economics 832 lecture 3 -...

Econ 832 Jan-Apr 2018 Hale Ramsey

Economics 832Lecture 3

Hale Ramsey

January 18, 2018


Thought for the Week

“In most real-world decisions about tax policy, the distributional impacts are paramount and dominate considerations of economic efficiency and operational simplicity. Public discourse on tax policy also focuses on the distribution of gainers and losers. Hence, the manner in which government officials assemble and present their information on the distributional effects of proposed or budgetary tax changes is critical, since this is the format most readily accessible to the public.”

Kesselman, J. and Cheung, R. (2004) Tax Incidence, Progressivity and Inequality in Canada. Canadian Tax Journal, Vol. 52, No. 3, p.719.

Page 1


Lecture Topics

• Extra readings: Kesselmann (2004)

• … Tax Incidence (cont’d)

• … back to Rosen …

Page 2


Extra Readings

Page 3


Kesselman and Cheung (2004)Tax Incidence, Progressivity and Inequality In Canada

Survey of incidence studies

• Identifies 3 analytical frameworks:• Inequality (INEQ): {partial eq. + general eq.}

• Estimate difference in inequality measures between gross and net income

• Computable general equilibrium (CGE):• Estimate lifetime utility incidence; generated from

assumed model structure and parameters.

• Fiscal Incidence (FINC): {partial eq.}• Micro-simulation methods to estimate incidence

patterns for individual or all taxes

Page 4



• Each type of study differs in:

• estimates/assuptions of incidence;

• measures of distributional effect; and,

• can differ in other aspects.

Page 5



• Budgetary measures of tax incidence distribution frequently differ from academic studies (p.719).

• K&C identify two approaches:• “typical taxpayer” (representative

individuals/HH, selected demographic traits, usually for taxes with assumed individual incidence income, sales, employee payroll, property)

• distribution tables (micro-simulations for individual tax bases)

Page 6



Page 7

Saskatchewan 2013-14

Budget

example of

K&C “typical

taxpayer”.



• Q: Why do budget documents use these incidence measures when INEQ, CGE and FINC studies exist?

• A: Budget documents are written for the general public, not economists.

• Most people relate better to “Sales Tax: $100”than to “equivalent variation in income”

• Also, studies do not all agree.

• The policy analyst’s dilemma: explain complex (sometimes counter-intuitive) concepts to non-economists.

Page 8



Measures of Inequality

• Gini coefficient

• most common measure

• measures degree of income inequality over income spectrum

• calculated as 2 x (area between diagonal and Lorenz curve) {see Kesselman, p.723}

• varies from 0 (complete equality) to 1 (complete inequality)

Page 9



Measures of Inequality

• Gini coefficient desirable properties:

• scale-independent (proportional changes in income do not affect Gini)

• satisfies Pigou-Dalton transfer principle (transfer from lower-income to higher-income HH must increase inequality)

• can be defined for negative incomes

Page 10



Measures of Tax Progressivity

• Most common measure: pattern of effective ATRs across income groups

• ATR rising/falling over a range of groups is progressive/regressive over that range

• Indices of global/local incidence can be constructed (pp. 728-732)

• good for analytics, difficult to convey to non-technical audience

Page 11



Measures of Economic Well-Being

• Different measure = different results

• Choices:

• Unit of observation: individual or HH?

• Income measure: broad income, pre-/post-tax/transfers/public services

• Period of observation: annual/lifetime

• Interpretation of model results requires knowledge of these

Page 12



INEQ Studies

• Typically PIT is examined

• Main measures:

• ATR progressivity and Gini coefficients

• Main results: (see tables 3,4)

• PIT strongly progressive

• Transfers reduce inequality more than taxes

• Transfers/tax credits increased over timePage 13



CGE Studies

• Most versatile; can examine entire tax system and provide different measures of incidence

• Most complex; requires specification of utility functions and associated utility/income translations

• Limited number (time, money constraints)

Page 14



CGE Results (Fullerton & Rogers,1993)

• See Kesselman, Table 9, p. 758

• Method: replace existing tax with “proportional tax on HH labourendowment” (ie: a lump-sum tax)

• Progressivity results:• PIT highly progressive

• Payroll/sales taxes regressive

• Variability in property/CIT

Page 15



• Efficiency results:• Measured in terms of sum of PV of

Equivalent Variations in Income (amount of income HH would pay to avoid the tax)

• Rankings (most to least efficient)• Payroll tax

• Consumption tax (sales/exise)

• PIT

• Property

• Corporate income or capital

Page 16



FINC Studies

• Combine incidence assumptions with income distribution datasets to derive income profile of ATRs

• Incidence and income base assumptions can significantly alter the results

• See Kesselman, p.761

• Assumptions turn progressive into regressive

Page 17



FINC Results (Canada, Kesselman and Rosen)

• Overall tax system is slightly progressive (to median income), then proportional, with some progressivityat very top income levels

• Federal system more progressive than provincial (proportional) or local (regressive)

Page 18



FINC Results• (for Canada, using Kesselman and Rosen)

• PIT most progressive

• CIT mildly progressive (until top)

• Payroll taxes prog/prop/reg

• Consumption, property and other taxes strongly regressive

• Lifetime incidence analysis suggests less regressivity than annual

Page 19



Summary

• Large-scale incidence studies scarce

• Many ways to estimate tax incidence

• Some robust results (PIT progressive), but many inconclusive

“The research literature on the distributional effects of taxes is large, diverse, and inconclusive in many ways. Any inferences that can be drawn for the direction of Canadian tax policies to reduce inequality must be highly qualified.” (Kesselman and Cheung, p.786)

Page 20


… Tax Incidence (cont’d) …

Page 21


Tax IncidenceGraphical Framework

Notes

• Taxing LS or LD

irrelevant

• DwL (EB) isarea fhm

• Tax revenue isarea h'hmm'

• Tax wedge isdistance hm(or wg – wn)

Page 22


Tax Incidence

• Worker (supplier) share of a change in the tax rate is:

dwn/wn = [ED / (ES – ED)] (dτ/(1+τ))

• But, formula derived differentially (suitable for small changes only) andelasticities can change with tax rates

• Typically, a change in tax rates will change prices, quantities, andelasticities

Page 23


Tax Incidence

• What happens to burden shares aselasticities change?

• Question is important when:

• considering changes in an existing tax (as opposed to implementing a new one)

• when making relatively large changes (formula derived assuming small changes)

• Burden share function is non-linear in behavioural elasticities

Page 24


Tax IncidenceSupply-side Incidence and Elasticities

Page 25

Unit

0 -0.2 -0.4 -0.6 -0.8 -1 -1.2 -1.4 -1.6 -1.8 -2 -2.2 -2.4 -2.6 -2.8 -3

0 -- -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00

0.2 0.00 -0.50 -0.67 -0.75 -0.80 -0.83 -0.86 -0.88 -0.89 -0.90 -0.91 -0.92 -0.92 -0.93 -0.93 -0.94

0.4 0.00 -0.33 -0.50 -0.60 -0.67 -0.71 -0.75 -0.78 -0.80 -0.82 -0.83 -0.85 -0.86 -0.87 -0.88 -0.88

0.6 0.00 -0.25 -0.40 -0.50 -0.57 -0.63 -0.67 -0.70 -0.73 -0.75 -0.77 -0.79 -0.80 -0.81 -0.82 -0.83

0.8 0.00 -0.20 -0.33 -0.43 -0.50 -0.56 -0.60 -0.64 -0.67 -0.69 -0.71 -0.73 -0.75 -0.76 -0.78 -0.79

Unit 1 0.00 -0.17 -0.29 -0.38 -0.44 -0.50 -0.55 -0.58 -0.62 -0.64 -0.67 -0.69 -0.71 -0.72 -0.74 -0.75

1.2 0.00 -0.14 -0.25 -0.33 -0.40 -0.45 -0.50 -0.54 -0.57 -0.60 -0.63 -0.65 -0.67 -0.68 -0.70 -0.71

1.4 0.00 -0.13 -0.22 -0.30 -0.36 -0.42 -0.46 -0.50 -0.53 -0.56 -0.59 -0.61 -0.63 -0.65 -0.67 -0.68

1.6 0.00 -0.11 -0.20 -0.27 -0.33 -0.38 -0.43 -0.47 -0.50 -0.53 -0.56 -0.58 -0.60 -0.62 -0.64 -0.65

1.8 0.00 -0.10 -0.18 -0.25 -0.31 -0.36 -0.40 -0.44 -0.47 -0.50 -0.53 -0.55 -0.57 -0.59 -0.61 -0.63

2 0.00 -0.09 -0.17 -0.23 -0.29 -0.33 -0.38 -0.41 -0.44 -0.47 -0.50 -0.52 -0.55 -0.57 -0.58 -0.60

2.2 0.00 -0.08 -0.15 -0.21 -0.27 -0.31 -0.35 -0.39 -0.42 -0.45 -0.48 -0.50 -0.52 -0.54 -0.56 -0.58

2.4 0.00 -0.08 -0.14 -0.20 -0.25 -0.29 -0.33 -0.37 -0.40 -0.43 -0.45 -0.48 -0.50 -0.52 -0.54 -0.56

2.6 0.00 -0.07 -0.13 -0.19 -0.24 -0.28 -0.32 -0.35 -0.38 -0.41 -0.43 -0.46 -0.48 -0.50 -0.52 -0.54

2.8 0.00 -0.07 -0.13 -0.18 -0.22 -0.26 -0.30 -0.33 -0.36 -0.39 -0.42 -0.44 -0.46 -0.48 -0.50 -0.52

3 0.00 -0.06 -0.12 -0.17 -0.21 -0.25 -0.29 -0.32 -0.35 -0.38 -0.40 -0.42 -0.44 -0.46 -0.48 -0.50

Supply-side Tax Incidence ( = [Ed/(Es-Ed)] )

Elasticity of

Supply

Elasticity of Demand

Elastic

E

l

a

s

t

i

c

Inelastic

I

n

e

l

a

s

t

i

c



Page 26

0

1

2

3

-1.0

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0.0

0

-1

-2

-3

Elasticity of Supply

Ed/(Es-Ed)

Elasticity of Demand

Supply-side Tax Incidence and Elasticities

Ed/(Es-Ed) shows

proportion of tax

passed from the firm to the worker

| Ed | > Es

| Ed | < Es



• If elasticities vary with changes in tax rates (and they are likely to do so), then tax burden estimates based on constant elasticities will be incorrect

• The extent of the error will depend on the extent of non-linearity in theneighbourhood of the change• Note that in the previous case, the burden

share changes rapidly at low elasticity values

Page 27


Tax IncidenceA Canadian Statutory Incidence Example

• EI system (2012) charges worker 1.83% statutory rate on employee earnings

• http://www.cra-arc.gc.ca/tx/bsnss/tpcs/pyrll/clcltng/ei/cnt-chrt-pf-eng.html

• Employer (firm) share is deemed to be 1.4 times the employee share

• Worker share + firm share= (0.0183 * InsEarn) + 1.4(0.0183 * InsEarn)

= (0.04392 * InsEarn)

• Implied split: worker 42%; firm 58%

Page 28



• How does implied statutory split compare with economic incidence formula?

• For worker share of 0.42, economic incidence requires:

-0.42 = ED/(ES – ED)

meaning that

| ED | < ES

(labour supply more elastic than demand)Page 29



• Combinations of ED and ES that yield worker share of burden = 42%

• To achieve this with reasonable values for ES, (up to 0.6) labour demand must be highly inelastic

Page 30

ED

ES

ED/(E

S - E

D)

-0.07 0.1 -0.42-0.14 0.2 -0.42-0.22 0.3 -0.42-0.29 0.4 -0.42-0.36 0.5 -0.42-0.43 0.6 -0.42-0.51 0.7 -0.42-0.58 0.8 -0.42


… back to Rosen text …

Page 31


Harberger Model (1974)

• Basic GE model

• Can be solved analytically; useful for basic insights into GE relationships

• 2 outputs, 2 inputs (L, K)

• Basic assumptions:

• Constant returns to scale (double inputs = double outputs)

• Elasticity of substitution (L, K) and factor intensity (K/L) differ across sectors

Page 32



• Basic assumptions (cont’d)

• HH maximize utility; firms max. profits

• K, L perfectly mobile, but fixed supply

• All prices perfectly flexible

• All factors fully employed with returns equal to the value of their marginal products

• Representative HH – therefore cannot get distributional effects

• Differential tax framework (substitute one tax for another)

Hale Ramsey Page 33


Harberger Model

• Nine possible ad valorem taxes …

… some of which are equivalent.

Page 34

Note:

see Table 14.2

in Rosen (2012)



General Results:

• Commodity (output) tax

• A tax on a sector’s output induces a decline in the relative price of the input used intensively in that sector.

• For example, if a tax is applied to the manufacturing sector’s output and manufacturing is labour intensive, then the relative price of labour will fall.

Page 35



General Results:

• Income tax (income from K & L)

• Equivalent to a tax on K and L at the same rate

• Burden is in proportion to people’s initial incomes

• Since factors must remain fully employed, there is no way to reallocate resources to escape the tax

Page 36



General Results:

• Income tax (labour only)

• Labour taxed in both sectors at the same rate

• No incentive to switch labour among sectors

• Since labour is fully employed and in fixed supply, labour bears the entire burden of the tax

Page 37



General Results:

• Partial factor tax

• Text uses example of taxing capital in manufacturing sector

• Two effects:

• Factor substitution effect: tax on capital in mfg leads to lower demand for mfg capital and lower price for capital (if K, L are substitutes)

Page 38



• Output effect: tax on capital in mfg. causes relative price of mfg output to rise, reducing market demand for mfg output

• If L/K high in mfg (labour intensive), then relatively large amounts of labour must change sectors, reducing the relative price oflabour (and increasing the relative price of capital)

• If K/L high in mfg (capital intentive), then relative price of capital falls

Page 39



Results can be theoretically ambiguous

Page 40

Note:

See Figure 14.11

in Rosen (2012)



• Like all GE models, Harberger model has theoretical ambiguities

• But ambiguities reveal the possibility for counter-intuitive results

• For example, a tax on capital in only one sector of the economy can reduce the relative price of labour in all sectors.

Page 41



• In general, GE models serve to illuminate the fact that a tax on one factor in one sector ultimately affects returns to both factors in both sectors.

• Partial Eq models do not capture this type of effect as they assume ceteris paribus (other things remain unchanged)

Page 42


Tax Incidence:What do we Know?

Where partial equilibrium models are appropriate (small share of economy):

• Need to know the market structure and basic shapes of S and D curves

• In cases other than monopoly, perfectly competitive model is useful

• Incidence analysis provides reasonable information

• If a market has a completely inelastic side, it will bear the entire tax burden

Page 43



Where general equilibrium models are appropriate (large share of economy):

• If a market has a completely inelastic side, it will bear the entire tax burden

• In most other cases, however, tax incidence is theoretically ambiguous

• Many taxes, such as corporate taxes, fall into this category, leaving incidence to be found empirically

Page 44



• Theoretical models do show what needs to be known to determine incidence (even if they don’t provide this knowledge)

• As Rosen (2012, p.298) points out: “To the extent that this information is currently unavailable, the models serve as a measure of our ignorance.”

Page 45


Chapter 14Skipped Sections

Some sections of Chapter 14 have been temporarily skipped

• Monopoly taxes (p. 284-5)

• Profits taxes (p. 285-6)

• Tax capitalization (p. 286-7)

These are short and will be picked up in later sections.

Page 46


The End

Questions?

Page 47

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