Fiscal Reform and Economic GovernanceContract No. GEG -I-00-04-00001-00, order No. 06

Tax Policy Analysis

2007

A Learning Tool of the Fiscal Reform and Economic Governance Project

www.fiscalreform.net

User note

• The user should print this MSPowerpoint presentation using the notes view, since the note pages provide much additional information.

• This course requires some background in microeconomic analysis

• Mini-course duration: 5 hours.• Fiscal Reform and Economic Governance Project advisors are

available to provide this training to USAID offices around the world.

• Contact David Dod, CTO at ddod@usaid.gov or Mark Gallagher, COP at mgallagher@dai.com.

Course outlineA. Objectives

B. Analytical Tools

B.1 Criteria for evaluating taxes

B.2 Economic efficiency

B.3 Tax on land

B.4 Personal income tax

B.5 Tax incidence

B.6 Conclusions

C. Analysis of tax incentives

C.1 Types of tax incentives

C.2 Arguments for and against

C.3 Analytical tools

C.4 Case studies

C.5 Consensus among experts

C.6 Conclusions

D. Resources

A. Objectives

• This Learning Tool was prepared for professionals with some training in economics. It will provide professionals with some of the basic analytical tools they need in their work in analyzing taxation and in working on teams to reform tax systems. Understanding and applying these analytic tools will help deepen the analyst’s understanding of the economic and social issues related to taxation and will take the analyst beyond merely being able to parrot the advice of top professionals in the field.

B. Analytical tools

B.1 Criteria for evaluating taxes

B.2 Economic efficiency

B.3 Tax on land

B.4 Personal income tax

B.5 Tax incidence

B.6 Conclusions

B.1 Criteria for Evaluating Taxes

• Efficiency• Simplicity• Equitable treatment

More criteria: two faces of the same coin

• Concentration

• Erosion

More criteria

• Objectivity

• Compliance

• Administrative costs

B.2 Economic efficiency: Deadweight Loss (social welfare)

S = MC

D = AR

Consumer surplus

Producer surplus

Po E: MC = MR = P = AR

Q

P/Pl

Qo

Deadweight loss from unit tax

S = MC

D = AR

Po

S’ = S + tQ

P/Pl

QQoQ1

Pc

Ps

A B CDEF

Continue……….

S = MC

D = AR

Po

S’ = S + tQ

P/Pl

QQoQ1

Pc

Ps

A B CDEF

S’

S’

S

S

D: e < 1

D: e > 1

Relative price indices

Quantities

Quantities

Market for Cigarettes

Market for Gouda

Excess burden and elasticity of demand

Excess burden and the tax rate

S = MC

D = AR

S’ = S + tQ

P/Pl

QQoQ1

C

S’’ = S + 2tQ

Q2

A

B

B.3 Tax on land

Po

P’

Q0=Q’

DoD’

Relative priceOf land

Quantity of land

B.4 Personal income tax

<- work : leisure ->

Net Earnings

24 hours per dayAll workand no play

Wo W’

Io

I’ I’

Io

Personal income tax (with downward sloping labor supply curve)

<- work : leisure ->

Net Earnings

24 hours per dayAll workand no play

WoW’

Io

I’I’

Io

Personal income tax with no impact on labor supply

<- work : leisure ->

Net Earnings

24 hours per dayAll workand no play

WoW’

I’

Io

Income tax and savings

• Income tax differs from consumption tax

• Consumption tax usually on transactions

• Income tax on accounts

• Tax base is equal to consumption plus saving

• So, does income tax affect saving?

B.5 Tax incidence

• Who really bears the burden of a tax

• It is measured in terms of lost surplus

• How taxes are really shared, depends on supply and

demand elasticities

Tax incidence: excise unit tax

S’

S’

S

S

D: e < 1

D: e > 1

Relative price indices

Quantities

Market for Cigarettes

Market for Gouda

Tax per unit

Tax per unit

Q

Q

Cs

Cg

Pg

Pc

Tax incidence: import tariffs

Domestic market forimported shoes

Domestic demand forImported shoes

World supplyPw

Pd = Pw(1+t)

Tax rate = t

D

A B

Incidence: VAT

• Full incidence is on the consumer• Since poor people consume all of their income but

the rich only a portion, then it must be true that the tax is regressive?

• Savings is merely future consumption, so maybe not.

Incidence and social class

• First, calculate who bears the incidence in the market– Producer– Consumer– Worker– Employer

• Then see how these persons are distributed by income class• Some questions

B.6 Conclusions

• Tax bases should be as broad as possible• Tax rates should be as low as possible• Income tax may or may not reduce the supply of

labor• Income tax may or may not affect savings• Tax incidence is based on elasticities• Tax cannot be exported

C. Tax Incentives

C.1 Types of tax incentives

C.2 Arguments for and against

C.3 Analytical tools

C.4 Case studies

C.5 Consensus among experts

C.6 Conclusions

C.1 Typology (profit/CIT)

• Low rates/differential rates• Investment tax credits• Tax holidays• Accelerated depreciation• Loss carry forward

C.2 Arguments for and against tax incentives

• For– Increase employment– Compensate for bad infrastructure– Encourage business formation– Attract foreign investment

• Against– Unfair, raise burden on others– Unfair competition, I succeed because of tax break not

because of better product, service, or management.– Open to cheating– Usually do not really work

C.3 Analytical tools

• Cost of capital model

• Favored sector

• Non-favored sector

• Compensated sector

Cost of capital and investing

CoK

CoK

VMPk

Io I’

Tax incentives: favored and non-favored industries

CoK

CoK’

Kf Kn

VMPkf

VMPkn

CoKCoK

Lf Ln

LfoLf’ Ln

Tax incentives: favored and compensating sectors

CoKco

CoK’

Kf Kn

VMPkf

VMPkn

CoKCoK

Lf Lc

LfoLf’ Lco

CoKc’

Lc’

C.4 Case studies

• Indonesia

• Uganda

• Cape Breton Island in Canada

• What the gurus say

Indonesia 1984

• Company tax reduced from 45% to 35%

• Selective incentives eliminated, such as: tax holidays,

preferential tax rates, and selective investment allowances

• Results

– Number of Foreign Direct Investment projects continued to rise

– Value of Foreign Direct Investments soared after 1986

– Indonesia’s share of Foreign Direct Investments into ASEAN-

Region nearly doubled by early 1990s

This chart adapted from a workshop presentation made By Dr. Bruce Bolnick of Robert Nathan Associates, Inc. at the World Bank, June 2005.

Uganda 1997

• Elimination of new tax holidays in favor of uniform 30% company tax, favorable capital allowances

• Effects: 3-year averages, before and after 1997

1994-1996 1998-2000Gross fixed capital formation, % GDP 15.7 % 16.6 %Foreign direct investment $110 m. $170 m.Tax revenue as % GDP 10.4 % 11.6 %Income tax (non P.A.Y.E), % total tax 9.2 % 9.8 %

Data sources: EIU Country Data Online, Bank of Uganda, Annual Report 2000/2001

This chart adapted from a workshop presentation made By Dr. Bruce Bolnick of Robert Nathan Associates, Inc. at the World Bank, June 2005.

Canada: Cape Breton Island

• Investment tax credit up to 60% of the investments

made on Cape Breton Island against Federal Tax

• Objective was to spur growth and create employment

Canada results of evaluation

• Led to substitution of capital for labor

• Lowered costs -> increased profit -> increased production in

Cape Breton

• Cost of jobs created was extremely high

• Cheaper to subsidize labor

• Direct subsidy would have created more jobs

• Only 19 of the investments were incremental

• -> Labor productivity, but->Capital productivity, not sustainable

C.5 What the experts say

• Solidifying positions

• Musgrave and Musgrave 1980

• Dale Chua, IMF: Tax holidays (1995)

• Holland and Van (1998)

• Tanzi and Zee (2000)

C.6 Conclusions

• Tax incentives are attractive to investors who are planning to invest with or

without the tax incentive.

• Tax incentives may lead to increased investment, production and employment,

but this is not necessarily the case.

• Increases in investment and jobs in one sector may decrease investment and

jobs elsewhere, resulting in a net reduction in overall investment and jobs.

• The jobs created because of tax incentives sometimes have been created at

very high cost

• Very careful analysis should be conducted before even contemplating creating

tax incentives.

D. Resources

1. Our library on tax policy and administration: http://www.fiscalreform.net/index.php?

option=com_content&task=category&sectionid=8&id=23&Itemid=61

2. OECD’s Centre for Tax Policy and Administration has useful resources. See:

http://www.oecd.org/about/0,2337,en_2649_37427_1_1_1_1_37427,00.html

3. For Bruce Bollnick’s report on Tax Incentives and SADC Region see:

http://pdf.usaid.gov/pdf_docs/PNACY929.pdf