Transcript The Role of Government

The Role of Government
Chapter 10
Tax Policy
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In 2003, Budget Speech the financial
secretary announced the salaries and
corporate profits taxes would be raised by up
to 1% and 2% respectively.
What are the reasons for such a rise and what
are the implications?
The government believes that it must raise
taxes to eliminate the operational budget
deficit.
Students Should Be Able To:
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Analyze distortions in the economy generated
by taxes.
Explain the Laffer curve.
HK Spending by Category
1998/99
Community Affairs
3%
Support
11%
District and
Community
Relations
1%
Recreation, Culture
and Amenities
3%
Economic
8%
Social Welfare
10%
Others
1%
Education
17%
Internal Security
7%
Immigration
1%
Environment
2%
Infrastructure
9%
Housing
15%
Health
12%
30
%
Government Expenditure (%GDP) 2000
60
50
40
20
10
US
UK
Sweden
Spain
Portugal
Poland
Norway
New Zealand
Netherlands
Luxembourg
Korea
Japan
Italy
Ireland
Iceland
Hong Kong
Greece
Germany
France
Finland
Denmark
Czech Rep
Canada
Belgium
Austria
Australia
0
Sources of Revenue
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Direct Taxes: Taxes on Income such as
Corporate Profits, Salary, Estate Taxes
Indirect Taxes: Taxes on Spending, Gambling
Revenues, Stamp Duties, Motor Vehicle
Registration Fees
Fees for Service
Investment Income
Sources of Revenue for Hong Kong
Funds
16%
Direct Tax
35%
Investment Income
15%
Fees and Charges
5%
Miscellaneous
11%
Indirect Tax
18%
Why do we have government?
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For economic activity, marketplace is the baseline
allocation mechanism. Government may step in
when market (arguably) fails.
Types of market failure
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Public Goods: Goods whose shared benefits cannot be
charged for including police, fire services, national
defense.
Externalities: Some goods may produce costs or benefits
not borne by the purchasers including parks, tourist sites
or pollution (negative externalities).
Coordination Failure: Some systems may work well only
if everyone uses them the same way, i.e. traffic.
Social Insurance
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Individuals in a society face certain risks such as
unemployment or poor health or long life which are
unpredictable at individual level but predictable at a
social level.
Various risks may be uninsurable in private markets
due to imperfect information. Example: Lazy people
might be most likely to buy unemployment
insurance, preventing insurance companies from
making a profit.
Government often will offer social insurance.
Expenditures: Transfer Payments vs.
Government Consumption
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Economists think its important to classify
government expenditures into two categories.
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Government consumption is spending on actual
goods and services
Transfer Payments are payments to individuals
for welfare or other social purposes which does
not require the recipients to offer anything of
value to the government.
HK September 2002
Categories of Government Expenditure
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Government Consumption
Transfer Payments
% of Expenditure
Tax Distortions
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Taxes are necessary to raise revenues for
public goods. Taxes reduce ability of
taxpayers to consume private goods.
Taxes also have distortionary effects which
may affect the quantity of goods produced and
result in a loss of efficiency for economic
allocation.
Capital and the Tax Wedge
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An increase in the tax wedge (the excess taxes
paid on investing in capital equipment)
increases the cost of capital and reduces
optimal capital.
The difference between the marginal product
of capital and the cost of capital is the
economic surplus value of the capital
The value of the efficiency loss for the
economy is specified by the triangle.
MPK
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r    g p  tw p K
K
r    g  p
pK
Distortion
K
K**
K*
K
Tax Distortions
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The size of tax distortions grows faster than the size
of the tax rate.
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Intuition: Diminishing Marginal Returns. Small tax
wedges eliminate only those investment projects which
are slightly more profitable than the cost of capital. The
larger the tax rate, the more valuable will be the projects
that are eliminated.
Simple models assume that distortions are
proportional to the square of the tax wedge.
Two implications
1.
2.
“Laffer Curve”
Tax Smoothing
MPK
r    g

Original
Distortion
K**

K

K*

 2tw p K
r    g p  tw p K
r   g p
K
K***
pK
K
p
K
Laffer Curve
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Revenue generated is not monotonically increasing in the tax
rate.
Mental experiment.
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Consider if tax rate on investing in physical capital were 0%. This
would generate no revenues.
Consider if the tax rate were 100%. No one would invest in capital
and capital taxation would generate zero revenues. Cutting taxes a
little would generate more revenue.
Laffer Curve represents relationship between tax rates and
total revenue.
Most economists believe that all developed economies are on
the left-hand side of the Laffer Curve.
Laffer Curve
Revenues
Tax
Rate
Tax Smoothing
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Distortions increase rapidly in the size of the distortionary tax
rate. This means that it is better to have a smooth tax rate over
time.
Example. Distortions are proportional to the square of tax
wedge. Distortion = A∙tw2. Consider the government chooses
tax wedges in two periods, periods zero and 1.
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Choice 1. tw0 = 0 and tw1 = .02.Atw0  Atw1  A 02  .022   A .0004
 2
2
2
Average Distortion
Choice 2. tw0 = 0 and tw1 = .02Atw2  Atw2 A
A
2
2
0
1
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
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.01

.01

Average Distortion
 2 .0002
2
2
2
2
Both choices produce the same average tax wedge, but the
smooth tax wedge produces a lower average distortion (and
more revenue).
Tax Policy
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Government should raise revenues from “inelastic”
activities. These have low distortions since taxes
have little effect on economic behavior.
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Consumption may be less elastic than investment
suggesting it may be more efficient to impose a
Government should distinguish between average tax
rates and marginal tax rates. Marginal tax rates are
taxes on marginal activity which affect activity. Poll
taxes may not cause inefficiency.
Problem: Most efficient types of taxes demand equal
payments from rich and poor people. Is this fair?