Policy Goals in Developing Economies

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Policy Goals in Developing Economies

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois at Urbana-Champaign

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Topics for today

• What is tax policy?
• What criteria define good tax policy?
• Is good tax policy different in developing
  economies than in developed economies?
• What data are most helpful for studying tax
  policy, where can those data be found, and what
  format should be followed in assembling a useful
  tax data set?

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Tax policy

• Set of plans
• Tax design
• Tax reform
• Set of goals and the instruments for achieving
  those goals

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Traditional tax policy goals

• Fairness the tax system should be equitable
• Efficiency the tax system should not be
  distortionary and should enhance economic
  efficiency
• Administrative feasibility the tax system
  should have low costs of administration and
  compliance

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Fairness

• Benefit principle taxes should be distributed
  according to the benefits received from
  government goods and services
• Ability-to-pay principle taxes should be
  distributed according to the capacity of
  households to pay them

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Benefit Principle

• Follows from the concept of market equity that
  payment should be based on the marginal benefit
  of consumption
• Those who enjoy greater benefit from government
  should pay higher taxes than those who enjoy
  lesser benefit.

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Equity in the Marketplace
Price
Person 1 pays PX1, person 2 pays PX2, and
together they pay the entire cost of producing
the good, PX. Is this fair?
DMB1 MB2
D1MB1
D2MB2
MC
P
X1
X2
XX1X2
Quantity
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Equity in the Public Sector
Tax price
MBMB1MB2
With a benefit tax, person 1 pays t1G, person 2
pays t2G, and together the pay the entire cost of
the good, MC G. Is this fair?
MC
t2
t1
MB2
MB1
Quantity
G
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Problems in Applying the Benefit Principle

• Taxpayers may not willingly reveal their marginal
  benefits from consuming a public good. Why not?
• Benefit taxes in general will not distribute the
  tax burden according to the ability of households
  to pay them.

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Ability-to-pay Principle

• Horizontal equity those with equal capacities
  to pay tax should pay equal taxes
• Vertical equity those more capable to pay tax
  should bear a higher tax burden

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Problems with Applying Ability-to-pay Principle

• Is income or consumption a better measure of
  ability to pay? (C Y S)
• Is annual or lifetime income a better measure of
  ability to pay? Lifetime income Y0 Y1/(1r)
• How much more should those who are more able
  pay in taxes?

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Should taxes be progressive?
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Utilitarian Answer
Marginal utility of income
TaxPOOR
If the MUY declines with income, does equal
sacrifice imply progressive taxation?
TaxRICH
MUY
Income
YPOOR
YRICH
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More Problems with Applying Ability-to-pay
Principle

• Individuals will not willingly reveal their
  marginal utility of income
• High marginal taxes may discourage work, saving,
  and investment, leading to inefficiencies.

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Efficiency

• In the absence of public goods and externalities,
  a perfectly competitive market economy
  efficiently allocates resources.
• Economic impacts of taxation
• Work, education, retirement
• Savings, investment, risk-taking
• Occupational choice, marriage, child bearing
• Tax avoidance and evasion

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Efficiency cost (excess burden)
Efficiency cost excess burden deadweight loss
of the tax
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Efficiency loss of a tax system
Efficiency loss is greater the more elastic the
demand or supply of the taxed good.
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Efficiency with Benefit Taxes
Benefit taxes, correctly set, lead to an
efficient (Lindahl) equilibrium with public goods
G
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Efficiency with externalities
Corrective taxes can be used to restore
efficiency in the presence of externalities.
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Administrative Feasibility

• Direct costs of administering the tax system
• Indirect costs
• Taxpayer compliance costs
• Efficiency costs associated with tax avoidance
  and evasion

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Additional Goals of Developing Economies

• Economic growth
• Revenue adequacy
• Transparency

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Revenue adequacy
Tax
price
MBMB
MB
1
2
If MC is constant, benefit taxes balance the
budget.
MC
t
2
t
1
MB
MB
1
2
Quantity of Public Good
G
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Revenue surplus
If MC is increasing, benefit taxes yield a
revenue surplus.
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Laffer effect
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Coming up
Thursday Commerce Library Chat topic Suppose a
tax expert recommends that your country replace
all its taxes with a single tax based on land.
Would you agree with the tax expert? Why or why
not. Next Tuesday Tax Structures in Developing
Economies