A Framework for Tax Analysis

I am back to work after my maternity leave and thought I would kick off this new era with a post off with a bit of a tax education piece. I am often asked about how do economists assess taxes and tax systems? How do we choose between different taxes and tax systems? How do we choose between different tax structures?

Well economists have a set of criteria that we use to make our assessments. We typically judge the efficacy of a tax system according to four widely accepted criteria: Equity —“fair” distribution of burden which is usually measured by vertical and horizontal equity; Efficiency—minimize the deadweight loss which is usually driven by elasticity and size of tax; Economic growth—does the tax encourage and support economic growth; and administrative costs—minimize collection and compliance costs.

EQUITY: Most agree that the tax burden should be distributed fairly, that all of us should pay our “fair share.”  However, there is endless debate about what constitutes a fair tax system.  There are essentially two leading theories on which to describe the “fairness” in a tax system. The first is the benefits-received principle. The second is the ability-to-pay principle. I have written about equity in detail before and I refer you to that post for more information.

EFFICIENCY:To economists, efficiency simply refers to the use of resources so as to maximize the production of goods and services. We know that taxes distort economic decisions, they impose burdens, and the excess burden refers to the amount by which the burden of a tax exceeds the total revenue collected.   These are also called dead weight losses (DWL-oddly the name of my softball team when I was doing my PhD).  However, that taxes can actually improve the market outcome.  E.g. Externalities, public goods, etc.  In these cases, taxes reduce the DWL.  This occurs when the market outcome is initially inefficient. Knowing when taxes are good, bad, and in between is vital when designing tax policy.

ECONOMIC GROWTH: The third criteria to assess taxes are their effect on economic growth.  Do taxes encourage or discourage economic growth?  We know that the more developed a country, the larger the government, and the greater the amount of revenue collected via taxes.  So there is a positive relationship, but since taxes distort behaviour, they also reduce growth. For example, taxes go to pay for essential services required to support economic growth such as roads, police, clean water and safe food, the legal system etc.  But taxes also create disincentives to economic growth.  For example, income taxes reduce the willingness of people to work additional hours, to accept risk inherent in investment since gains are taxed, and create “red tape” e.g. the GST on businesses. The key is that taxes are required for economic growth, but they must be carefully balanced and designed to minimize the DWL associated with them. I have written about taxes and economic growth before.

COST: The administrative burden/cost of taxes is part of the DWL of the inefficiencies created by taxes.  This includes time spent filling out forms and record keeping as well as resources to administer and enforce tax laws. Cost could be reduced by simplifying the system.  Simplification, however, can jeopardize the other components of the tax system that we have looked at.  That said a 2800 page Income Tax Act is probably quite inefficient though! One of the costs of taxation that is often overlooked is that of tax avoidance. An individual rightfully go to great lengths to avoid taxation but in most cases these results in deadweight loss as well as inefficiencies.

So there is our big secret. This is how economists assess taxes. And now you can too.

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