Tax theories Basis of tax: Whom to tax At what rate

Two basic principles: Benefit approach Ability to pay approach

Benefit Approach: The benefit approach or its variant, the voluntary exchange principle, as developed by De Viti de Marco and Erik Lindahl.

Hypothesis: The state should supply social goods up to that point where the peoples total demand for such goods is equal to the total supply The cost of provision of the social goods is fully covered by the prices. The goods should be paid for by their users in proportion to the benefits they derive from such goods.

The result is plotted in above graph 3.1 in which the amounts of social goods which might be provided by the state are measured on the horizontal axes, the aa curve shows on the left vertical axis the percentage share of the cost which individual A is willing to bear as larger amounts of social goods are provided and the bb curve shows on the right inverted vertical axis the percentage share of the cost which individual B is willing to bear as larger amounts of social goods are provided. The curves have been drawn on the usual assumption of diminishing marginal utility which an individual derives from successive increments of the consumption of any commodity. Supposing that initially AB amount of social goods are provided by the state and individual A is being made to continue BJ percentage share of the cost and individual B is being made to contribute HJ percentage share of the cost, both A and B under the circumstances would vote for a large amount of social goods, since at AB amount of social goods A is actually willing to contribute a higher percentage share of the cost, viz, BC and B is also willing to contribute a higher percentage share, viz, HD. If, on the other hands, AI amount of goods are provided A will be willing to contribute only IM percentage share of the cost and B will be willing to contribute only LK percentage share of the cost so that their total voluntary percentage share of the contribution, IM + LK, will be less than 100% of the cost by KM. Thus by a process of trial and error it will be found that only at AE amount of social goods the percentage share of the cost willingly contributed by A and B, i.e., EF+GF will be exactly equal to 100% of the cost, or, in other words, only at AE output the total cost of provision of the social goods would be just (and only just) covered by the contributions(in the form of tax payments) willing made by A and B who derive benefit from the social goods in question. Hence AE

will be the optimum amount of social goods and EF and GF percentage share of the cost would be the optimum tax liability of A and B respectively.

Ability to Pay Approach: J.S. Mill rejected the benefit principle of taxation as it would mean that the poor would have to pay most of the taxes Stated alternatively, the ability to pay principle requires that the sacrifice made by all the individuals while paying taxes should be equal. Hypothesis: I. The marginal utility of income is cardinally measurable. II. The marginal utility of income decreases as income increases. III. All persons have the same relationship between their units of income and units of marginal utility whatever by their levels of income. IV. If assumption (III) is not correct, then interpersonal comparison of utility can be made.

Suppose that the MU and TU schedules show respectively the marginal and total utilities derived by two individuals(who would be called rich man and poor man, the former having an income larger than the latter) which they derive from income, the same schedules, by assumption, applying to both. Suppose further that, to begin with, the rich man has an income of OR, and the poor man has an income of OP, the total utility derived by them from their income being respectively AB and CD. Let us assume that the state has decided to raise from the two individuals a total sum of Rt in tax. Under equal absolute sacrifice principle, the tax liability of the rich man will be RR and that of the poor man will be PP (note, RR + PR= Rt), for in that case the absolute loss of sacrifice made by the two individuals (defined as the absolute reduction in the total utility derived by the individuals from their income) will be the same, the reduction of total utility from income of the rich man in the post-tax situation being BE, the corresponding amount of the poor man being DF; and BE=DF. But note that though BE=df, BE/BADF/DC. In other words, in this method of distribution of the tax burden though the equal absolute sacrifice principle is being satisfied, equal proportional sacrifice principle is not being fulfilled. In order, therefore, to raise the same amount of tax according to equal proportional sacrifice principle, the rich mans tax liability should be increased to RR ,and the poor mans liability should be reduced to PP, (note, RR+ PP= Rt), so that in the post-tax situation BG/BA (i.e., the rich mans proportional sacrifice)= DH/DC (i.e. the poor mans proportional sacrifice). But, again, note that in this distribution of the tax share though the equal proportional sacrifice principle is being satisfied, the equal marginal sacrifice principle (and ipso facto the least aggregate sacrifice principle) is not being satisfied, for in the post-tax situation the marginal utility of income of the rich man is not equal to that of the poor man . Therefore, if the equal marginal sacrifice principle

is accepted, the rich mans tax burden should be increased further to RR and the poor mans share should be reduced further to PP (note, RR + PR =Rt) so that in the post-tax situation the marginal utility of income of both the individuals becomes equal, namely RP. Tax shifting and incidence: Major criteria influencing tax shifting: a. Market structure. b. Unrealized profits c. Industry cost conditions d. Price elasticity e. Type of tax & f. Political jurisdiction. Market structure Pure (Perfect) Competition. The purely competitive (Perfectly competitive) market is characterized by: Large Number of buyers and sellers. Goods are humongous. Individual buyers and sellers cant influence price.

The, purely competitive (perfectly competitive) market is characterized by many sellers and buyers of homogeneous (non differentiated) goods.$ Figure 7-1 indicates the initial pretax equilibrium for a purely competitive firm and for a purely competitive industry, at point a for the firm, in Figure a, and at point a' for the industry, in Figure b. The firm is producing an output of 25 units and selling at a price of $10, as determined by the intersection of its marginal cost curve, MC, with marginal revenue (MR) and price (AR), as the latter is set by the industry. v. Then, assume that an excise tax of $5 per unit is imposed on the good. The individual firm can initiate no effort on its own to shift the tax forward via a higher selling price, since it has no control over price. It completely lacks -power due to the homogeneity of its product and the fact that it is one of many sellers. Thus, any forward shifting which may occur can take place only through industry forces. In the immediate or market period this will not occur. Industry forces, however, may allow partial shifting of the tax in the short run, though. The overall possibility of shifting is reduced by the inability of the individual firm to influence price. Any shifting which does occur through industry forces in the short run would not involve the exit of hunts from the industry. Yet. In the long run, under constantcost supply conditions, the tax %- be fully shifted forward to the consumer, due to the action of industry forces in the form of an exodus of some firms from the industry. Thus, over the long run, some marginal firms will leave the industry because the industry determined short-run price increase is not equal to the new excise tax burden. When this occurs, the industry supply schedule will shift upward until market price has risen suffi-

ciently so that the representative firm again can earn a normal profit. This is demonstrated for the industry in Figure, at point V where the industry supply Curve-, S, has shifted upward by file amount of the tax to become due to post tax supply schedule, St. Industry price increases from $IO to $ 15, and the firm can now sell all of its output 11 the higher price. The burden of the tax has thus been fully shifted forward though, significantly, this has .not occurred through monopoly power by the individual firm, but instead through the operation of long-run competitive industry forces. For the purpose of the example. Such To ward shifting assumes constant factor prices and hence the impossibility of backward shifting. The final equilibrium price ($ 15)

Tax shifting and incidence (in monopoly)

As depicted in Figure, the pure monopoly firm, which is identical with the industry since no competitors exist, is in pretax equilibrium, producing output OX, charging price OP, and caring monopoly profits PABC. Assume first that an excise tax is imposed on the economic good produced 1.y the monopoly. As a result, the marginal cost curve, MC, and the average cost curve, AC, shift upward and become MC' and AC1, respectively. Thus, a new post tax equilibrium is set at output OX' and price OP1, which yields monopoly profits equal to the rectangle P'DEF. This profit rectangle is smaller than the profit rectangle PABC which existed before the excise tax was imposed. Hence, the pure monopoly firm in this case does not fully shift the excise tax. In fact, the extent to which it can shift any part of the tax will be determined by numerous factors (some of which will be discussed below), such as industry cost conditions and the price elasticities of product demand and resource supply. Importantly, however, the pure monopoly firm could initiate a price change on its own due to the absence of competitors, and it could do so in any time period, which will tend to enhance its forward tax. Shifting potential since tax shifting can be attained only through a price change? In Figure 7-2, the portion of the tax home by the monopolist is equal to the difference between the larger pretax and the smaller post tax profit rectangles. Meanwhile, the upward movement in absolute price from P to P' is an indicator of the amount of tax per unit chat is shifted forward.

Tax shifting & unrealized profit: Next, assume that a corporation (business) income tax is imposed on the profits of a pure monopoly firm. In this instance. The tax is levied on a surplus or residual amount, that is, on the profits of the

I the comparative shift ability of an excise tax by a pure competition Am as opposed to a pure monopoly rim. In different time periods. May be summarized as follows.

Time period Short-run ..........

Pure competition Little, if any shitting and through industry forces only full shifting, and through

Pure monopoly Shifting, to varying degrees Possible through firm monopoly power

Long-run................

industry forces only (Constant cost conditions)

Shifting, to varying degrees Possible through firm monopoly power

The long run apart from the MC MR point due to the possible presence of monopoly profits. Thus, an imperfectly competitive firm which is not operating at the profit-maximizing point will be in a position to possibly shift a corporation (business) income tax, if there exists a buffer area of unrealized profits within which price-output rearrangements cart be made. Figure 7-3, which is described later, demonstrates this phenomenon.

First, however, the critical question must be asked: Why would a firm choose not to maximize profits at the MC = MR point? Such considerations as imperfect market and production knowledge, the fear of antitrust action, the fear of an unfavorable public image, the fear of attracting new entrants two the industry, the Fear Of Stimulating union wage demands, and public utility regulation may prevent a fine or benchmarks as: maximization of gross receipts (sales); achievement of a target rate of return on investment; maintenance of stable prices on goods produced by the firm; application of a percentage markup price over Figure 7-3 Unrealized profits as a necessary contrition for shifting a business income tax by a firm in impeded competition

Explanation: Rectangle PABC= Maximum profits where MC = MR at output X Rectangle PDEC= profits at output X1 which is a position of suboptimal profits. The excess of PABC over PVEC - Unrealized Prate. thus allowing the possibility of shifting the burden of a profits tax as price is increased toward P and output is decreased toward the profit maximization output X

Price elasticity Price elasticity of product demand. Another

on a particular economic good. In Figure 75, the S curve represents the supply and curve D represents the demand for the good. Constant-cost conditions of supply are assumed. In Figure 7-5a, demand is relatively elastic throughout the relevant portion of the demand curve, while in Figure 7-5b demand is relatively inelastic throughout the relevant portion. In Figure 7-5c, the demand for the good is perfectly (completely) inelastic throughout the entire curve. When the excise tax is imposed, the price of the good is initially increased by the amount of the- tax - The most likely occurrence of tax shifting is shown in Figure 7-5c, where the demand is perfectly inelastic, since there is no quantity reaction as the price increases from p to p. The initial quantity. X, and the post tax quantity.

Tax shifting and elasticity

In Figure 75, the S curve represents the supply and curve D represents the demand for the good. Constant-cost conditions of supply are assumed. In Figure 7-5a, demand is relatively elastic throughout the relevant portion of the demand curve, while in Figure 7-5b demand is relatively inelastic throughout the relevant portion. In Figure 7-5c, the demand for the good is perfectly (completely) inelastic throughout the entire curve. When the excise tax is imposed, the price of the good is initially increased by the amount of the- tax - The most likely occurrence of tax shifting is shown in Figure 7-5c, where the demand is perfectly inelastic, since there is no quantity reaction as the price increases from p to p. The initial quantity. X, and the post tax quantity.

Tax shifting and type of tax: characteristics as (1) whether it is direct or indirect and (2) broad based or narrow based, Generally speaking the more direct the tax, the more difficult shifting becomes, sinct Hence, direct taxes such as the personal income tax are not especially conducive to the rather market transactions that are necessary for the successful for ward shifting of a tax. In contrast, indirect taxes such as general retail sales and excise taxes ai~e more closely associated with further market transactions and are thus more conducive to forward shifting. in terms of the extent of the tax base, the more broad based a tax, the easier it tends to be to shift the tax.2 Oppositely, the more narrow based the tax, the more difficult tax shifting becomes. Tax shifting and political jurisdiction: The geographical nature of the political unit which levies a tax also helps to determine its shiftablity. In this context, a political unit may be a local, state, national, or even international government. Generally, the narrower the geographical limits of a political unit, the more difficult it is to shift a tax. For example, a new (or increased) general retail sales tax in a city may lead to consumption readjustments.