L11200 Introduction to Macroeconomics 2009/10 Lecture 21: Taxation Reading: Barro Ch.13 18 March 2010

Summary Last time: introduced topic of government expenditure Large proportion of GDP and employment Spent on transfer payments and activities Offsets private consumption Today: understanding tax structures More realistic structures than a lump-sum tax

Lump-Sum Taxation Last week modelled taxation as a lump-sum transfer to the government Each period households paid T and (maybe) received V, irrespective of current income or wealth

Forms of Taxation In reality, taxation takes two forms: income tax and asset income tax Income tax: tax paid on earned income from employment Asset income tax: tax paid (per annum) on value of asset income gained by the household Two forms have different implications for household behaviour

Income Taxation IFS SLIDE ON MARGINAL TAX RATES

Modelling Income Tax Household budget constraint: Now assume that tax is taken in proportion to income. Tax rate τ, so every extra unit of income earned raises net income by (1-τ)

Substitution and Income Effects Taxing income affects labour supply decision Hour of work now yield less income, so negative substitution effect (encourages leisure) Less overall income causes negative income effect, households demand less leisure / consumption and so work more Plus, income effect is offset if additional tax is used to increase transfer, V So net effect likely to increase leisure

Effect on factor inputs Less labour supply means MPK also falls Labour and capital combined in production via Cobb-Douglas production function So fall in labour supply causes MPL to increase (wage increase) But causes MPK to fall as capital-labour ratio now increased Fall in MPK reduces demand for capital services

Effect on Output Income tax reduces supply of labour and demand for capital services So overall production in the economy falls Lower output produced in current and future periods Hence taxation isn’t neutral (as in the case of a lump-sum tax), it does influence the production decision.

Tax on Asset Income Tax levied on income arising from asset returns Now income earned from bond / capital holdings is taxed at rate τ So after-tax real interest rate is So households have incentive to defer consumption

Effect on factor inputs But does taxing asset income also affect factor inputs? New return on capital investment: So households now seek to maximise this modified return when making capital investment decisions after-tax real interest rate = after-tax rate of return on ownership capital

Effect on factor inputs Modifying return to capital supply leaves optimal supply unchanged MPK remains the same, so demand for capital services as before Modified capital income expression implies no change to optimal κ, so utilisation also unchanged Households employ the same capital services as before

Effect on Output Asset income tax does not change output decision But does encourage households to bring consumption forward Higher consumption now means lower investment, so lower long-run growth Effect of asset income tax is to reduce GDP in the long-run

Which is better? Which form of taxation is to be preferred? Income taxation lowers output permanently Asset income taxation reduces investment in the short-run and output in the long-run i.e. asset income taxation similar to a consumption tax which taxes future consumption more heavily

Summary Taxing the return to factor inputs alters the decision about how much of those inputs to use Taxation labour income discourages labour supply Taxing asset income discourages investment Lump-sum taxation created neither of these distortions, but taxed individuals irrespective of their wealth So trade-off between efficiency and equity

Summary Taxation is not ‘neutral’: Next time: Money neutrality: changing money supply has no effect on real activity Tax non-neutrality: taxing income / asset returns does affect real activity Next time: Governments tax and spend, but also have debt Consider the ‘public budget’