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

2. 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

3. 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

4. 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

5. Income Taxation
IFS SLIDE ON MARGINAL TAX RATES

6. 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)

7. 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

8. 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

9. 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.

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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’