The Role of Government

1
The Role of Government

• Chapter 10

2
Tax Policy

• In 2003, Budget Speech the financial secretary
  announced the salaries and corporate profits
  taxes would be raised by up to 1 and 2
  respectively.
• What are the reasons for such a rise and what are
  the implications?
• The government believes that it must raise taxes
  to eliminate the operational budget deficit.

3
Students Should Be Able To

• Analyze distortions in the economy generated by
  taxes.
• Explain the Laffer curve.

4
HK Spending by Category1998/99
5
Government Expenditure (GDP) 2000
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Sources of Revenue

• Direct Taxes Taxes on Income such as Corporate
  Profits, Salary, Estate Taxes
• Indirect Taxes Taxes on Spending, Gambling
  Revenues, Stamp Duties, Motor Vehicle
  Registration Fees
• Fees for Service
• Investment Income

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Sources of Revenue for Hong Kong
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Why do we have government?

• For economic activity, marketplace is the
  baseline allocation mechanism. Government may
  step in when market (arguably) fails.
• Types of market failure
• Public Goods Goods whose shared benefits cannot
  be charged for including police, fire services,
  national defense.
• Externalities Some goods may produce costs or
  benefits not borne by the purchasers including
  parks, tourist sites or pollution (negative
  externalities).
• Coordination Failure Some systems may work well
  only if everyone uses them the same way, i.e.
  traffic.

9
Social Insurance

• Individuals in a society face certain risks such
  as unemployment or poor health or long life which
  are unpredictable at individual level but
  predictable at a social level.
• Various risks may be uninsurable in private
  markets due to imperfect information. Example
  Lazy people might be most likely to buy
  unemployment insurance, preventing insurance
  companies from making a profit.
• Government often will offer social insurance.

10
Expenditures Transfer Payments vs. Government
Consumption

• Economists think its important to classify
  government expenditures into two categories.
• Government consumption is spending on actual
  goods and services
• Transfer Payments are payments to individuals for
  welfare or other social purposes which does not
  require the recipients to offer anything of value
  to the government.

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HK September 2002
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Tax Distortions

• Taxes are necessary to raise revenues for public
  goods. Taxes reduce ability of taxpayers to
  consume private goods.
• Taxes also have distortionary effects which may
  affect the quantity of goods produced and result
  in a loss of efficiency for economic allocation.

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Capital and the Tax Wedge

• An increase in the tax wedge (the excess taxes
  paid on investing in capital equipment) increases
  the cost of capital and reduces optimal capital.
• The difference between the marginal product of
  capital and the cost of capital is the economic
  surplus value of the capital
• The value of the efficiency loss for the economy
  is specified by the triangle.

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MPK
Distortion
K
K
K
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Tax Distortions

• The size of tax distortions grows faster than the
  size of the tax rate.
• Intuition Diminishing Marginal Returns. Small
  tax wedges eliminate only those investment
  projects which are slightly more profitable than
  the cost of capital. The larger the tax rate, the
  more valuable will be the projects that are
  eliminated.
• Simple models assume that distortions are
  proportional to the square of the tax wedge.
• Two implications
• Laffer Curve
• Tax Smoothing

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MPK
Original Distortion
K
K
K
K
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Laffer Curve

• Revenue generated is not monotonically increasing
  in the tax rate.
• Mental experiment.
• Consider if tax rate on investing in physical
  capital were 0. This would generate no revenues.
  
• Consider if the tax rate were 100. No one would
  invest in capital and capital taxation would
  generate zero revenues. Cutting taxes a little
  would generate more revenue.
• Laffer Curve represents relationship between tax
  rates and total revenue.
• Most economists believe that all developed
  economies are on the left-hand side of the Laffer
  Curve.

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Laffer Curve
Revenues
Tax Rate
19
Tax Smoothing

• Distortions increase rapidly in the size of the
  distortionary tax rate. This means that it is
  better to have a smooth tax rate over time.
• Example. Distortions are proportional to the
  square of tax wedge. Distortion Atw2. Consider
  the government chooses tax wedges in two periods,
  periods zero and 1.
• Choice 1. tw0 0 and tw1 .02.
• Average Distortion
• Choice 2. tw0 0 and tw1 .02
• Average Distortion
• Both choices produce the same average tax wedge,
  but the smooth tax wedge produces a lower average
  distortion (and more revenue).

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Tax Policy

• Government should raise revenues from inelastic
  activities. These have low distortions since
  taxes have little effect on economic behavior.
• Consumption may be less elastic than investment
  suggesting it may be more efficient to impose a
• Government should distinguish between average tax
  rates and marginal tax rates. Marginal tax rates
  are taxes on marginal activity which affect
  activity. Poll taxes may not cause inefficiency.
• Problem Most efficient types of taxes demand
  equal payments from rich and poor people. Is this
  fair?