Econ 551 Government Finance: Revenues Fall 2019 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture 7: Choosing a Tax Base ECON 551: Lecture 7 1 of 43
Agenda 1. Equity Principles 2. (Schanz) Haig Simons Definition of Income 3. Exemptions and Deductions 4. Alternative Bases 5. The Optimal Tax Approach 6. Canada’s system ECON 551: Lecture 7 2 of 43
Equity Principles Q: Who should pay taxes? On what principle should we distribute the tax burden? ECON 551: Lecture 7 3 of 43
Q: Who should pay taxes? Answer 1 : Those who benefit from the spending. ..also known as ‘the benefit principle’ Answer 2 : Those who have the ability to pay. …also known as ‘ability to pay principle’ ECON 551: Lecture 7 4 of 43
Benefit Principle Long history back to at least Adam Smith (1776): “ […] The expence of government to the individuals of a great nation is like the expence of management to the joint tenants of a great estate, who are all obliged to contribute in proportion to their respective interests in the estate. In the observation or neglect of this maxim consists what is called the equality or inequality of taxation. ” Adam Smith, The Wealth of Nations, Book V, Chapter 2, Part 1. ECON 551: Lecture 7 5 of 43
Benefit Principle Imagine we thought the current distribution of income was just. Then, it might make sense to tax only those who receive benefits, or else the just distribution would be disturbed. Another way to think about it is voluntary exchange. If taxes exceed benefits, then people would not likely make this exchange voluntarily. Under this view, taxation is only possible through coercion. Swedish economist Knut Wicksell went so far as to argue a unanimity rule: everyone must agree to an expenditure for it to be equitable. But should we take an insurance view? Maybe we *would* have benefited in another state of the world. ECON 551: Lecture 7 6 of 43
Ability to pay Principle John Stewart Mill: Principles of Political Economy (1848), Book V, Chapter II.8 ‘On the general principles of taxation’ [ link] “If we wanted to estimate the degrees of benefit which different persons derive from the protection of government, we should have to consider who would suffer most if that protection were withdrawn: to which question if any answer could be made, it must be, that those would suffer most who were weakest in mind or body, either by nature or by position. Indeed, such persons would almost infallibly be slaves. If there were any justice, therefore, in the theory of justice now under consideration, those who are least capable of helping or defending themselves, being those to whom the protection of government is the most indispensable, ought to pay the greatest share of its price: the reverse of the true idea of distributive justice , which consists not in imitating but in redressing the inequalities and wrongs of nature.” ECON 551: Lecture 7 7 of 43
Ability to pay Principle If we think the current distribution of resources is not just, we might want to adjust it for the reasons we have already discussed in a previous lecture. Note that it ignores the spending side of the budget. ECON 551: Lecture 7 8 of 43
Ability to Pay or Benefit Principle? Now go back to Adam Smith… “ The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; ” ..next sentence… “… that is, in proportion to the revenue which they respectively enjoy under the protection of the state.” If you think of the state defending your right to keep your income, higher income people benefit more from the state. This mixes benefit and ability to pay principles. ECON 551: Lecture 7 9 of 43
Vertical vs Horizontal Equity Vertical equity: Definition: Tax burdens should be increasing in ability to pay. Horizontal equity: Definition: Those with equal ability to pay should have the same tax burden. Q: Are these actually distinct concepts? ECON 551: Lecture 7 10 of 43
Indexing ability to pay How should we measure ‘ability to pay’? Any suggestions? ECON 551: Lecture 7 11 of 43
Indexing ability to pay Wealth Income Consumption IQ Natural endowment ECON 551: Lecture 7 12 of 43
Agenda 1. Equity Principles 2. (Schanz) Haig Simons Definition of Income 3. Exemptions and Deductions 4. Alternative Bases 5. The Optimal Tax Approach 6. Canada’s system ECON 551: Lecture 7 13 of 43
(Schanz)-Haig-Simons Definition of Income This definition is most often associated with Haig and Simons, but German economist Georg von Schanz had an earlier claim… Robert Murray Haig in ‘The Federal Income Tax’, 1921. p. 27: “Income is the money value of the net accretion to one’s economic powe r between two points in time.” Henry C. Simons in ‘Personal Income Taxation’ 1938, p. 50: “Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question.” ECON 551: Lecture 7 14 of 43
(Schanz) Haig Simons Definition of Income Georg Schanz in “ Der Einkommensbegriff und die Einkommensteuergesetze” FinanzArchiv 1896: [ link] Wir wollen wissen, welche wirtschaftliche Leistungsfähigkeit einer Person, ohne daß sie ihr Kapital aufzehrt oder Schulden macht, in einem bestimmten Zeitabschnitt zukommt, über was sie so z. B. in einem bestimmten Jahr disponieren kann ; ob diese Summe wiederkehrt, wie sie sich zusammensetzt, ob sie der Wiederkehr fähig ist, ist für das betreffende Jahr gleichgültig. In English via Google translate: “We want to know which economic performance of a person without that it absorbs its capital or debt, makes plays in a given time period, about what they can, for example, dispose in any given year, whether this sum returns as composed, whether it is capable of repetition, no matter for that year .” ECON 551: Lecture 7 15 of 43
S-H-S in math: The H-S concept can be expressed algebraically as the sum of consumption and the change in the value of all assets. H-S income = C + A This definition has roots right back to Adam Smith in ‘The Wealth of Nations.” It is meant to measure the amount that one could consume over the time period, holding wealth constant. (It is not clear in principle why we should want to hold wealth constant, however.) Q: Do you think this concept is a good measure of ‘ability to pay’? ECON 551: Lecture 7 16 of 43
S-H-S example: Income 2018=$15K House value 2017=$850K House value 2018=$950K Gain in value of assets = $100K Pure H-S definition of income would include the $100K To access this, however, Granny might have to sell her house! ECON 551: Lecture 7 17 of 43
S-H-S implementation problems: Valuing assets every period This could be very difficult to do – think of stamp collections, other unique assets. Even if unrealized, you would be taxed. Example of Granny in an appreciated house, but little cash income. Inflation Consider a time when inflation is 10% annually. If you have a return of 10% on your bond, your real return is 0%. So, A=0, but a system that taxes nominal income would say A>0. ECON 551: Lecture 7 18 of 43
Agenda 1. Equity Principles 2. (Schanz) Haig Simons Definition of Income 3. Exemptions and Deductions 4. Alternative Bases 5. The Optimal Tax Approach 6. Canada’s system ECON 551: Lecture 7 19 of 43
Exemptions and deductions in S-H-S H-S income = C + A How should we measure ‘C’? Joe has income of $40K. He must pay $3,000 per year for insulin to stay alive. Frank has income of $40K and spends it all on beer, cigarettes, and pizza. Q: Since they have the same income, should they be treated the same? Do they both have the same ‘ability to pay’? Another example: Arthur has 10 children and an income of $40K. George has income of $40K and lives on his own in a cool downtown condo sipping lattes and eating out at fancy restaurants. ECON 551: Lecture 7 20 of 43
Three categories of ‘C’ that might deserve special treatment 1. Expenses necessary to earn income. Some things don’t bring utilit y to the household directly, but instead allow the household to generate income. Some examples: Union dues or professional fees. Tools, commuting expenses. Childcare costs. Moving expenses. Interest paid on funds borrowed to make investments. What if these weren’t treated specially? In this case, it would bias the tax system against work outside the home. Challenge: how far to go in defining these expenses. What about food? Clothing? Entertainment and hospitality? ECON 551: Lecture 7 21 of 43
Three categories of ‘C’ that might deserve special treatment 2. Involuntary expenses. Some expenses result from bad luck or expenses that must be made without choice. Why should we include those expenses in our index of ability to pay? One could argue these are differences in need rather than a choice among gratifications. Medical expenses. Caregiver expenses. Special treatment of children. Basic living expenses. However, isn’t there really some choice involved in some of these – such as children? Also, how to limit thing s under this category. Wouldn’t umbrellas count? I don’t get gratification from buying an umbrella. ECON 551: Lecture 7 22 of 43
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