Tax is an involuntary payment to the government by an economic agent (individuals, firms, corporations etc...) which does not entitle the payer to a benefit in exchange.
Benefit tax is an involuntary payment to the government that entitles the taxpayers to a benefit. (Ex: Social Security Taxes)
Direct Taxes: Taxes which generally with varying tax rates based on the value of tax base. Income tax, Kurumlar Vergisi, Motor Vehicle Tax, Property Tax are examples of direct taxes in Turkey. The rate of income tax varies with the income level of the tax payer. For example high income individuals pay %35 of their income while low income individuals pay only %20 of their income. Direct taxes presumed to be more equitable (more fair) method of collecting tax revenue.
Indirect taxes: The taxes which are paid the same amount by everybody. KDV, ÖTV are examples of indirect taxes in Turkey. Everybody pays %18 (for the most goods) of the value of the good as KDV to the government.
Lump Sum Taxes
Taxes change the behavior of the individuals. Remember that if there are no distortions in the market (externalities, public goods, monopolies etc...) the free markets yield efficient(optimum) outcomes. So taxes (since they change the optimum behaviors of the economic agents) cause social welfare losses. The decline in the social welfare is called
excess burden due to taxes. Most taxes depend on the economic value of the taxpayer or taxed commodity. So there is excess burden involved with these taxes. In other words taxes do not simply take X amount of money from consumers’ (producers’) pocket and put it in government’s vault. They cause damage to consumers’ utility (producers’ profit) by more than X TL.
Lump sum taxes are the taxes which the tax rate does not depend on the economic value of the taxed taxpayer or taxed good. If government says everybody is going to bring 2000 YTL ever year to the government this is an example of lump sum tax. If government says everybody with a brown eye will pay 5000 YTL to the government, this is another example of lump sum tax. Lump sum taxes are the most efficient tax types. However, since it is not seen as equitable (or moral) to tax everybody the same amount, it is not practiced in modern times.
Commodity Taxation and Effect of Taxes on Efficiency
Taxes reduce the efficiency because they change the individuals’ behavior. In the below example it is shown that as a result of tax, consumers buy less than optimum amount of the good in this taxed market. They stop purchasing the good at Qt level rather than Q*. In fact if they have not stopped over there Qt+1 st unit of the good would give bigger marginal benefit than its marginal cost. Since tax causes that last unit not to be consumed (and produced) society is devoid of that beneficial consumption. The yellow shaded triangle is the social welfare loss (deadweight loss) due to the tax.
Individuals optimize their consumption choices. Optimum consumption occurs where utility curve is tangent to budget constraint. (At point A without any tax) When the government imposes a per unit tax on orange the price of oranges increases so the budget constraint of the consumer rotates to the left. The new optimum consumption occurs at point B. However if the government instead of per unit tax on orange imposed a lump sum tax on the consumer, the individual would be at point C. (with lump sum tax, the prices of apple and orange do not change, but since government requires a certain amount the income of the consumers go down and budget constraint shifts parallel to the original budget line)
Since the consumer is at a higher utility curve at point C than point B, he is better of with lump sum tax. And government collects the same tax revenue with both types of the tax, so lump sum tax is more efficient than per unit tax. (Actually all types of taxes)
Notice that the social welfare loss (the area of the yellow triangle) depends on the base of the triangle (per unit tax) and change in the quantity of consumption (The height of the triangle). The change in the consumption depends on the elasticity of supply and demand and also the magnitude of the per unit tax.
The social welfare loss due to a tax is proportional with
a) the elasticity of the supply and demand of the taxed commodity (Ramsey Rule) b) the square of the tax rate.
So in order to minimize the efficiency loss (social welfare loss) the government should tax the commodities with low elasticity. However low elasticity goods or services are generally necessities such as bread and health care services. So it is considered to be unfair to tax those goods which poor and rich consume. Equity requires that luxuries goods to be taxed more since rich consume those luxuries goods more than poor. However luxuries goods generally have higher elasticity of demand thus tax on those results substantial efficiency losses. Policy makers have to trade off between efficiency and equity concerns and have to find an optimum balance.
Moreover notice that the social welfare loss is proportional with the square of the tax rate. So doubling the tax rate quadruples the efficiency loss. (And does not double the tax revenue but increases it less than that) That is one of the reasons why broadening the tax base ( making everybody to pay taxes rather than a specific segment of the society) is very important. When the tax base is wide enough a relatively small tax rate is enough to collect significant tax revenue. Smaller tax rates substantially reduce the efficiency losses due to taxes.
S S’ = S +t D Q P Deadweight loss due to tax Q* Qt
2t D D’ S Q Q* Q2t A B C F G P Q D S Q*
In the figure on the left only half of the sector is taxed by 2t. The other half is not taxed or evading the tax. The collected tax revenue is the area of ACFB square. The efficiency loss due to the tax is the area of FCG.
In the first we have seen that taxing orange without taxing apple causes excess burden. Changing the relative prices of the commodities distort the market and reduce the social welfare. One might consider that income tax does not change the relative prices of the commodities and only cause a parallel shift on the budget line. So it must not have excess burden (or cause social welfare loss). However that is not completely true. Even if income tax does not change the relative price of commodities it changes the relative price of working and leisure. It might cause people to work less. (If you know that government will take away some portion of you earned income, you would be less enthusiastic about working)
Income taxes are considered to be more equitable than taxes depend on consumption (sales tax, KDV, ÖTV) Generally rich are spending a smaller portion of their income than poor are. 8rich saves and invests more than poor) So sales taxes result that poor give a bigger portion of their income to the government as taxes than rich do. That is considered very unfair. But with income taxes (with constant income tax rate) rich and poor are paying the same portion of their income as taxes. So income taxes are considered fairer (more equitable) than sales taxes.
t D D’ S Q P Q* Qt K L P M N
In the figure on the left only half of the sector is taxed by t. The other half is the taxed by t as well. (and they are paying their taxes) The collected tax revenue is the area of KPML square. The efficiency loss due to the tax is the area of PMN. Similarly from the other half of the sector (the figure on the right) tax collected by the area of KPML square and as a result there would be efficiency loss by the area of PMN. So total tax revenue would be 2KPML and efficiency loss would be 2PMN.
Let’s compare these with the previous graph at which only half of the sector is paying the taxes by 2t. Notice that Q2t is smaller than Qt because at Q2t the price level is higher thus consumers purchase less of the taxed good. Thus the tax revenue ACFB is bigger than KPML but less than twice of the KPML. So in the below figure (where everybody pays the taxes) the tax revenue is bigger. However the efficiency loss at the above figure (FCG) is bigger than efficiency loss below (2PMN). The base of above triangle is 2t and below triangle t but the height of the triangle in the above triangle (Q* -Q2t) is
bigger than (Q* - Qt) thus FCG is bigger than 2PMN.
Thus we can conclude that widening the tax base not only increases the tax revenue but also decreases the efficiency loss due to taxation.
t D D’ S Q K L P M N Qt Q*
However income taxes discourage saving. Because with income taxes when an individual make money he is taxed. If he does not spend all of his income but save certain portion of that income, he would make more money in the future. (investments financial or real will make money for him in the future). So he would be taxed again for the new income. Thus income tax results double taxation of savings. Naturally double taxation discourages savings which is very important for long run growth.
TAX EVASION AND LAFFLER CURVE