Public Sector Economics

ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Empirical Incidence Studies Tax Incidence with a Mobile Factor Application to European soccer players • From our theoretical analysis, we expect that mobile factors of production will be very sensitive to taxes and bear little of the tax burden • Example: high ability football/soccer players Tax Incidence with a Mobile Factor Application to European soccer players Two policy changes in Europe allowed researchers to study how taxes affect the market for top soccer players 1. 2. The 1995 Bosman ruling lifted the cap on foreign-born players on European club teams. This made it easier for foreign players to sign with teams in low tax European countries Spain’s 2004 “David Beckham rule” allowed foreign workers living in Spain to pay a lower tax rate. All else equal, this policy made Spanish teams more attractive for top European soccer players Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Source: Kleven, Landais and Saez (2013) Empirical Incidence Studies Average Tax Rate, Total Taxes, by Broad Income, Canada, 1990 to 2005 Figure 14.12 14-12 Empirical Incidence Studies Decile Cut-offs, 1990 and 2005 (in constant 2010 dollars) Table 14.3 14-13 Empirical Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005 Figure 14.13 14-14 Empirical Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005 Figure 14.14 14-15 Chapter 14 Summary • Statutory incidence refers to the legal liability for a tax, while economic incidence shows the actual sacrifice of income due to the tax. • Economic incidence is determined by the way price changes when a tax is imposed; the incidence of a tax ultimately falls on individuals via both their sources and uses of income. • In partial equilibrium competitive models, tax incidence depends on the elasticities of supply and demand. • Due to capitalization, the burden of taxes may be borne by current owners of an inelastically supplied durable commodity, such as land. 14-16 Chapter 14 Summary (cont) • Applied incidence studies indicate the Canadian system is progressive up to the middle of the income distribution, then modestly regressive thereafter. 14-17 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Who pays taxes? Now that we know how to measure the progressivity of the tax system we can start thinking who actually pays taxes in Canada (or any other country for that matter). It turns out that this is a complicated question to answer. Consider the following example from the textbook. Suppose that the price of a wine bottle is $10. The government imposes a tax of $1 per bottle sold. The tax is collected by firms as the government requires that stores must pay $1 to the government for each bottle sold. Who pays this tax? Three (out of many) possible scenarios. • • • The price of a wine bottle rises to $11 The price of a wine bottle stays at $10 The price of a wine bottle rises to $10.30 LO1 Tax Incidence Vocabulary • Statutory Incidence: the party that is legally responsible for paying the tax (firms in our wine bottle example) • Economic Incidence: who actually pays for the tax, as measured by the change in the distribution of private real after-tax incomes. • Tax Shifting: the transfer of the burden of paying the tax from those that are legally liable for it to others due to equilibrium price changes • Forward shifting: the transfer of a tax burden from sellers who are legally liable to buyers through higher prices of the taxed good • Backward shifting: the transfer of a tax burden from buyers who are legally liable to sellers through lower prices of the taxed good 14-6 Tax Incidence Vocabulary • Unit tax: a tax that is a fixed dollar amount per each unit of the good bought/sold ! =#+% • Ad-valorem tax: a tax that is a fixed percentage of the price of a good ! = # + &# = #×(1 + &) Tax Incidence: General Remarks • Only people can bear taxes • Businesses (whatever their legal form) do not pay taxes. It is the owners of the business (shareholders, partners) that pay the tax • Taxes and the functional distribution of income • Studies the impact of taxes on how income is distributed across different factors of production (i.e. owners of capital, labourers, landlords) • This analysis answers the question: does a particular tax affect owners of capital more than labourers? • Taxes and the size distribution of income • Studies the impact of taxes on how income is distributed among people (i.e. those in the top 1%,, bottom 20% etc…) 14-8 Tax Incidence: General Remarks • Both sources and uses of income should be considered • Consider the wine example from a few slides ago • Suppose wine is disproportionately consumed by the poor but that the vineyards are owned by the rich • Ignoring the effects of taxes on the sources side when considering a commodity tax can be misleading (same applies if ignoring the effects on the uses side when considering a tax on an input) • Incidence depends on how prices are determined • Tax incidence depends on how taxes affect market prices • How prices are determined in perfect competition is very different from how prices are determined in a monopoly or oligopoly • We will study both 14-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Partial Equilibrium Models • Models that look only at the market in which the tax is imposed and ignore the ramifications in other markets 14-5 Price per litre of wine Unit Taxes on Commodities Price and Quantity Before Taxation a Pa Sw u b P0 m Pc u n Dw Figure 14.1 Qa Q0 Qc Litres of wine per year 14-6 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Demand Side Sw Pg P0 Pn u D’ Figure 14.2 Q1 Q0 Dw w Litres of wine per year 14-7 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Demand Side Tax Revenue = kfhn Price paid by consumers Original price Price received by producers Pg P0 Pn k f m n Sw Tax wedge = fh g h u D’ Figure 14.2 Q1 Q0 Dw w Litres of wine per year 14-8 Important Results/Concepts Unit Taxes on Commodities • Economic incidence does not depend on whether it is levied on consumers or producers • This is called the irrelevance of statutory incidence result in public economics • Economic incidence depends on elasticities of supply and demand • Elasticity of demand: !” = − • Elasticity of supply: !0 = % &'()*+ ,) ” % &'()*+ ,) – % &'()*+ ,) 0 % &'()*+ ,) – = =− .” .- × ” .0 × .0 14-9 Unit Taxes on Commodities LO4 Price per litre of wine Incidence of a Unit Tax Imposed on the Supply Side Price paid by consumers Original price Price received by producers S’ j P’ u w Sw Pi gP 0 P’ n Dw Figure 14.3 Q’1 Q0 Q1 Litres of wine per year 14-10 Unit Taxes on Commodities LO4 Price per litre of X Tax Incidence when Supply is Perfectly Inelastic SX Pg=P0 u Price received by suppliers falls by the full amount of the tax Pn Dx D’x Figure 14.4 X per year 14-11 Unit Taxes on Commodities LO4 Price per litre of Z Tax Incidence when Supply is Perfectly Elastic Pg Price paid by consumers increases by the full amount of the tax u Pn=P0 Sz Dz D’z Figure 14.5 Z1 Z0 Z per year 14-12 Formula for the effect of a unit tax on the market price paid by buyers !ℎ#$%& ‘$ ( ∆( &, = = !ℎ#$%& ‘$ ) ∆) &, + &. The buyer bears a greater burden if the seller is more elastic than the buyer ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Price per unit of clothing Ad Valorem Taxes Ad-valorem taxes shift the perceived demand curve down by the same proportion at all points. In this example, the tax levied on buyers shifts perceived demand down by 25%. Sc r Pr s P0 m Pm n Dc Qr Q0 Qm Units of clothing Figure 14.6 14-5 LO4 Ad Valorem Taxes Price per unit of clothing Incidence of an Ad Valorem Tax S’c Sc Pg P0 Pn Q1 Q0 Dc D’c Units of clothing Figure 14.7 14-6 Can we tell from this pay stub how much tax Joseph Mayer paid? Taxes on Factors of Production • The payroll tax • Tax on labor used to finance the Canada Pension Plan (CPP) • In 2019, workers pay a CPP payroll tax of 5.1% of their earnings between $3,500-$57,400 • Employers pay the same 5.1% rate for each worker • The reason why employers and workers pay the same rate is because politicians have long felt that the payroll tax burden should be shared between firms and workers. • What does our analysis of tax incidence tell us about who “pays for” the CPP payroll tax? 14-8 LO4 Wage rate per hour The Payroll Tax SL Pr wg = w0 wn DL DL’ Figure 14.8 L0 = L1 Hours per year 14-9 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Reading material: RWS Chapter 14 (ignore pages 294-298) Commodity Taxation with Imperfect Competition • Monopoly • Despite market power a monopolist is generally made worse off • • • • Quantity demanded goes down Price paid by consumers goes up Price received by the monopolist goes down Profits go down • Oligopoly • Can result in higher or lower profits 14-4 Equilibrium of a Monopolist $ Economic Profits MXX P0 ATC0 c d a ATCX b DX MRX Figure 14.9 X0 X per year 14-5 Imposition of a Unit Tax on a Monopolist $ Economic Profits MXX c P0 Economic Pn i Profits dh after unit tax ATC0 a f g ATCX b DX MRX X1 X0 MRX’ DX’ X per year Figure 14.10 14-6 Taxes on Profits LO5 • Economic profit: the return to the owners of a firm in excess of the opportunity costs of the factors used in production (also called supranormal or excess profits) • Perfect competition • Short run: a tax on profits doesn’t change MR or MC so output and prices paid by consumers doesn’t change. Owners of the firm bear the full burden of the tax • Long run: economic profit is zero so a profit tax yields 0 revenue • Monopoly • The monopolist bears the whole tax. The intuition is similar to the one for profit taxes in a perfectly competitive market in the short run 14-7 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Taxes on Land • Let’s look at a tax on land. Suppose Rt is the annual rental income on land in year t and that the market for land is competitive • Also assume that the land will be economically useful for T years • Question: What price should buyers be willing to pay for the land? 14-4 Taxes on Land • Question: What price should buyers be willing to pay for the land? $%( $%+ $%/ !” = $%& + + + ⋯+ + 1 + * (1 + *) (1 + *)/ PR is the present value of the income the owner of the land will receive. 14-5 Taxes on Land Now suppose that the government announces a tax will be imposed on land. The tax payment is u0 in year 0, u1 in year 1 and so on… Question: what will the new price of land be? 14-6 Taxes on Land Now suppose that the government announces a tax will be imposed on land. The tax payment is u0 in year 0, u1 in year 1 and so on… Question: what will the new price of land be? !”# $(‘- − *-) $(‘0 − *0) $(‘2 −* 2 ) = $(‘( − *() + + + ⋯+ 0 1+/ (1 + /) (1 + /)2 14-7 Tax Incidence and Capitalization After the introduction of the tax, the price of land falls by !” − !”$ = $'( + $*+ ,-. + $*/ (,-.)/ + ⋯+ $*3 (,-.)3 We say that the present value of the tax liability is capitalized into the price of the asset Capitalization: a stream of tax liabilities becomes incorporated into the price of an asset 14-8 ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) General Equilibrium Models • Up to now, we have only been studying the incidence of taxes in partial equilibrium models • Ignoring the feedback of taxes into other markets leads to an incomplete picture of how taxes affect incomes • Example: suppose a tax is levied on all capital used in the construction of housing • Partial equilibrium: the burden of the tax is borne by suppliers and demanders of housing capital. The most elastic party bears the smallest burden • General equilibrium: if the tax lowers the return (i.e. incomes) of suppliers of housing capital, they may choose instead to invest their funds in another sector (e.g. manufacturing, natural resources). But this movement of capital will affect prices in those other sectors. As a result, we will need to measure how prices and the incomes of all other sectors change. General Equilibrium Models • There is very little good empirical evidence on the incidence of taxes in general equilibrium. Why? • Because tracing out the effects of taxes in all markets depends on assumptions about • Consumer preferences (and how they vary across people) • How mobile/fixed factors of production are (short vs. long run answers differ) • Market structure (perfect competition versus imperfect competition) • Production technology • Whether the model allows new goods/services to enter a market ECON 3C03 Public Sector Economics: Taxation Adam M. Lavecchia Department of Economics McMaster University February 2021 TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited. Outline for Lecture • Measuring the progressivity of the tax system • Tax Incidence • • • • • Statutory versus economic incidence of a tax Tax incidence in competitive markets Tax incidence in imperfectly competitive markets Tax incidence and capitalization Tax incidence in general equilibrium • Empirical Incidence Studies Background reading material: RWS Chapter 14 (ignore pages 294-298) Tax Incidence Who pays taxes? Now that we know how to measure the progressivity of the tax system we can start thinking who actually pays taxes in Canada (or any other country for that matter). It turns out that this is a complicated question to answer. Consider the following example from the textbook. Suppose that the price of a wine bottle is $10. The government imposes a tax of $1 per bottle sold. The tax is collected by firms as the government requires that stores must pay $1 to the government for each bottle sold. Who pays this tax? Three (out of many) possible scenarios. • • • The price of a wine bottle rises to $11 The price of a wine bottle stays at $10 The price of a wine bottle rises to $10.30 LO1 Tax Incidence Vocabulary • Statutory Incidence: the party that is legally responsible for paying the tax (firms in our wine bottle example) • Economic Incidence: who actually pays for the tax, as measured by the change in the distribution of private real after-tax incomes. • Tax Shifting: the transfer of the burden of paying the tax from those that are legally liable for it to others due to equilibrium price changes • Forward shifting: the transfer of a tax burden from sellers who are legally liable to buyers through higher prices of the taxed good • Backward shifting: the transfer of a tax burden from buyers who are legally liable to sellers through lower prices of the taxed good 14-6 Tax Incidence Vocabulary • Unit tax: a tax that is a fixed dollar amount per each unit of the good bought/sold ! =#+% • Ad-valorem tax: a tax that is a fixed percentage of the price of a good ! = # + &# = #×(1 + &) Tax Incidence: General Remarks • Only people can bear taxes • Businesses (whatever their legal form) do not pay taxes. It is the owners of the business (shareholders, partners) that pay the tax • Taxes and the functional distribution of income • Studies the impact of taxes on how income is distributed across different factors of production (i.e. owners of capital, labourers, landlords) • This analysis answers the question: does a particular tax affect owners of capital more than labourers? • Taxes and the size dis.