The Effects of Taxation on Economic Behavior

The Effects of Taxation on Economic Behavior

1. Introduction

Empirical evidence shows that, almost always taking the size of the tax into account, the price elasticity of demand for goods will affect the incidence of the tax on consumers. A tax will be shifted mostly to the consumer if the good has an inelastic demand or supply curve. This is because a good which is price inelastic has a smaller response of demand to a price change. A supplier will not increase the quantity in which they produce the good if the tax causes the price to increase. This means the supplier does not have to bear as much of the tax relative to the consumer. The same logic explains why a tax on a good with price inelastic demand will be mostly borne by the consumer. Price elastic goods have a larger response of demand to a price change. As a result, suppliers of price elastic goods will have to bear a higher proportion of the tax relative to the consumer. The supply of goods in which the tax is bearable to the supplier is when marginal cost is offset by marginal revenue. An equal incidence of tax on both producer and consumer will occur when the price elasticity of both demand and supply curves are equal.

Introduction – An increase in tax could affect the supply of goods and services in an economy. The increased tax liability on a supplier would shift the supplier’s supply curve to the left, provided the good is a normal good. This is because the supplier now has to bear a higher cost to produce the good. As a result, the increased cost is passed onto the consumer, which in turn raises the price of the good. The effect of the price rise is seen as a movement along the demand curve. Consumers ultimately bear the burden of the tax as they are the ones who pay the increased price for the good. This means that the income and substitution effect of a tax on normal goods will always lead to a decrease in consumption of the good. This is in contrast to the effect of a tax on an inferior good, which has an ambiguous effect on consumption.

2. Theoretical Framework

Suppose that the private behavior to be modeled takes place within a given institutional framework and that this framework includes a specific set of existing rules, customs, and laws. In a general sense, any rule or law is a statement of what may or may not be done, and it may be interpreted as a constraint which, if relevant to behavior, limits the set of feasible alternatives available to the decision maker. Thus, a change in the institutional framework which is interpreted as a change in a relevant constraint has the effect of altering the set of feasible alternatives available to the decision maker being constrained. Inasmuch as a change in the tax structure may be interpreted as a change in relevant constraints, the modeling of tax effects requires that we know how to adjust the given model of private economic behavior when the set of constraints defining the feasible alternatives has been altered.

Before attempting to model the effects of taxation on economic behavior, we must first specify the objectives to be pursued by economic agents and the institutional framework within which they operate. In this section, our emphasis will be on the choice of tax instruments in the public sector and the economic behavior of private households and firms when such instruments are in place. The model will be a general one in the sense that it will be applied to the behavior of households and firms in various market situations and to the behavior of public sector institutions.

3. Empirical Studies

By using meta-regression analysis, they find strong evidence of a negative substitution effect between taxes and labor, such that as the net of tax rate decreases, there is a relative increase in the labor supply compared to unconstrained leisure. They obtain similar findings for both men and women and in all countries, except for single women in Spain. This has important policy implications since it suggests that changes in tax policies targeted at certain types of workers can have large effects on the labor supply. This study is, in fact, an estimate of the tax elasticity given the comparison of the net wage with unconstrained leisure and work using the budget equation which incorporates the tax rule.

Perhaps the most satisfactory evidence on the effects of taxation on behavior comes from microeconometric studies using household or firm level data. These studies estimate the parameters of utility or profit maximization subject to constraints given by the tax system, and as such can be used to simulate the effect of tax changes. Though theory is relatively undeveloped in this area, results from this simulation methodology are convincingly consistent with basic theory. For example, a number of studies have tested for the theoretical responses of the labor supply decision to taxation, with the wage offer or hours worked responding to a tax change in the appropriate direction. It is beyond the scope of this survey to attempt to evaluate all such studies. However, a recent and comprehensive study is that by Bargain et al. (2011) who conducted a large Tax Repayment study on the taxpayers of seven European countries, with the aim of estimating the microeconometric elasticities of the labor supply decisions of men and women in cohabiting relationships. The study is the first of its kind to compare results in the same setting and using comparable methods for different European countries.

Ideally, we would like to be able to test directly the theoretical relationships between tax structure and levels of economic activity. However, because the effect of tax changes on activity should cumulate gradually over time to maximum impact, the use of simple correlational or regression analysis with single year data is problematic. It is very likely that earlier activity levels will affect changes in tax structure, and such simultaneous relationships make it difficult to identify effects clearly. Additionally, changing tax policy to test its effect is generally undesirable and often politically infeasible. For these reasons, estimation of the effects of taxes on economic activity with time series or cross-sectional data is likely to be unsatisfactory. Many studies have tried to estimate the effects of tax changes on activity by using macroeconomic data, and results generally suggest only a small effect of tax structure on output or unemployment. However, the evidence is largely inconclusive and inconsistent.

4. Policy Implications

Theoretically, a tax only on the ‘excess burden’ of consumers’ commodities could be imposed by restricting a specific subsidy to consumers of the commodity in question. In practice, the specific commodity subsidies now in existence tend to have adverse incentive effects on the use of resources in the subsidized industries. A less market-distorting policy is to transfer tax incidence forward on the wage rates of resources employed in specifically stated production activities. This is done in the negative income tax proposal, and the guaranteed wage plan has a similar effect. Because the tax incidence effects of subsidization or penalization of specific industries are, in large part, determined by the elasticity of resource supply to the industry, consumer’s commodity taxes are still relevant to the issue.

For the purposes of this paper, the most useful approach for policymakers is to examine the impact of specific policies in reducing some currently perceived discrepancy between private and social cost, rather than to impose an across-the-board tax. This would probably raise the cost of funds to both the private and public sectors, and consequently reduce the stock of resources. While for many policies it is possible to suggest an excise tax which would approximately carry out the desired marginal cost price increase, it is also true that a tax system already exists and changes in tax structure may be politically more feasible than new program expenditures. This study has already written several papers examining the incidence of specific excise taxes in the United States. The general finding is that not too much of the tax burden is shifted forward on consumers’ good prices because demand for the good is relatively inelastic.

5. Conclusion

The conclusions to be drawn from the tools of analysis presented in this paper are largely tentative and should be thought of as indicating fruitful areas for future research as much as providing firmly established findings. The main reason for this is the immaturity of the theoretical frameworks underlying our discussion. The economic approach to the study of the effects of taxation is built on the assumption that taxes are distortionary, and yet for the most part, our theories of how and why taxes affect behavior are not well enough specified to yield clear comparative static predictions. In most instances, we have only partial equilibrium remedies, neglecting general equilibrium interactions, and we deal with cases where the effects of taxes on relative prices can be shown to be non-neutral, but where the basic tax incidence can take many alternative forms. Under such circumstances, it is difficult and often impossible to come up with precise predictions that can be analyzed empirically. In a sense, this difficulty has been to the advantage of theoreticians, for it has meant that “the effects of taxation” can take the form of a virtually limitless source of conclusions that can be deduced from a very few behavioral hypotheses! But it is not to the advantage of the science of public finance, and especially not to future researchers in the area.

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