Tax rates and poverty

Syllabus aims…. Students should understand the possible link between changes in tax rates and tax revenues.

Recap HWK set p 412 Make your own notes on the inefficiencies of taxes Using the 3 bullet points in the paragraph – add your own micro diagrams to support the criticisms of taxed. P415 – explain the difference between progressive, proportional and regressive taxes.

Inefficiency in tax system VAT & excise duties – push the supply curve to the left… which in turn leads to a fall in demand. Did your curve swivel? Income Tax is likely to lead to a fall in supply of labour to the market. Did your curve shift inward? Corporation tax is likely to reduce a fall in the supply of entrepreneurs to the market. BUT… tax on environment / negative externalities brings private costs & benefits in line with social costs & benefits.

Inefficiency in tax system Distorts the market Creates a loss of efficiency – to tax an individual item But…. Tax is more cost efficient way to raise govt revenue….

Different types of tax Progressive taxation — as income rises, a larger % of income is paid in tax (eg UK income tax). Regressive taxation — as income rises, a smaller % of income is paid in tax (eg VAT). Proportional taxation — the same % of income is paid in tax, no matter what the level of income.

Regressive taxes A tax that takes a larger percentage from low-income people than from high-income people. A regressive tax is generally a tax that is applied uniformly. This means that it hits lower-income individuals harder. For example, if a person has £10 of income and must pay £1 of tax on a package of cigarettes, this represents 10% of the person's income. However, if the person has £20 of income, this £1 tax only represents 5% of that person's income.

Progressive and regressive taxation Progressive taxes –With a progressive tax, the marginal rate of tax rises as income rises. –i.e. as people earn more income, the rate of tax on each extra pound earned goes up –This causes a rise in the average percentage rate of tax Regressive taxes –With a regressive tax, the rate of tax falls as incomes rise –In the UK, most examples of regressive taxes come from duties on items of spending such as cigarettes and alcohol.

Factors affecting tax revenues Oil prices & other costs – affect business profits Changes in the real incomes of people in work The tax base – how many things the government taxes Asset prices – e.g. changes in share and house prices Rate of economic growth and the rate of inflation Level of employment and unemployment Factors that influence total tax revenues

Judging effective taxes…. A person earning $100,000 in Sweden has 37.5% of it deducted as income tax, according to an annual survey of effective tax rates by KMPG, an accounting firm. Sweden’s income-tax rates are among the world’s highest, but the addition of social-security contributions means that people earning this sum in Slovenia, India or Italy take home an even smaller share of their gross earnings. Slovenia’s government deducts almost 55% from earnings of $100,000. Social-security levies eat up a chunky 22% of earnings at that level in France, but low income taxes bring the total take, at 36%, into line with that in other rich nations. Switzerland’s effective tax rate on the fairly well-off is one of the lowest in the world.

Fiscal drag Government tax revenues can often rise without anyone really noticing! Fiscal drag happens when the value of items that are taxed rises more quickly than the value of tax free allowances –Income tax: Earnings from work rise faster than the annual upgrade in the tax free allowance –House prices: Tend to rise faster than the allowances for stamp duty and inheritance tax When the economy is strong and real incomes and asset prices are rising, “fiscal drag” can add several billion pounds a year of extra tax revenue into the government’s coffers General definition –The increase in real tax revenue when inflation raises nominal income and pushes people into higher tax brackets in a progressive income tax system

Laffer Curve theory What is the most efficient rate of tax?

The Laffer Curve Idea 0 Total tax revenue Average tax rate (%) 100 R max. t1t1 How much tax revenue would be earned at 0%? How much tax revenue would be earned at 100%?

Laffer Curve concept… Professor Art Laffer suggested that, as taxes increased from fairly low levels, tax revenue received by the government would also increase. However, as tax rates rose, there would come a point where people would not regard it as worth working so hard (or find loopholes to avoid paying the higher rate). This lack of incentives would lead to a fall in income and therefore a fall in tax revenue. The logical end-point is with tax rates at 100% where no one would bother to work (understandably!) and so tax revenue would become zero

Link to MR V work Gini co- efficient Lorenz curve… The more efficient the tax system – the better the equality!

The Laffer Curve – use… Often used as a justification for lower taxes as a supply side policy to improve incentives Of contemporary relevance given the interest in flat-rate taxes e.g. in Eastern Europe Concept that there might be a revenue maximising tax rate – the peak of the Laffer Curve, where raising taxes beyond this point could reduce tax yields

The Laffer Curve – economic reasoning The government offers a lump-sum tax rebate or lowers the basic / higher rates of tax 1.Post tax rates of return to working increase – improved incentives to work “at the margin” 2.Lower taxes may encourage inflows of FDI 3.Higher disposable incomes – boosts consumption 4.Less incentive to avoid / evade taxes 5.Lower company taxes increases planned investment and boosts stock prices (reducing the cost of capital) 6.Lower taxes may lead to an improvement in the long run trend rate of growth for the economy

Evaluation The central question is the elasticity of work with respect to tax rates – will people work longer if taxes are cut? –No guarantees! –How many people have flexibility in the hours they work? Why should the government seek to maximise revenue from taxation? Which is best – a lump sum tax rebate or a cut in tax rates? Lower taxation will, in the short term, increase the size of the budget deficit, this will increase bond yields (interest rates) which might have a negative effect on demand Really – the Laffer Curve is just an application of the idea of diminishing returns

Taxation and the supply-side Consensus that tax systems can have an important effect on the supply-side of an economy –Income tax and the incentive to work –Corporation tax Incentives to invest in new capital Tax competition as a means of attracting foreign direct investment into a country –Taxation and the incentive to spend on research and development –Employment taxes and the demand for labour

More recent tax proposals Romania’s fat tax! China’s land tax

Your go… Textbook p Case study on Flat Tax Do Q 1 & 2 Explain the difference between the current income tax system and the proposed flat tax Discuss whether a flat tax would be more efficient and more equitable than the current tax system