Prepared by Apostolos Serletis PowerPoint Slides to accompany Prepared by Apostolos Serletis University of Calgary

C h a p t e r 1 3 Taxes

Taxes in Canada

Types of Taxes

Types of Taxes

Types of Taxes Taxes fall on forms of income: individual income taxes, corporate profits taxes, and contributions for Social Security. Other taxes are based on expenditures: sales taxes, excise taxes, and customs duties.

Types of Taxes The marginal tax rate is the additional tax paid on an additional dollar of income. The average tax rate is the ratio of total taxes paid to total income. An important property of the Canadian federal individual income tax is that the marginal tax rate rises with income.

Types of Taxes

Types of Taxes

Types of Taxes

Taxes in the Model Household Budget Constraint C + (1/P)·ΔB + ΔK = (w/P)·Ls+ r·(B/P+K) + V − T Let τw be the marginal tax rate on labour income. a higher τw will generate more tax revenue for the government unless the amount of labour income falls sharply.

Taxes in the Model Let τw be the marginal tax rate on labour income. a higher τw will generate more tax revenue for the government unless the amount of labour income falls sharply. After-tax real wage rate = (1−τw)·(w/P)

Taxes in the Model If the marginal tax rate, τw, rises, for a given w/P, (1−τw)·(w/P) falls. We predict that the household would reduce the quantity of labour supplied, take more leisure time, and consume less.

Taxes in the Model V − T = −G. Therefore, if government purchases, G, are unchanged real transfers net of real taxes, V − T, must also be unchanged. For given G, we do not get any changes in household real income through the term V − T. In other words, if G is fixed, there are no income effects from a change in τw.

Taxes in the Model

Taxes in the Model For a given pretax real wage rate, w/P, a higher τw implies a lower after-tax real wage rate, (1 − τw) · (w/P) . A rise in τw shifts the labour supply curve leftward from the blue one labeled Ls to the green one labeled (Ls)ʹ . This decrease in labour supply reflects the substitution effect from the higher labour-income tax rate, τw

Taxes in the Model A higher marginal tax rate on labour income, τw, lowers the quantity of labour input, L. This effect will spill over to the market for capital services because the reduction in L tends to reduce the marginal product of capital services, MPK.

Taxes in the Model

Taxes in the Model Y = A· F(κ K, L) We found that a rise in the labour-income tax rate, τw, reduced the quantities of labour, L, and capital services, κK. A higher marginal tax rate on labour income, τw, leads to a reduction in overall market activity, as gauged by real GDP, Y.

Taxes in the Model A Tax on Asset Income C+ (1/P)·ΔB+ΔK = (w/P)·Ls + r · ( B/P +K) + V − T Suppose now that real taxes, T, depend on a household’s real asset income, r · (B/P + K) r = ( R/ P) · κ − δ(κ) Let τr be the marginal tax rate on asset income.

Taxes in the Model A Tax on Asset Income For the choice between C1 and C2 is the after-tax real interest rate, (1 - τr)·r . If τr rises, for given r, (1− τr)·r declines. Households have less incentive to defer consumption, and react by increasing C1 compared to C2. For given real income in year 1, an increase in τr motivates households to consume more and save less in year 1.

Taxes in the Model A Tax on Asset Income (1−τr) · r = (1−τr)·[(R/P)·κ−δ(κ) ]

A Tax on Asset Income We know that a decrease in (1 − τr ) · r has intertemporal-substitution effects on consumption. The household raises year 1’s consumption, C1, compared to year 2’s, C2. For given real income in year 1, the household consumes more and saves less in year 1. Recall that year 1’s real GDP, Y1, does not change, and that Y1 = C1 + I1 + G1. We are assuming that government purchases, G1, are unchanged. The increase in C1 must correspond to an equal-sized reduction in year 1’s gross investment, I1. Thus, the key result is that a higher tax rate, τr , on asset income leads to higher C1 and lower I1.

An Increase in Government Purchases Financed by a Labour Income Tax In Chapter 12, we examined the effects from a permanent increase in government purchases, G. We assumed that the increase in G was financed by lump-sum taxes. Our finding was that an increase in G by one unit left real GDP, Y, unchanged and reduced consumption, C, by about one unit. Gross investment, I, was unchanged. Also unchanged were the real wage rate, w/P, the real rental price, R/P, and the real interest rate, r.

An Increase in Government Purchases Financed by a Labour Income Tax We will get different results if the combination of permanently increased government purchases, G, and the higher marginal income tax rate, τw, affects the quantity of labour supplied, Ls.

An Increase in Government Purchases Financed by a Labour Income Tax The various forces that affect Ls. An increase by one unit in each year’s government purchases, G, required real taxes less real transfers, T − V, to rise by one unit in each year. We found in this chapter that the substitution effect from a higher marginal tax rate, τw, on labour income reduces the quantity of labour supplied.

An Increase in Government Purchases Financed by a Labour Income Tax We see that the overall effect from a rise in government purchases, G, on the quantity of labour supplied, Ls, depends on the offsetting influences from an income effect and a substitution effect. The income effect predicts that Ls would rise. The substitution effect predicts that Ls would fall. The overall effect on Ls is uncertain.

An Increase in Government Purchases Financed by a Labour Income Tax Empirically, the overall effect from permanently increased government purchases, G, on the quantity of labour supplied, Ls , seems to be small.

The Laffer Curve

Transfer Payments Suppose that the government increases real transfers, V, and finances these expenditures with increased real taxes, T, collected by a tax on labour income. In this case, marginal income tax rates, τw, rise for two reasons. First, the rise in T goes along with a higher τw for households that pay individual income taxes. Second, for households that are receiving transfers—such as poor welfare recipients—the expansion of the transfer program raises the implicit marginal income tax rate, τw, because of the income testing for benefits. We therefore predict even stronger effects In particular, labour input, L, capital services, κK, and real GDP, Y, tend to decline.