Transcript Tax Revenue

Lecture 6
Chapter 11: Fiscal Policy and the
Federal Budget
Naveen Abedin
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Every government has a budget. The
Government of Bangladesh releases a budget
every year.
http://www.mof.gov.bd/en/index.php?option
=com_content&view=article&id=268&Itemid
=1
Every federal budget has two parts –
Government Expenditures/Government
Spending and Tax Revenues
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The government imposes taxes and fees that
generate revenue
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Progressive Income Tax: Tax rate increases as a
person’s taxable income increases. For Example, in Year
1, your annual income is Tk. 2 lakh, and the income tax
rate charged on your income is 10%. In Year 2, your
annual income increases to Tk. 3 lakh, and as a result,
your income tax rate also increases to 15%.
Bangladesh maintains a progressive tax rate system:
First 1,65,000/- Nil
Next 2,75,000/- 10%
Next 3,25,000/- 15%
Next 3,75,000/- 20%
Rest Amount 25%
http://www.asiatradehub.com/bangladesh/tax.asp
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Proportional Income Tax/Flat Tax: The same
tax rate is used for all income levels, i.e. the
rate of tax is constant. If proportional income
tax rate is 10%, then you pay 10% income tax,
whether your income is TK. 1 lakh or TK. 10
lakh per year.
Regressive Income Tax: The tax rate
decreases as a person’s taxable income level
rises. In Year 1, your annual income was TK.
2 lakh, and your tax rate was 10%. In Year 2,
your annual income increased to TK. 3 lakh,
but your tax rate has decreased to 8%.
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The government budget can be in one of
these three states:
1) Budget Deficit: Government expenditures
are greater than tax revenue
2) Budget Surplus: Tax revenues are greater
than government expenditures
3) Balanced Budget: Government expenditures
equal tax revenues
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When the government is in a budget deficit,
it means the government has to borrow
funds.
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Total Deficit = Structural Deficit + Cyclical Deficit
 Structural deficit exists in an economy when the
economy is operating at full employment
 Cyclical Deficit occurs due to a downturn in economic
activity. Initially the government is maintaining a
balanced budget, i.e. GE = TR. If the economy falls
into a sudden recessionary gap then Real GDP will fall
and two effects will happen:
1)
Tax revenue will fall (consumption, investment all
falls)
2)
Government transfer payments will rise (more
unemployment benefits)
As a result government expenditure will rise and tax
revenue will fall, changing the budget from
balanced to a deficit.
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When the government is in a budget deficit, it
has to borrow from different sources. Public
debt/National debt/Federal debt is the
amount that the federal government owes to
its creditors.
Creditors are other governments,
development agencies, etc. from whom the
government has taken money as loan.
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1)
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b.
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Value-Added
Value added is the difference between what a
producer sells a final good for and what it pays for
an intermediate good.
A farmer gets some free wheat seeds from a
government agricultural agency. He plants the
seeds and harvests wheat.
He then sells his wheat for $1 to a baker.
Therefore:
Sold final good for : $1
Bought intermediate good for : $0
Value Added = Selling price for final good – Buying
price for intermediate good
Value-Added = $1 - $0 = $1
Farmer gets to keep: $1
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1.
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1.
2.
Value-Added (cont.)
The baker bought the wheat from the farmer for
$1, and used it to bake bread.
He sells his bread for $1.4.
Value added = $1.4 - $1 = $0.4
He gets to keep $0.4
There are two important points to notice about
value-added
The sum of the values added is equal to the price
paid by the consumer for the bread.
Value-added at each stage is equal to the profit
or residual that the producer gets to keep
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2) Tax
 VAT is tax applied to the value added at each
stage of production. Suppose VAT is 10%, this
means that 10% VAT is applied on the $1
value addition made by the farmer, and 10%
VAT is applied on the $0.4 value addition
made by the baker. Total VAT is equal to $0.1
+ $0.04 = $0.14.
 When VAT is introduced into the picture, the
sellers respond accordingly by changing the
price of sales.
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Since the farmer has to pay $0.1 tax to the
government on the wheat he sells to the baker, he
will shift this tax over to the baker by charging him
$1.10 instead of $1 for the wheat.
The baker now has to pay $1.1 to the farmer for the
wheat, and a VAT of $0.04 to the government. He will
try to shift this increase in cost of production and the
VAT to the consumers. The total price he charges
consumers for his bread is $1.4 + $0.1 + $0.04 =
$1.54
Although VAT is charged to producers at each step of
sales, producers simply shift this tax to consumers in
the form of higher prices. Hence VAT is also known
as a sales tax.
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This is the use of Government Expenditures and
Tax Revenue to achieve economic stability,
reduce unemployment and promote economic
growth.
Expansionary Fiscal Policy: Government
expenditures are up and/or taxes are down
Contractionary Fiscal Policy: Government
expenditures are down and/or taxes are up
Discretionary Fiscal Policy: When the government
deliberately/intentionally brings about changes
in expenditure and taxes, fiscal policy is
discretionary.
Automatic Fiscal Policy: When changes in
expenditures or taxes occur automatically in
response to economic situations.
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Fiscal policy that affects aggregate demand
through changes in Government Purchases
(G) and Taxes (T) is known as Demand-Side
Fiscal Policy
AD = C + I + G + NX
If G increases, AD increases (rightward shift)
If taxes(T) increases, that affects both C and I
negatively, causing AD to decrease (leftward
shift).
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Keynesian economists believe that the economy is not selfregulating. So if it in a recessionary gap, then it will need the
help of the government to return to long-run equilibrium.
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Crowding out is a decrease in private
expenditures (consumption, investment) as a
consequence of increased government
spending or financing needs of a budget
deficit.
Crowding out can occur in two ways:
 Direct crowding out effect
 Indirect crowding out effect
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Types of Crowding Out Effects
 If government spends $2 million more on public
libraries but that does not reduce the consumption of
books from bookstores by even $1, then there is no
crowding out effect. ∆G > 0; ∆C =0
 If the government spends $2 million more on public
libraries and as a result people spent $2 million less
on books bought in bookstores then there is
complete crowding out effect, meaning the degree of
crowding out is dollar for dollar. ∆G > 0; ∆C < 0,
where ∆G = |∆C|
 If the government spends $2 million on public
libraries but that causes consumers to spend $1.2
million less on books from bookstores then we have
incomplete crowding out effect. ∆G > 0; ∆C < 0,
where ∆G > |∆C|
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In the event of complete or incomplete crowding
out effect, expansionary fiscal policy will have less
impact on aggregate demand and Real GDP than
Keynesian theory predicts.
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Data Lag: It takes some time to realize that the
economy is unstable due to time it takes to
collect relevant data.
The Wait-and See Lag: Economists usually wait
for some time to see if the economy does recover
itself
The Legislative Lag: Take majority vote in
parliament
Transmission Lag: It takes time to implement the
policy, i.e. communicate and apply the changes
The Effectiveness Lag: Takes time for the actual
policy effect to sink in into the economy - just
because government expenditure increased this
week does not mean AD will shift right next week
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Marginal tax rate is the change in a person’s tax
payment divided by the change in the person’s
taxable income.
As marginal tax rate of individuals decreases,
people are more encouraged to engage in
productive activities rather than succumb to
leisure and tax-avoidance activities. For example,
if Person A’s income increases by $1, and she
has to pay a tax of $0.28 on her additional $1
income, then her marginal tax rate is 28%.
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As the marginal tax rate decreases the
incentive to engage in productive activities
increases. The effect of this on the economy
will be a rightward shift of the SRAS curve,
which will allow the economy to reach
stability.
If the marginal tax rate is permanently low,
this might even allow the LRAS curve to shift
rightward.
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The reason why SRAS shifts right if marginal tax
rate decreases can be explained by the Laffer
curve.
 Laffer curve is a very famous curve in
macroeconomics that shows the relationship
between tax rate and tax revenue. There are
three construction points to the Laffer curve:
1) There will be no tax revenue at marginal tax
rates 0% and 100%.
2) An increase in tax rate could cause the tax
revenue to increase.
3) A decrease in tax rates could cause tax
revenues to increase.
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Tax Revenues = Tax base × (average) Tax Rate
Tax base is the total amount of taxable income in the
economy.
For example, if tax rate is 20% and tax base is $100
billion, then Tax Revenues will equal to TR = $100
billion × 0.2 = $20 billion
Case 1: Suppose tax rate decreased from 20% to 15%
- a 25% reduction in tax rate. This causes tax base to
expand from $100 billion to $120 billion. Tax
revenue drops to $18 billion.
Case 2: Tax rate drop by 25% from 20% to 15%. This
causes the tax base to expand from $100 billion to
$150 billion, which is a 50% increase in tax base. This
causes tax revenue to increase to $22.5 billion.
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If the economy is on the downward sloping portion, a
reduction in tax rate causes tax revenue to increase. If the
economy is on the upward sloping portion of the curve, a
reduction in tax rate causes tax revenues to decrease.
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