1. Redistribution

2. If there is inequality…should there be redistribution? market-based distribution does not reflect productivity due to……………………… as an individual gets more and more income, the marginal utility of an extra dollar tends to………….. (DMU of money) too much income inequality could lead to many problems (such as crimes, poor health etc.), which impact the economy (negative externalities of poverty)

3. Methods that can be used to promote equity (redistributing income) Transfer payments Subsidized provision and direct provision of merit goods Government intervention in markets eg minimum wage legislation Designing various taxation schemes and systems

4. 1. Transfer Payments Transfer payments (social security/welfare) are from the government to individuals. They transfer income from those who work and pay taxes towards those who cannot work and need assistance DISPOSABLE INCOME = Y d = income − income taxes + transfer payments people who receive transfer payments – elderly – sick people – children of poor families – unemployed people etc

5. (continued) Transfer payments include: – old age pensions – disability pensions – unemployment benefits – war veterans’ benefits – maternity benefits – child allowances – housing benefits for the poor – student grants and many more

6. . Subsidized provision or direct provision of merit goods Merit goods are beneficial for consumers but are underprovided by the market and underconsumed They are underprovided and resources are underallocated for their production due to….. – Positive externalities – Low levels of income and poverty (some people are too poor to afford them) – Consumer ignorance and unawareness (e.g. HIV tests, annual immunization and health check-ups, museums)

7. (continued) If income distribution were left entirely to the market, two of the most important merit goods: education and health care would be underconsumed due to low incomes and poverty Merit goods can be made accessible to all if governments directly provide them free of charge or nearly free of charge (below the market price and cost of production) to consumers through subsidies Governments may also provide subsidies to private providers to increase supply

8. 3. Government intervention in markets Governments can also intervene in markets in ways that change the distribution of income food price ceilings price floors for farmers minimum wage legislation

9. 4. Taxation System Taxes are the source of government revenue/budget income to spend on transfer payments, subsidies, public goods, military, etc., yet, are also an important instrument for redistributing Two broad categories: direct and indirect taxes (slides 10 onwards for more information done with Group III)  H/O pp 10/11 (Group III Mon April 4) – Three principles or philosophies: proportional, progressive and regressive(slides 16 onwards for more information) – Two (mathematical) forms: average and marginal tax rates – (slides 26 onwards for more information) –  Japanese system and effects on Gini Coeff (pp 6/7)

10. Two Broad Categories of Taxation

11. Direct and Indirect Taxes – Direct and indirect basically comes from whether taxes are paid directly to the government through incomes – or - indirectly through consumption/expenditure

12. Direct Tax Direct taxes are taxes paid directly to the government tax by the taxpayer They include : – Personal income taxes: charged on all forms of income, including wages, rental income, interest income and dividends. The largest contributor of government budget – Corporate income taxes: taxes on the profits of corporations – Wealth taxes: taxes on the ownership of assets i.e. property and inheritance taxes – Social insurance (social security) contributions or payroll taxes: paid by workers and their employers which are used by the government for specific purposes pensions, social insurance and health care. Often known as earmarked taxation

13. Indirect Taxes Indirect taxes are taxes on spending on goods and services “indirect” because while consumers are the ultimate payers of a part or all of these taxes, they pay indirectly through the suppliers of the good or service purchased (the suppliers may be the producers, the retailers, or generally the sellers) – expenditure taxes, sales taxes, consumption taxes: these are taxes on spending or sales of goods and services often a fixed percentage of the retail price of goods and services with some goods i.e. necessities such as food and medications being exempt from being taxed. In the EU it is a ‘value added tax’ (VAT) …

14. (continued) VAT differs from a sales tax in that it is a tax paid on the value added by each producer in the production process – The production process until the final completed good can involve many distinct stages involving different producers. Producers may have to purchase semi-made goods from other producers to complete the good. Now, if there is more than one stage in the production process, the firm pays VAT for each stage in which value is added. Thus the total VAT paid by the firm is the sum of the value added taxes paid at each stage in the production process. When the good or service reaches the market place, its price includes the VAT that has been paid by all the firms involved in its production. Each country in the European Union has its own particular VAT rates

15. (continued) Other indirect taxes : – Excise taxes - taxes paid on specific goods and services, such as cigarettes and petrol (gasoline) – Customs duties also known as tariffs which are tax applied on imports of foreign goods into a country Usually comprise a small portion of developed countries government budget (around 1 to 3%) but a huge part of developing countries (in some cases close to 50%). Alas, trade matters for world development

16. Three Principles of Taxation

17. One purpose of taxation is to redistribute income to make society more equal and equitable. This can be based on different principles and methods The different types of taxes can be defined or classified as being proportional, progressive, or regressive depending on the relationship between income and the fraction of income paid as tax Fraction of income paid as tax, in percentage terms = the tax rate

18. (continued) Proportional taxation: as income increases, the fraction/percentage/proportion of income paid as taxes remains constant; there is a constant tax rate Progressive taxation: as income increases, the percentage of income paid as taxes increases; there is an increasing tax rate Regressive taxation: as income increases, the percentage of income paid as taxes decreases; there is a decreasing tax rate

19. Example The table shows three possible income levels, and four hypothetical taxation systems with differing tax rates In each case, the amount of tax is calculated by multiplying the amount of income times the corresponding tax rate What pattern do you see? What can you say about the redistribution and equality in income after the tax? – the more progressive a tax system, the more equal (or less unequal) the after-tax distribution of income (disposable) becomes … is it fair and equitable is a normative question which depends on the values of the people

20. Linking these principles to the different types of taxes Progressive, proportional and regressive taxation apply to all types of taxes, whether direct or indirect – Personal income taxes in most countries are progressive (or proportional eg local income tax in Japan) – Corporate income taxes are usually proportional – Social insurance contributions are also usually proportional (flat-rate taxes) – Indirect taxes (of all types) are ……………… (H/O and slides 22/23) – Lump-sum taxes are……………………

21. Example Assume a hypothetical tax system with an exclusion of £10 000; this means that any income up to this amount is not taxed at all. And suppose that all incomes above this amount are taxed at 15% (proportional taxation) as shown below for different income levels Taxable income is income minus the exclusion; the amount of tax is calculated as 15% of taxable income. The effective tax rate is found by dividing the amount of tax by the amount of income. And as you can see, the effective tax rate is increasing, the proportional tax system with exclusions has become progressive

22. Calculating the tax rate for an indirect tax For example, suppose a family with an annual income of €50 000 spends €40 000 on goods and services, which includes an indirect tax (a value added tax or sales tax) of 18% Therefore 18% of the €40 000 represents payments on the indirect tax. This family must pay a total amount of €40 000 × 0.18 = €7200 on indirect taxes. As a percentage of income, this amount of tax represents amount of tax represents €7200/ €50000 = 0.144, or 14.4% of income That is, the average indirect tax rate for this family is 14.4% (and NOT 18%!)

23. Why Indirect Taxes are Regressive To see why indirect taxes are regressive, consider two individuals, XX and XY. Individual XY has an annual income of $10 000 and individual XX has an annual income of $20 000 Each one buys a car for $10 000 (without tax), on which there is an indirect tax (VAT, or sales tax, or tariff) of 10%, therefore, amounting to $1000 Now, the $1000 of tax is 10% of individual XY’s income, and it is 5% of individual XX’s income. In other words, as income increases from $10 000 to $20 000, the percent of the total income paid on the indirect tax decreases from 10% to 5%. And this is the definition of regressive taxation It follows that indirect taxes are inconsistent with the objective of a more equal distribution of income.

24. Two Main (Mathematical) Forms of Taxation

25. Average vs Marginal Tax Rates Average tax rate is defined as tax paid divided by total income, expressed as a percentage Marginal tax rate is defined as the tax rate paid on additional income. In the real world, income taxes in a progressive tax system are calculated using successive layers of income, and applying a different tax rate to each layer. The layers of income are called ‘tax brackets’, and the corresponding tax rates are called ‘marginal tax rates’  H/O and following examples

26. Based on these marginal tax rates, suppose we want to calculate the amount of income tax paid on an annual income of $59 000 The total tax paid is as follows: And the total tax rate is

27. Relationship between marginal and average (continued) Calculate the income tax paid on income of $175 000 Total tax paid is: Total tax rate is: Now, comparing with the case of $59 000 with 16.2% as the average tax rate we see that the higher income has a higher average tax rate, just as expected since this is a progressive tax system Also notice that the marginal rate is…………………than the average rate

28. To Sum All countries have tax systems consisting of many different types of taxes. Whether the overall tax system of a country is more progressive or regressive depends on the mix of taxes and tax rates, and their relative importance as sources of government revenue. It also depends on the people’s beliefs towards equity and fairness as represented by the government – For example, suppose a country has a system of progressive income taxes, as well as a variety of indirect taxes, which are regressive. If most tax revenues come from indirect taxes, it is likely that the overall tax system tends to be…………… (and vice versa)

29. Redistribution in Japan See H/O page 12

30. Evaluation of progressive taxes FOR AGAINST

31. Effect of an increase in taxes (i.e. a reduction in DISPOSABLE INCOME Y d = income – taxes + transfer payments) Suppose earning ¥2000 per hour and the average tax rate increases from 5% to 10% Y d1 = Y d2= Substitution Effect Income EffectOVERALL effect

32. Evaluation of redistribution FOR AGAINST

33. A rich guy’s case………. See H/O pp 13-14 + digital version Tax Havens….the PANAMA papers http://www.theguardian.com/news/2016/apr /03/the-panama-papers-how-the-worlds-rich- and-famous-hide-their-money-offshore