taxing asset income also affect factor
inputs?
– New return on capital investment:
(1   )  r  (1   )   R / P      ( ) 
after-tax real interest rate = after-tax rate of return on ownership capital
– So households now seek to maximise this
modified return when making capital investment
decisions
Effect on factor inputs
• Modifying return to capital supply leaves
optimal supply unchanged
– MPK remains the same, so demand for capital
services as before
– Modified capital income expression implies no
change to optimal κ, so utilisation also unchanged
– Households employ the same capital services as
before
Effect on Output
• Asset income tax does not change output
decision
– But does encourage households to bring
consumption forward
– Higher consumption now means lower
investment, so lower long-run growth
– Effect of asset income tax is to reduce GDP in the
long-run
Which is better?
• Which form of taxation is to be preferred?
– Income taxation lowers output permanently
– Asset income taxation reduces investment in the
short-run and output in the long-run
– i.e. asset income taxation similar to a
consumption tax which taxes future consumption
more heavily
Summary
• Taxing the return to factor inputs alters the
decision about how much of those inputs to
use
– Taxation labour income discourages labour supply
– Taxing asset income discourages investment
– Lump-sum taxation created neither of these
distortions, but taxed individuals irrespective of
their wealth
– So trade-off between efficiency and equity
Summary
• Taxation is not ‘neutral’:
– Money neutrality: changing money supply has no
effect on real activity
– Tax non-neutrality: taxing income / asset returns
does affect real activity
• Next time:
– Governments tax and spend, but also have debt
– Consider the ‘public budget’