4.4 — Taxation

# 4.4 — Taxation
## ECON 410 • Public Economics • Spring 2022
### Ryan Safner<br> Assistant Professor of Economics <br> <a href="mailto:safner@hood.edu"><i class="fa fa-paper-plane fa-fw"></i>safner@hood.edu</a> <br> <a href="https://github.com/ryansafner/publicS22"><i class="fa fa-github fa-fw"></i>ryansafner/publicS22</a><br> <a href="https://publicS22.classes.ryansafner.com"> <i class="fa fa-globe fa-fw"></i>publicS22.classes.ryansafner.com</a><br>

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# Outline

## [Motivation and Types of Taxation](#3)

## [Incidence of Taxation](#13)

## [Some Principles of Tax Fairness](#23)

## [Taxes Distort Incentives](#39)

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# Motivation and Types of Taxation

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# Motivation for Taxation

- Often two types of reasons for a tax:
    1. Raise revenue for the provision of public goods and transfers
    2. Discourage or encourage certain behaviors and transactions

- Taxes thus have two effects:
    1. Generate tax revenue
    2. Distort individual incentives

]
]

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# Types of Taxation

.pull-left[
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![:scale 80%](https://www.dropbox.com/s/vzhoixz7kx09qsb/1040_income_tax.jpg?raw=1)

![:scale 80%](https://www.dropbox.com/s/ovm89pml0ew23y5/w2.jpg?raw=1)

]
]

Taxes on **Income**:

- .hi-purple[Individual income tax] on income (of all sorts) over a year
- .hi-purple[Payroll tax] on wage income earned at a job
- .hi-purple[Captal gains tax] on net value from selling capital assets (e.g. stocks, paintings, houses)
- .hi-purple[Corporate income tax] on net income of corporations
]

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# Types of Taxation

]
]

- .hi-purple[Wealth tax] on value of owned assets
- .hi-purple[Property tax] on value of real estate (land plus structures)
- .hi-purple[Estate tax] on value of estate (assets) left behind when one dies
]

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# Types of Taxation

]
]

- .hi-purple[Sales tax] on all goods and services at point of sale
- .hi-purple[Excise tax] on particular goods and services
- .hi-purple[Tariff] tax on imports (and sometimes exports)

]

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# Types of Taxation

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# Incidence of Taxation

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# Incidence of Taxation

- Economists focus on the .hi[incidence] of taxation: .hi-purple[how does a tax change behavior and affect welfare?]

- A tax imposes a .hi-purple[statutory burden] on party *legally required* to pay the tax

- This does not directly translate to the .hi[economic burden], who actually bears the incidence of the tax
]

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# Economic vs. Statutory Incidence

- Economic and statutory burdens are not the same thing!

- Parties may be able to alter their behavior to .hi-purple[avoid] or .hi-purple[shift] it onto others
  - Businesses may pass higher prices onto consumers
  - Consumers can switch to lesser-taxed substitutes (including nothing)
  - People may move their wealth into lesser-taxed assets or jurisdictions
]

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# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-1-1.png" width="504" style="display: block; margin: auto;" />
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- Gasoline market in equilibrium
  - `$q_d=q_s=$` 50 billion gallons
  - p `$=$` $3.00/gallon
]

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# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-2-1.png" width="504" style="display: block; margin: auto;" />
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- Gasoline market in equilibrium
  - `$q_d=q_s=$` 50 billion gallons
  - p `$=$` $3.00/gallon

- Suppose the government levies a .purple[$1.00 tax] on .hi-red[suppliers]
  - .hi-red[Supply] shifts **up** by .purple[$1.00]
]

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# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-3-1.png" width="504" style="display: block; margin: auto;" />
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- Gasoline market in equilibrium
  - `$q_d=q_s=$` 50 billion gallons
  - p `$=$` $3.00/gallon

- Suppose the government levies a .purple[$1.00 tax] on .hi-red[suppliers]
  - .hi-red[Supply] shifts **up** by .purple[$1.00]

- `$Q_t$` decreases to 37.5 
]

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# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-4-1.png" width="504" style="display: block; margin: auto;" />
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- .blue[$3.50: Gross price] buyers pay (with tax)

- .red[$2.50: Net price] sellers receive (after tax)

- Difference between the two is the .purple[$1.00 tax]!
]
]

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# Example: Efficiency & Welfare Effects

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.pull-right[
- Now we examine the .hi-purple[efficiency] and .hi-purple[welfare effects] of the tax with some .hi-purple[comparative statics]

- Start with the pre-tax market equilibrium
  - .blue[Consumer surplus]
  - .red[Producer surplus]
]

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# Example: Efficiency & Welfare Effects

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-6-1.png" width="504" style="display: block; margin: auto;" />
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- .blue[Consumer surplus] decreases
  - Buyers pay higher price for fewer gallons

- .red[Producer surplus] decreases
  - Sellers receive lower price for fewer gallons
]
]
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# Example: Efficiency & Welfare Effects

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-7-1.png" width="504" style="display: block; margin: auto;" />
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- .blue[Consumer surplus] decreases
  - Buyers pay higher price for fewer gallons

- .red[Producer surplus] decreases
  - Sellers receive lower price for fewer gallons

- .green[Tax revenue] to government
  - `$\color{green}{R_G=t \times q_t}$`
  - Transfers from .blue[consumers] and .red[producers] to .green[government]
]
]

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# Example: Efficiency & Welfare Effects

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- **Deadweight Loss (DWL)**
  - Surplus that existed pre-tax that is now wasted
  - Gains from exchange between willing buyers and sellers that is now made impossible

- .hi-purple[This is the true social cost of a tax]
  - .green[Tax revenues] are just a transfer, changes the **distribution** of surplus, but it still exists (going to *someone*)
  - DWL *destroys* pre-existing surplus
]
]

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# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-9-1.png" width="504" style="display: block; margin: auto;" />
]

- Gasoline market in equilibrium
  - `$q_d=q_s=$` 50 billion gallons
  - p `$=$` $3.00/gallon
]

---

# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-10-1.png" width="504" style="display: block; margin: auto;" />
]

- Gasoline market in equilibrium
  - `$q_d=q_s=$` 50 billion gallons
  - p `$=$` $3.00/gallon

- Suppose the government levies a .purple[$1.00 tax] on .hi-blue[consumers]
  - .hi-blue[Demand] shifts **down** by .purple[$1.00]
]

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# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-11-1.png" width="504" style="display: block; margin: auto;" />
]

- Gasoline market in equilibrium
  - `$q_d=q_s=$` 50 billion gallons
  - p `$=$` $3.00/gallon

- Suppose the government levies a .purple[$1.00 tax] on .hi-blue[consumers]
  - .hi-blue[Demand] shifts **down** by .purple[$1.00]

- `$Q_t$` decreases to 37.5 
]

---

# Example: An Excise Tax on Gasoline

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-12-1.png" width="504" style="display: block; margin: auto;" />
]

- .blue[$3.50: Gross price] buyers pay (with tax)

- .red[$2.50: Net price] sellers receive (after tax)

- Difference between the two is the .purple[$1.00 tax]!
]
]

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# Example: Efficiency & Welfare Effects

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-13-1.png" width="504" style="display: block; margin: auto;" />
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.pull-right[
- Start with the pre-tax market equilibrium
  - .blue[Consumer surplus]
  - .red[Producer surplus]
]

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# Example: Efficiency & Welfare Effects

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-14-1.png" width="504" style="display: block; margin: auto;" />
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- .hi-blue[Consumer surplus] decreases

- .hi-red[Producer surplus] decreases

- .hi-green[Tax revenue] to government

- Surplus lost to **Deadweight loss**
]
]

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# Example: Efficiency & Welfare Effects

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-15-1.png" width="504" style="display: block; margin: auto;" />
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- The .hi-purple[statutory burden is irrelevant!]

- Placing the tax on .hi-red[Suppliers] or on .hi-blue[Demanders] resulted in the same .hi[economic incidence] of the tax!
]

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# Statutory Burden vs. Economic Incidence

- The .hi-purple[statutory burden is irrelevant!]

- Individuals may *shift* burden onto others until the same equilibrium is reached
- .hi-purple[Relative price elasticities] actually determine the distribution of the .hi-purple[economic incidence] between consumers & producers

]

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# Relative Price Elasticities and Economic Incidence

<img src="4.4-slides_files/figure-html/unnamed-chunk-16-1.png" width="504" style="display: block; margin: auto;" />
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.center[
.smallest[
.blue[Demand] more elastic than .red[Supply]
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<img src="4.4-slides_files/figure-html/unnamed-chunk-17-1.png" width="504" style="display: block; margin: auto;" />
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# Relative Price Elasticities and Economic Incidence

- .hi-purple[Group with a relatively lower elasticity bears more tax burden]

- Elasticity `$\implies$` responsiveness in buying/selling behavior to price change
  - Elasticity `$\implies$` the ability to .hi-purple[avoid] the tax by changing behavior

- .hi-purple[Relatively _more_ elastic group shifts some burden onto relatively _less_ elastic group]

]

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# Estimating Pass-Through

]

- Portion of tax burden borne by .blue[consumers], known as the .hi-purple[“pass-through”] rate, is a function of the elasticities:

`$$\rho = \frac{\epsilon_{S}}{|\epsilon_D| + \epsilon_{S}}$$`

- Remainder is borne by .red[producers]

`$$(1-\rho) = \frac{\epsilon_{D}}{|\epsilon_D| + \epsilon_{S}}$$`
]

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# Estimating Pass-Through

]

`$$\rho = \frac{0.5}{|-1| + 0.5} = 0.333$$`
.blue[Consumers], (a higher elasticity than .red[producers]) bear 33% of the tax burden, while .red[producers] bear 67%.
]

--
.pull-right[
.content-box-green[
.hi-green[Example 2:] Let 
- `$\epsilon_s = 1$`
- `$\epsilon_d = -0.5$`

]

`$$\rho = \frac{1}{|-1| + 0.5} = 0.667$$`
.blue[Consumers], (a lower elasticity than .red[producers]) bear 67% of the tax burden, while .red[producers] bear 33%.

]

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# Visualizing Incidence

.center[
[![:scale 60%](../images/shiny-taxincidence.png)](https://ryansafner.shinyapps.io/tax-incidence/)
]

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# Some Principles of Tax Fairness

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# Tax Fairness Principles

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![:scale 100%](https://www.dropbox.com/s/tw6hyf701f00vcb/tax-fairness.png?raw=1)
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- .hi-purple[Benefits principle]: those who benefit from public spending should bear the burden of the cost

- .hi-purple[Ability-to-pay principle]: those with a greater ability to pay should pay more taxes (and vice versa)

- Ideal .hi-purple[“Lindahl Tax”]: each person pays their max WTP for public goods
  - Obviously implausible, not incentive-compatible

]
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# Types of Taxes

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![:scale 100%](https://www.dropbox.com/s/tw6hyf701f00vcb/tax-fairness.png?raw=1)
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.smallest[
- .hi-purple[Progressive tax]: (effective) tax rates increase with taxable activity
  - Income tax: Higher-income groups pay higher tax rates

- .hi-purple[Regressive tax]: (effective) tax rates decrease with taxable activity
  - Sales tax: Lower-income groups pay more in taxes (consume more, invest less, compared to wealthy)
  - Payroll tax: caps out at a maximum

- .hi-purple[Flat tax]: tax rates are the same for everyone
]
]

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# Marginal vs. Average Tax Rates

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- For many taxes, especially individual income tax, key difference between:

- .hi-purple[Marginal tax rate]: tax rate on last (marginal) dollar of taxable income
  - individual income tax has increasing marginal tax rates (progressive)

- .hi-purple[Average tax rate]: ratio of total taxes paid to total taxable income:
`$$\frac{\text{Taxes Paid}}{\text{Taxable Income Earned}}$$`

]

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# Individual Income Tax: Marginal Tax Rates

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# Marginal vs. Average Tax Rates (Example)

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- First $9,950 is taxed at 10% ($995)
- From $9951—$40,525 is taxed at 12% ($3,469)
- From $40,526 to $50,000 is taxed at .hi-red[22%] ($2,084)
- **Total tax bill: $6,548**
]
]
]

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# Marginal vs. Average Tax Rates (Example)

.pull-left[
<img src="4.4-slides_files/figure-html/unnamed-chunk-20-1.png" width="504" style="display: block; margin: auto;" />
]

- First $9,950 is taxed at 10% ($995)
- From $9951—$40,525 is taxed at 12% ($3,469)
- From $40,526 to $50,000 is taxed at .hi-red[22%] ($2,084)
- **Total tax bill: $6,548**

- .hi-purple[Average (effective) tax rate] $6548/$50,000 = 13%

- .hi-red[Marginal tax rate]: 22%
]
]
]

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# Individual Income Tax: Distribution

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# Individual Income Tax: Average Tax Rate

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# Taxes Distort Incentives

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# Taxes Distort Incentives

]

Taxes have two effects:

1. Raise revenue for State

2. Discourage individuals from taxed activity
  - reduce activity
  - find untaxed substitutes (legal or illegal)
  - engage in hoarding, tax avoidance

- Optimal tradeoff between two effects for revenue-maximizing government
]

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# Taxes Distort Incentives 
 
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# Taxes Distort Incentives

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- Tax of `$2t$`:
  - `$G_2=12$`
  - `$DWL_1=4$`

- Higher tax rates *increase the rate of loss* of surplus
  - `$\Delta G=1.5x$` increase
  - `$\Delta DWL=4x$` increase

- In fact, `$\Delta DWL=(\Delta t)^2$`
]
]
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# Using The Tax System for Political Goals

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![:scale 80%](https://www.dropbox.com/s/he3y5y9as8dzsl7/tax-complexity.jpg?raw=1)
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- Taxes and subsidies are political tools politicians can use to bargain and benefit special interest groups
  - Special deductions, tax credits, tax breaks, etc.

- This is why our tax code is so complicated!

- This is also why you get your health insurance through your employer

]

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# Using The Tax System for Political Goals

]

.pull-right[
.smallest[
- Businesses can deduct interest payments on their **debt** from corporate taxes, but not on **dividend** payments to shareholders `$\implies$` corporations use more debt than equity

- **R&D tax credit**: businesses can reinvest corporate profits into research and development to avoid corporate income taxes

- 401(k)s benefits are not taxed `$\implies$` people invest more in 401(k)s for retirement

- Homeowners can deduct **mortgage interest** payments from their taxes, but renters cannot deduct anything `$\implies$` more homeownership than renting
]
]

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# Messing With the Tax Code: Good Politics

.center[
![:scale 65%](https://www.dropbox.com/s/hig5cae4wfnxok1/onion_boehner_corporate_tax_breaks.png?raw=1)
]

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# Messing With the Tax Code: Consequences

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.center[
![](https://www.dropbox.com/s/l1tjuxo6rubpo86/carrier_tax_subsidies.png?raw=1)
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# Messing With the Tax Code: Consequences

<blockquote class="twitter-tweet"><p lang="en" dir="ltr">Honestly, I’m not sure people completely understand how small distilleries, generally with VERY little capital on hand, are changing their business models in just a week. We appreciate the outpouring of love. We’re working like crazy to get what we need to make more sanitizer.</p>&mdash; Skip Tognetti (@togneter) <a href="https://twitter.com/togneter/status/1242853822445182976?ref_src=twsrc%5Etfw">March 25, 2020</a></blockquote> <script async src="https://platform.twitter.com/widgets.js" charset="utf-8"></script>

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# Messing With the Tax Code: Consequences

<blockquote class="twitter-tweet"><p lang="en" dir="ltr">There is literally no medical reason to denature. Taxation. That’s it. <br><br>In WA, that means if I sell a liter for $10, which I’m barely covering my costs on, the tax owed between state and federal governments is EIGHT DOLLARS AND TWENTY THREE CENTS.<br><br>And yet...</p>&mdash; Skip Tognetti (@togneter) <a href="https://twitter.com/togneter/status/1242853835602710529?ref_src=twsrc%5Etfw">March 25, 2020</a></blockquote> <script async src="https://platform.twitter.com/widgets.js" charset="utf-8"></script>

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# Messing With the Tax Code: Consequences

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# Messing With the Tax Code: Benefits Some Special Interests!

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![:scale 100%](https://www.dropbox.com/s/498sc3z3np2nasg/rentseekingtaxeswide.png?raw=1)
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.pull-right[
Source: [*ProPublica* (Mar 20, 2017)](https://www.propublica.org/article/filing-taxes-could-be-free-simple-hr-block-intuit-lobbying-against-it)
]

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# Tax Avoidance and Tax Evasion

]
]

- .hi-purple[Tax _Evasion_]: *illegal* actions of not paying taxes due (on income, wealth, property, etc)
  - alternatively, turning to black markets for un-taxed substitutes
  - concealing assets from the government, offshore, etc.
]

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# Tax Avoidance and Tax Evasion

]
]

- .hi-purple[Tax _Avoidance_]: *legal* actions that changing behavior and wealth allocations to minimize the amount of taxes due
  - buying non-taxed substitutes
  - using tax deductions, credits, loopholes, exemptions, trusts, foundations
  - reinvesting corporate profits
  - having good accountants

]

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# Tax Avoidance

- More of the world than you imagine is **optimized for tax avoidance**

In Ukraine, an imported car is taxed heavily, so importers cut the cars in half (which are taxed lighter as ”spare parts” and then welded back together in the country))
]

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# Tax Avoidance

- More of the world than you imagine is **optimized for tax avoidance**

In the Netherlands, houses were taxed based on their canal frontage (rather than height or depth), so they were built tall and thin (to minimize canal frontage)
]

.source[[99% Invisible: Vernacular Economics: How Building Codes & Taxes Shape Regional Architecture](https://99percentinvisible.org/article/vernacular-economics-building-codes-taxes-shape-regional-architecture/)]

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# Tax Avoidance

- More of the world than you imagine is **optimized for tax avoidance**

In the UK, property taxes used to be based on the number of windows a building had, so many buildings still feature ”bricked up” window slots]

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# Raising Taxes?

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![](https://www.dropbox.com/s/ilwad4982jf3vs8/economists_on_raising_taxes.jpg?raw=1)
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.center[
![](https://www.dropbox.com/s/ay0hnuflgrlo2rg/hollywood_tax_avoidance.png?raw=1)
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# Wealth Taxes?