PUBLIC FINANCE

THEORETICAL CONCEPTS
OF TAXATION
 WHAT TO FOCUS ON

Economic Effects of Taxation

Incidence of Taxation
Different Concepts of Taxation
 ECONOMIC EFFECTS OF TAXATION

1.Tax effects on Consumer and Producer Surplus

In a market without taxes, the difference between the market price of a
good and the highest amount consumers would be willing and able to pay
for it is referred to as consumer surplus. Consumer surplus occurs because
first, every consumer has his own maximum price he would be willing to pay for a
good (although the market aggregates this demand, along with supply, to produce
a market price); secondly, is due to the fact that demand is rarely perfectly
elastic. For most goods there is a limit to how much or how little consumers will
buy, no matter how much the price changes. For example, people are unlikely to
stop buying bread if the price rises, and they are unlikely to buy a lot more bread if
the price falls. In effect, consumer surplus can be seen as the total use or value
that consumers get without paying for it
 ECONOMIC EFFECTS OF TAXATION

Producer surplus represents the difference between the market price and
the lowest amount for which producers would be willing and able to sell a
good in a market without taxation.
It is possible -- and, in fact, normal -- that there will be consumer surplus and
producer surplus for the same good.
In the same way each consumer has her own maximum price for a good, each
producer has a minimum price for the good.
In most cases, this is at or slightly above the producer's costs, because there is no
benefit to producing and selling more cheaply than this. In effect, producer surplus
means profit.
 ECONOMIC EFFECTS OF TAXATION

Tax Effect
The addition of the tax will also remove some consumer and producer surplus. Consumers are
forced to pay more for the same good because the price has risen.
Meanwhile, producers are losing out on potential profits because their revenue has not increased by
as much as the price rise would suggest.
Total surplus will therefore be reduced, because people and firms sell or buy less of a good when
the tax adds to its price. The effective price paid may rise, causing the demand curve to shift to the
left, or the effective price received may fall, causing the supply curve to shift to the left, creating
the Deadweight Loss. This means that some people that would have engaged in trade without the
tax, no longer are "willing and able" to buy or sell the good, meaning their surplus disappears, and
the tax revenue that would have been derived from their market participation disappears as well.
Thus, taxes always cause deadweight Losses for society and always negatively affects the free
market system.
 ECONOMIC EFFECTS OF TAXATION

Graphic example of the effect of sales tax on producers and consumers

The initial equilibrium is at point E, with price Pe and quantity Qe. At the outset, the gains from trade
are shown by PmaxEPmin, allocated as before between consumers and producers. Suppose now
that the government imposes a per unit sales tax of say, TZS T per disk on the sale of compact disks
(A to E'). We know that the tax raises the costs of production by TZST for each disk that is produced.
As a result, the industry supply curve shifts up vertically by the TZST, leading to a higher equilibrium
price, PT and a lower equilibrium quantity, QT. The impact of the tax on consumers' surplus is clear:
From consumers' perspective, the price of disks rises, and they reduce consumption in response.
Instead of enjoying a surplus of PmaxE’Pe, they now must makedo with the smaller surplus PmaxE'PT.
Thus, consumers lose the area PTE'EPe.

As viewed by producers, the tax-inclusive price of CDs rises to PT, but of course TZST per disk must
be handed over to the tax collector. Thus, the net (after-tax) price received by sellers falls to PN
(which equals (PT - T)). The new level of producers' surplus is shown by the triangular area PNAPmin,
which is clearly smaller than before the tax. Indeed, producers lose the area PeEAPN
 ECONOMIC EFFECTS OF TAXATION

2.Tax Effects on Demand and Supply

Putting a tax on a good distorts the relationship between demand and supply. Taxes have an effect
on the amount of supply produced and consumer’s demand for goods. Taxation puts both
consumers and producers in a worse position because with the introduction of taxes, the price that
consumers pay is higher than what they would have paid before. On the other hand, the price that
producers get after the introduction of taxes is lower than what they would have received before
taxation.

The resulting change in relative cost of goods and services will have an effect of motivating
consumers to switch from one product or activity to another. The act of switching from one product
to another as a result of a tax, given a certain income level, leads to substitution effect. The
substitution effect interferes with consumer choice and subsequently leads to economic
inefficiency. Taxes that affect relative prices and influence consumers to substituting consumption
of the taxed commodity for another are also termed distortionary taxes and the substitution
changes the consumer’s tax liability.
 ECONOMIC EFFECTS OF TAXATION

3.Tax effects on savings

Taxes can reduce economic growth by affecting savings and investment. The higher the proportion
of income that is being saved and invested, the higher will be the future income level. In other
words, through its impact on the amount of the income being saved or invested, taxation policy
has a crucial effect on the future level of income per capita. The effect of taxes on saving (of
individuals and companies) is briefly presented below
a. Impact of Taxes on Savings of Individuals
• Wealthy individuals save more than poor citizens, so it is expected that the taxes collected from
higher tax brackets create more burden on savings than the ones collected from lower tax
brackets.
• Consequently, a more progressive income tax seems to be creating a heavier burden on
savings than a less progressive tax system.
• This claim suggests that a less progressive income tax system would be favorable to the
increase in savings of individuals
 ECONOMIC EFFECTS OF TAXATION

b. Impact of tax on gross savings of

companies
• If profit taxation law allows accelerated depreciation, then
depreciation reserves and company savings will increase in the
first years following the purchase of fixed assets.
• Profit is divided in the dividends distributed to company owners
and undistributed profit remaining in the company.
• Higher taxation of the retained profit will stimulate its
distribution to dividends, while lower taxation of the retained
profit will increase the company’s savings
 ECONOMIC EFFECTS OF TAXATION

4.Tax effects on labour supply

• Unskilled Labor:
• Inelastic Supply: The supply of unskilled labor is generally
inelastic, meaning that the quantity of labor supplied doesn't
change much in response to wage changes. This inelasticity
means that unskilled workers cannot easily reduce their work
hours or find alternative employment to avoid the tax burden.
• Burden of Payroll Tax: Because the supply is inelastic,
unskilled workers end up bearing most of the payroll tax
burden. Employers can pass the tax onto workers through
lower wages.
 ECONOMIC EFFECTS OF TAXATION

• Skilled Labor:
• More Elastic Supply: Workers with valuable skills have a more
elastic supply of labor. They can more easily move between jobs
or negotiate higher wages because their skills are in demand.
• Higher Compensation: There is more competition for skilled
workers, leading to higher wages and better compensation
packages.
• Tax Burden: Highly compensated individuals can negotiate
wages that more effectively offset payroll taxes. Additionally,
employers of skilled labor might bear more of the payroll tax
burden to retain these valuable employees.
The overall effect is that the tax incidence of the payroll tax falls
more heavily on lower income workers than on higher income
 ECONOMIC EFFECTS OF TAXATION

a. Impact of income tax on wages and employment

Taxation of labour introduces a difference between real gross cost of labour for a company and
real net wage that employees receive. Thus, taxes create a difference between the cost of labour
and net wage that is called tax wedge in economic theory. Tax wedge is the difference between
before-tax and after-tax wages. The tax wedge measures how much the government receives as a
result of taxing the labour force
b. Impact of taxes on consumption on wages and employment
Beside direct taxes, indirect taxes (that is, consumption taxes) also have impact on the supply of
labour by reducing the purchasing power of net wage. However, workers seem to be reacting
somewhat slower to a change in the consumption taxes, and the impact of the consumption taxes
on labour supply also appears within a longer period of time than normally is the case with direct
taxes. Taxes on labour income and consumption spending encourage households to shift away
from work in the legal market sector and toward untaxed uses of time such as leisure, household
production, and work in the shadow economy. Empirical evidence also show that taxes affect work
activity directly through labour supply-and- demand channels and indirectly through government
spending responses to available tax revenues. Higher tax rates on labour income and
consumption expenditures lead to less work time in the legal market sector, more time working in
the household sector, a larger underground economy, and smaller shares of national output and
 ECONOMIC EFFECTS OF TAXATION

Effects of Taxation on Production, Consumption and Distribution

A. Effects on Production:
a. Production is affected by taxes in two ways:
i. By affecting the ability to work, save and invest
ii. By affecting the desire to work, save and invest
b. A tax on necessaries of life will obviously affect the workers productivity and hence reduce
production. A heavy tax on income tends to reduce the ability to save and invest on part of
individuals. A decrease in investment is bound to affect adversely the level of output in the
country
c. Normally taxation induces people to work harder, earn more, save more and invest more to
increase their income and enjoy the same income after tax
d. Some taxes has no adverse effects, for e.g., import duties, tax on monopolists, etc.
e. High marginal rates of income tax are likely to affect adversely the tax payers desire to work, save
and invest
f. The reaction varies from individual to individual. It depends on the individuals elasticity of demand
for income. When it is fairly elastic, the tax will lessen his desire to work and save
g. Entrepreneurs may avoid the production of goods which are taxed. There is likely to be a diversion
 ECONOMIC EFFECTS OF TAXATION

B. Effects on Income Distribution:

• The effects of taxes on income distribution depends on the type of taxes
and rates of taxes
• Taxation of goods of mass consumption is regressive and redistributes
incomes in favour of rich.
• But if such commodities are exempted and luxuries are taxed, and the
taxation is made progressive, then the income will be redistributed in
favour of poor
C. Effects on Consumption:
• By imposing tax on a consumable good which is injurious to health, its
consumption can be checked.
• Similarly, the tax on luxury goods can decrease their consumption and
 INCIDENCE OF TAXATION

Tax incidence is said to be on the person who ultimately bears the burden of
tax whereas impact of tax is on the person from whom government collects
money in the first instance. It is important for the government to know who
ultimately bears the tax in order to achieve equality in taxation.
1. Statutory and economic incidence
It is usual to distinguish between statutory / legal and economic incidence.
The statutory / legal incidence refers to the person on whom the law says
the tax obligation falls. Legal incidence is established by law when new
taxes are enacted, and specifies which individuals or companies must
physically remit tax payments to the revenue authorities.

•
 INCIDENCE OF TAXATION

B. Absolute incidence and differential incidence of tax

The distributional impact of tax or systems of taxes depends partly on
how the question is framed.
An Absolute incidence of taxation refers to the ultimate economic
burden of a tax. It identifies the individuals or entities that ultimately
bear the cost of the tax, regardless of who initially pays it. This
concept helps in understanding the true impact of a tax on different
groups within the economy..
The analysis of the ultimate economic burden of a tax, identifying who
ultimately bears the cost, regardless of who initially pays it.
Example: Sales tax where retailers collect the tax, but the true
burden may be shared between consumers and retailers depending on
 INCIDENCE OF TAXATION

A differential incidence examines how incidence differs when one tax is replaced
with another, holding the government budget constant. The differential incidence
analysis carries out a revenue- neutral change in tax by raising one tax while
lowering another.
The analysis of the economic effects and burden of one type of tax relative to
another. It compares the impacts of different tax policies or changes in tax
structures.
Example: Comparing the impact of a corporate tax vs. a payroll tax to understand
which policy imposes a greater burden on businesses and employees.
C. Shift ability of Incidence of taxation
Burden of tax may be shifted from one person to another; shifting finally ends in
incidence. A person on whom tax is levied may shift the burden of tax on another
person either entirely or partly or he may not be able to pass on the burden at all.
 INCIDENCE OF TAXATION

TYPES OF INCIDENCE SHIFTING

i. Forward shifting of tax takes place if burden of tax falls

entirely on user and not on the manufacturer/supplier of the
goods or service;
ii. Backward shifting occurs when the price of the product/
service remains same but the cost of tax is borne by the
manufacturer.
iii.In certain cases, there would be no shifting of tax at all.
 INCIDENCE OF TAXATION

Factors determining shift ability of Incidence of taxation

It would appear that the incidence of a tax or where its ultimate
burden rest, depends on a number of factors. We give below
some of them in a summary way.
• Elasticity:
While considering incidence we consider both elasticity of
demand and elasticity of supply. If the demand for the
commodity taxed is elastic, the tax will tend to be shifted to the
producer but in case of inelastic demand, it will be largely
borne by the consumer. In case of elastic supply, the burden
will tend to be on the purchaser and in the case of inelastic
 INCIDENCE OF TAXATION

a) If supply elasticity ᶯs is zero (very inelastic supply), Id is

zero; consumers bear none of the tax incidence.
b)If supply elasticity ᶯs is ∞ (very elastic supply), Id is one;
consumers bear the entire tax incidence.
c) If demand elasticity ᶯd is zero (very inelastic demand), Id is
one; consumers bear the entire tax incidence.
d)If demand elasticity ᶯd is ∞ (very elastic demand), Id is
zero; consumers bear none of the tax incidence.
 INCIDENCE OF TAXATION

• Price: Since shifting of the tax burden can only take place through a change in price, price is
a very important factor. If the tax leaves the price unchanged, the tax does not shift.
• Time: In short run, the producer cannot make any adjustment in plant and equipment. If,
therefore, demand falls on account of price rise resulting from the tax, he may not be able to
reduce supply and may have to bear the tax to some extent. In the long run, however, full
adjustment can be made and tax shifted to the consumer
• Cost: Tax raises the price; rise in price reduces demand and reduced demand results in the
reduction of output. A change in the scale of production affects cost and the effect will vary
according as the industry is decreasing, increasing or constant costs industry. For instance, if
the industry is subject to decreasing cost, a reduction in the scale of production will raise the
cost and hence price, shifting the burden of the tax to the consumer.
• Nature of tax: The incidence of taxation will definitely depend on the nature of tax. For
example, an indirect tax burden is fall on the consumer.
• Market form: Another factor determining the incidence of taxation is the market form. Under
perfect competition, no single producer or single purchaser can affect the price; hence
shifting of tax in either direction is out of the question. But under monopoly, a producer is in a
 INCIDENCE OF TAXATION

Theories of Tax Shifting and Incidence

i. Concentration or Surplus theory:
According to concentration theory, each tax tends to concentrate on a
particular class of people who happen to enjoy surplus from their products.
ii. Diversion or Diffusion theory
The diffusion theory states that the tax eventually got diffused in the entire
society. That is, the final placing of tax is not one but multiple. The process
of diffusion took place through shifting or through process of exchange.
iii. Modern Theory:
According to modern theory, the concentration and diffusion theories are
partially true. Actually there are both concentration and diffusion of taxes
according to the conditions present. The modern theory seeks to analyse the
conditions which bring about concentration or diffusion
 EXAMPLE

• Corporate Tax vs. Payroll Tax

• Corporate Tax: In a highly competitive industry, a corporate tax
might be absorbed by shareholders through lower dividends
(concentration), while some of the burden might also be passed to
employees through lower wages (diffusion).
• Payroll Tax: In a labor market with high mobility, an increase in
payroll taxes might lead to a more diffused burden, with some of the
tax being absorbed by employers (through lower profits) and some by
employees (through lower wages or higher prices)
 DIFFERENT CONCEPT OF TAXATION

Tax Buoyancy
Tax buoyancy explains this relationship between the changes in government’s tax revenue growth
and the changes in GDP. It refers to the responsiveness of tax revenue growth to changes in GDP.
When a tax is buoyant, its revenue increases without increasing the tax rate.
Example: In a particular year, country A GDP growth rate was nearly 9 per cent. The tax revenue
of the government, especially, that of direct taxes registered a growth rate of 45 per cent in the
same year.
Tax buoyancy = change in tax revenue in response to one unit change in tax base/GDP
Higher Tax Buoyancy (More than 1)
Tax Revenue rises faster than the economic growth
As economy grows, the Government can expand its activities OR reduce tax rates
Low Tax Buoyancy (Less than 1)
Tax Revenue rises slower than the economic growth
As economy grows, the Government will need to cut down its activities OR increase tax rates
 DIFFERENT CONCEPT OF TAXATION

Tax Elasticity
A similar concept to Tax Buoyancy is tax elasticity. Tax elasticity,
unlike tax buoyancy, tax elasticity excludes the impact of
discretionary effects (e.g. impact of changes in tax rates and tax
bases) on the increase of tax revenue. It measures the pure
response of tax revenues to changes in the national income.
It reflects only the built-in responsiveness of tax revenue to
movement in national income/GDP. The value of the tax elasticity
gives an indication to policy-makers of whether tax revenues will
rise at the same pace as the national income.
 DIFFERENT CONCEPT OF TAXATION

Taxable capacity
Taxable capacity refers to maximum capacity of a community to pay taxes or the maximum
limit up to which people can normally pay taxes. It is the ability of the tax payer to pay the tax
assessed to him/her and the same time retain a reasonable level of income to enable him/her to
live the life he/she is accustomed. i.e. ability of a nation to obtain from tax payer the revenue
necessary from the imposed taxes.
There are two types of taxable capacity
• Absolute taxable capacity: means maximum amount or proportion of national income that
can be taken by the Government in form of taxes without producing disagreeable
(unpleasant) effects.
• Relative taxable capacity: This is a comparative term. Is the ratio of the taxable capacity
of one unit to that of the other unit. Through it, the taxable capacity of two countries or two
individuals can be compared.
Taxable capacity = (Estimated Tax revenue/ (GDP/national income)
 DIFFERENT CONCEPT OF TAXATION

The following are determinants of the nation’s taxable capacity

The size of population
The distribution of national income
Purpose of taxation
Psychological factor. If people are satisfied that government is doing
its utmost to raise standard of living of the masses and in maintaining
prestige of the country, then they try to sacrifice their lives what to
say of money for the government
Standard of living of people
Effect of inflation
 DIFFERENT CONCEPT OF TAXATION

Excess burden
Excess burden or DWL of taxation, also known as distortionary cost of taxation, is the economic
loss that societies suffers as the result of the tax, over and above the revenue it collects.

Optimal taxation
Tax system is said to be optimal if it attain the goals of revenue collection with a minimum
possible distortions in the economy. The level of distortion is measured by using excess burden.
So a tax system that minimizes excess burden and yet achieve the revenue collection goals is
optimal. The optimal taxation theory thus seeks to answer a crucial tax policy question, “at
what rates should various goods and services be taxed to raise target revenue with minimum
possible excess burden
 DIFFERENT CONCEPT OF TAXATION
Tax Incentives
A tax incentive is defined as ‘a deduction, exclusion or exemption from a tax liability, offered as an
inducement to engage in a specified activity such as investment in capital goods for a certain period’. Tax
incentives are granted to attract FDI and/or to promote specific economic policies, such as to encourage
investment in certain sectors
Arguments for:
• Substantial increase in the level of investment and economic activity.
• Taxes are an important impediment to invest since they reduce retained earnings and increase product or prices.
• Incentives may make unpromising investments attractive by permitting a rapid recovery of capital and a higher rate of return.
• They also make available to the taxpayer funds that would not otherwise be at his disposal.
• Tax incentives do publicize and enhance a country’s investment climate.

Arguments against:
• They reduce government revenue.
• Bring inequity as they cause differentials in tax burden.
• Different burdens upon tax administration.
• Increase compliance costs.
 DIFFERENT CONCEPT OF TAXATION
Tax Competition
It refers to the competition between countries which compete for investment by
lowering the tax rates on business, or offering other tax advantages, in order to attract
or keep companies located within them.
Argument for tax competition
Proponents of tax incentives often argue that lower tax burdens give investors a higher
net rate of return and therefore free up additional income for re-investment. The host
country thus attracts increased FDI, raises its income and also benefits from the
transfer of technology.
Argument against tax competition
a. Result in a loss of current and future tax revenue
b. Create differences in effective tax rates and thus distortions between activities that
are subsidized and those that are not
c. Could require large administrative resources
d. Could attract mainly footloose firms