Chapter-04: Taxation and Economic

Efficiency
Issues to be learned
 Understanding Tax , Taxation and Tax System
 Characteristics of any Tax System,
General Framework for Choosing among Tax System,
Tax System in Bangladesh
Tax Incidence in competitive and monopolized
markets.
Tax Incidence, Taxation of Capital, Optimal Taxation.
Economic Efficiency in Inflationary and Deflationary
situation
10/22/2024
Tax Policy for Developing Countries
1 1
 4.1 Understanding Taxation
Taxation, as part of the tax system, is a
fundamental pillar in any modern economy. It
refers to set of rules, laws and regulations that
govern the collection of taxes by the State.
Revenue generated through taxes is essential to
finance public services, infrastructure and social
programs that benefit society as a whole. This
article explores the importance of taxation in the
economy and how its correct management can
have a significant impact on the development of
a country.
10/22/2024 1 2
 4.1 Understanding Tax and Taxation
Tax is a compulsory levy paid to government.

The term "taxation" applies to all types of mandatory levies, from

income to capital gains to estate taxes. Though taxation can be a
noun or verb, it is usually referred to as an act; the resulting revenue
is usually called "taxes“ .

Taxation is a term for when a taxing authority, usually a government,

levies or imposes a financial obligation on its citizens or
residents. Paying taxes to governments or officials has been a
mainstay of civilization since ancient times.

Some important features of taxation is discussed below:

10/22/2024 1 3
 Contd
• Taxation occurs when a government or other
authority requires that a fee be paid by citizens
and corporations, to that authority.
• The fee is involuntary, and as opposed to other
payments, not linked to any specific services
that have been or will be provided.
• Tax occurs on physical assets, including
property and transactions, such as a sale of
stock, or a home.
• Types of taxes include income, corporate,
capital gains, property, inheritance, and sales.
10/22/2024 1 4
 Understanding Tax System
A good tax system should meet five basic
conditions:
i) fairness, ii) adequacy, iii) simplicity, iv)
transparency, and v)administrative ease.
Although opinions about what makes a good tax
system will vary, there is general consensus that
these five basic conditions should be maximized
to the greatest extent possible.

10/22/2024 1 5
 4.2 Purposes and Justifications for Taxation

• The most basic function of taxation is to fund

government expenditures. Varying
justifications and explanations for taxes have
been offered throughout history. Early taxes
were used to support the ruling classes, raise
armies, and build defenses. Often, the
authority to tax stemmed from divine or
supranational rights.

10/22/2024 1 6
 Contd
• Later justifications have been offered across
utilitarian, economic, or moral considerations.
Proponents of progressive levels of taxation on
high-income earners argue that taxes encourage a
more equitable society. Higher taxes on specific
products and services, such as tobacco or gasoline,
have been justified as a deterrent to consumption.
• Advocates of public goods theory argue taxes may
be necessary in cases in which the private provision
of public goods is considered sub-optimal, such as
with lighthouses or national defense.
10/22/2024 1 7
 4.3 Characteristics of a good tax system
Some of the most important principles or characteristics of a
good tax system are as follows:
1. Productivity or Fiscal Adequacy
2. Elasticity of Taxation
3. Diversity
4. Taxation as in Instrument of Economic Growth
5. Taxation as an Instrument for Improving
Income Distribution
6. Taxation for Ensuring Economic Stability.

As per Adam Smith, taxation system should also be such

that it meets the requirements of increasing state activity
and achieves the objectives the society has placed before it.
10/22/2024 1 8
 i) Productivity or Fiscal Adequacy
An important principle of a good tax system for a
developing country is that it should yield adequate
amount of resources for the Government so that it
should be able to perform its increasing welfare
and developmental activities.

If the tax system fails to yield enough resources,

the Government will resort to deficit financing.
10/22/2024 1 9
 ii)Elasticity of Taxation
Another principle of taxation suitable for the
developing countries is the principle of
elasticity of taxation. According to the
concept of elasticity of the taxation system, as
national income increases as a result of
economic growth, the Government revenue
from taxes should also increase.
10/22/2024 1 10
 iii)Diversity
A good tax system should follow the principle
of diversity.
This implies that there should not be a single or
a few taxes from which Government seeks to
raise large revenue.
This is because if a Government tries to get
large revenue from a single tax or few taxes, it
will have to raise the rates of taxation too high
which will not only adversely affect the
incentives to work, save and invest but also
encourage evasion of taxes.
10/22/2024 1 11
 Contd.
Therefore, the tax system should be a multiple tax
system with a large variety of taxes so that all those
who can contribute to the public revenue should be
made to do so.
This calls for a mix of various direct and indirect taxes.
With the diverse tax system, the principles of fiscal
adequacy and equity will also be better satisfied.

10/22/2024 1 12
 iv) Taxation as an Instrument of Economic
Growth

In a developing economy such as ours, taxation

should serve as an instrument of economic growth.
Economic growth is primarily a function of rate of
capital formation. If in the development strategy
public sector has been assigned an eminent place,
then capital formation in the public sector must
occur at a relatively higher rate.
10/22/2024 1 13
v) Taxation as an Instrument for Improving
Income Distribution:
A good tax system for a developing economy
should also serve as an instrument for
reducing economic inequalities.
The purpose of a good tax system for a
developing economy is not merely to raise
revenue for the Government but also to
ensure that burden of taxes falls more on the
rich rather than poor.

10/22/2024 1 14
 Contd.
This requires that the rates of progressive
direct taxes on income, wealth, expenditure,
capital gains etc., must be sufficiently high.
This objective of reducing income inequalities
will be better served if a good part of the tax
revenue is used for poverty alleviation
programmes.

10/22/2024 1 15
 vi) Taxation for Ensuring Economic
Stability.
A tax system must also ensure economic stability.
Economic fluctuations have been a big problem
in the developed countries and for reducing
these fluctuations, taxation can play a useful
role.
For this purpose, tax system must have built-in-
flexibility. To have built-in-flexibility, the taxation
system must be progressive in relation in the
changes in national income.
10/22/2024 1 16
 4.4 General Framework for Choosing
among Tax System

10/22/2024 1 17
 4.5 Tax Incidence in competitive and
monopolized Markets
.

Understanding Tax Incidence

Tax incidence" (or incidence of tax) is an economic term for
understanding the division of a tax burden between
stakeholders, such as buyers and sellers or producers and
consumers. Tax incidence can also be related to the price
elasticity of supply and demand. When supply is more elastic
than demand, the tax burden falls on the buyers. If demand is
more elastic than supply, producers will bear the cost of the
tax.
10/22/2024 1 18
 Contd
In economics, tax incidence or tax burden is
the effect of a particular tax on the
distribution of economic welfare. Economists
distinguish between the entities who
ultimately bear the tax burden and those on
whom the tax is initially imposed.

10/22/2024 1 19
 Contd
• A tax incidence describes a case when buyers and
sellers divide a tax burden.
• A tax incidence will also lay out who bears the
burden of a new tax, for instance among producers
and consumers, or among various class segments of
a population.
• The elasticity of demand of a good can help
understand the tax incidence among parties.
• Tax incidence shows who or what ultimately bears
the burden of a tax, as opposed to just who directly
pays the tax.
10/22/2024 1 20
 Contd.
Foe example, if a 10% tax is imposed on sellers
of butter, but the market price rises 8% as a
result, most of the burden is on buyers, not
sellers.

RQ : Define tax incidence with example .What

does it measure? Explain

10/22/2024 1 21
 Tax incidence in competitive markets

In competitive markets , firms supply quantity

of the product equals to the level at which the
price of the good equals marginal cost (supply
curve and marginal cost curve are indifferent).
If an excise tax (a tax on the goods being sold)
is imposed on producers of the particular good
or service, the supply curve shifts to the left
because of the increase of marginal cost. The
tax size predicts the new level of quantity
supplied, which is reduced in comparison to
the initial level.
10/22/2024 1 22
 Contd
In a competitive market the economic
incidence of a tax on output is determined by
the value of the elasticity of supply relative to
the elasticity of demand. If demand is
perfectly elastic the economic incidence falls
on suppliers; if demand is perfectly inelastic
the economic incidence falls on consumers.
10/22/2024 1 23
 Contd.

10/22/2024 1 24
10/22/2024 1 25
Tax incidence in Monopoly market
What is Monopoly?
 Many buyers
 Only one seller
 (Homogeneous product)
 Perfect information
 Restricted entry (and possibly exit)
 The monopolist’s demand curve is the (downward
sloping) market demand curve.
 The monopolist can alter the market price by
adjusting its output level.
10/22/2024 1 26
 Tax incidence in monopolized markets
• Works roughly the same way as competitive markets,
except that prices are determined by the intersection of
MR (marginal revenue) and MC (marginal cost), rather
than demand and MC.
• As a general matter, the burden of a tax will be borne
partly by sellers and partly by buyers.
• Depending on the details of demand functions, tax
burdens may fall more heavily on sellers in monopoly
markets than they do in the1case of competitive markets. 27
10/22/2024
 Contd
– You get a smaller quantity reaction for a given tax,
which in turn leads to a smaller effect on consumer
price.
– Reflects that monopoly supply is somewhat less
responsive to cost than supply in competitive
markets.
– For example, if a monopolist has a horizontal MC
curve, then the price response to the imposition of
a tax is less than one-for-one; if the market were
instead competitive, with the same MC curve, the
price response to a tax would instead be one-for-
one.

10/22/2024 1 28
 Contd.
Imposition of lump sum tax and profit tax
simply reduces excess profits of the monopolist
since these two taxes are an addition to the
total fixed cost. If the government imposes a
20% tax on profit of a monopolist then the fixed
cost of the monopoly firm will go up since this
type of tax is like a fixed cost. Same is true with
respect to lump sum tax.

10/22/2024 1 29
 Contd

As fixed cost is independent of the level of

output, imposition of such taxes will not alter
MC of the monopolist. Hence the equilibrium
in the monopoly market will remain the same
and, consequently, output and price will
remain unchanged. The only change that will
occur is the reduction of profit of the
monopolist. This has been shown in Fig. 5.8.

10/22/2024 1 30
10/22/2024 1 31
 Contd
Equilibrium point is E where MC = MR.
Corresponding monopoly output and price are
OQ and OP, respectively.
Assume that AC is the pre-profit tax average
cost curve. The monopolist enjoys
supernormal profit to the extent of MNRP.
After the imposition of profit tax (or lump sum
tax), AC shifts to ACT without disturbing
equilibrium output and price.
10/22/2024 1 32
 Monopoly: Equilibrium
MC The shaded area
is the excess
profit
P
AC

Pm

ym
MR Demand y
10/22/2024 1 33
 Application: Tax Incidence in Monopoly

Claim
When you have a linear demand curve, a
constant marginal cost curve and a tax is
introduced, price to consumers increases by
“only” 50% of the tax, i.e. “only” 50% of the
tax is passed on to consumers

10/22/2024 1 34
 Application: Tax Incidence in Monopoly
Output decision is as before, i.e.
MC=MR
So Ybt is the output before the tax is
P imposed

MCbt

ybt
MR Demand y
10/22/2024 1 35
 Application: Tax Incidence in Monopoly
Price is also the same as
before

P Pbt = price before tax is

introduced.

Pbt

MCbt

ybt
MR Demand y
10/22/2024 1 36
 Application: Tax Incidence in Monopoly
The tax causes the MC curve
to shift upwards
P

Pbt
MCat

MCbt

ybt
MR Demand y
10/22/2024 1 37
4.6 Tax Incidence and Taxation of Capital,

A capital tax is a tax levied on a corporation

that is based on its assets rather than its
income.

10/22/2024 1 38
 4.7 Optimal Taxation
Optimal tax theory or the theory of optimal taxation is
the study of designing and implementing a tax that
maximizes a social welfare function subject to economic
constraints.[1] The social welfare function used is
typically a function of individuals' utilities, most
commonly some form of utilitarian function, so the tax
system is chosen to maximize the aggregate of
individual utilities.
10/22/2024 1 39
 Contd.
Tax revenue is required to fund the provision
of public goods and other government
services, as well as for redistribution from rich
to poor.
The optimization problem involves minimizing
the distortions caused by taxation, while
achieving desired levels of redistribution and
revenue.

10/22/2024 1 40
 Contd

Some taxes are thought to be less distorting,

such as lump-sum taxes (where individuals
cannot change their behaviour to reduce their
tax burden) and Pigouvian taxes, where the
market consumption of a good is inefficient and
a tax brings consumption closer to the efficient
level.
10/22/2024 1 41
 Economic Approach to Optimal
Taxation
 Choice of tax rates is often viewed as a purely political issue
 Economic approach: set tax rates based on tradeoff between
equity vs. efficiency
 Equity: Additional $1 of income is worth more in terms of
utility (well-being) to a family earning $10,000 per year than a
family earning $250,000 per year

 This force pushes towards higher tax rates on high-income

earners
 Efficiency: higher tax rates on the rich  less incentive for
them to work  less economic innovation, growth, etc.

 This force pushes towards lower tax rates on high-income

earners.
10/22/2024 1 42
 Economic Approach to Optimal
Taxation
 Optimal tax system balances gain from equity with efficiency
cost
 Gains from equity rely on value judgements: how much more is
money worth to low-income households than high-income
households?

 Economists typically leave these judgements to the

public/political process.

 Efficiency impacts depend upon how much rates of work are

affected by changes in tax rates.

 Large literature on estimating elasticity of labor supply with

respect to tax rate using modern tax data.

10/22/2024 1 43
 4.8 Optimal Tax and capital Flight

10/22/2024 1 44
 Contd.

See Ramsey Rule about optimal

taxation and capital formation

10/22/2024 1 45
 4.9 The Impact of Inflation in Economy

The primary impact of inflation is decreasing

purchasing power. Although the denomination
of currency doesn't change, the impact of
inflation is that the same amount of currency
can buy less across inflationary periods.
Though individuals may receive the cost of
living adjustments to wages they take home,
they more commonly see repercussions in the
groceries they buy, the rent they pay, and
transactions they incur.
10/22/2024 1 46
 contd
As a result of higher inflation, the Federal
Reserve often enacts monetary policy leading
to higher federal funds rates. Higher federal
funds rates have a domino effect to many
other forms of lending and cause the cost of
debt to be higher. Higher federal funds rates
often, and credit card rates.

10/22/2024 1 47
 Contd
Because of higher debt rates, a downstream
effect of higher inflation is a slower economy.
During inflationary periods, prices are higher,
and it is more expensive to incur debt. For
these two reasons, companies often sell fewer
products and the economy slows. This may
lead to diminished corporate profits, layoffs,
and pressures on households.

10/22/2024 1 48
 Benefits of Inflation
• When the economy is not running at capacity, meaning
there is unused labor or resources, inflation theoretically
helps increase production. More dollars translates to more
spending, which equates to more aggregated demand. More
demand, in turn, triggers more production to meet that
demand.
• British economist John Maynard Keynes believed that some
inflation was necessary to prevent the Paradox of Thrift. This
paradox states that if consumer prices are allowed to fall
consistently because the country is becoming too
productive, consumers learn to hold off their purchases to
wait for a better deal. The net effect of this paradox is to
reduce aggregate demand, leading to less production,
layoffs, and a faltering economy
10/22/2024 1 49
 Contd
Economists once believed an inverse relationship
existed between inflation and unemployment,
and that rising unemployment could be fought
with increased inflation. This relationship was
defined in the famous Phillips curve. The Phillips
curve was somewhat discredited in the 1970s
when the U.S. experienced stagflation.
10/22/2024 1 50
 Review Questions
 Discuss the tax system of Bangladesh
 State the Characteristics of good/ fair Tax System.
 How Economic Efficiency is maintained in Inflationary and
Deflationary situation
 What is Tax incidence? How does it works? Give example.
 Graphically explain Tax incidence in a Competitive and
Monopolistic markets

10/22/2024 1 51