Introduction to Taxation
Government plays an important role in most modern economies. In the Kenya, the role of
the government extends from providing for national defense to providing social security and
Medicare to the elderly. In order to provide for these program and services, the government
needs revenues. The sources of the revenues comes from taxes that are paid for by households.
In this chapter, we’ll go over a quick overview of taxes and look at how taxes affect economic
A. Sources of Government Revenue
Taxes has two parts: (1) a base and (2) rate structure.
The base is the measure or value upon which a tax is levied. The base can be measures such as income, sales purchases, home value, corporate profits, etc… The tax rate structure is the
percentage of the tax base that must be paid in taxes.
For example if you pay 35% of your income in taxes, then your income is the tax base, and 35% is the tax rate structure. The tax base can either be a stock measure (property, inheritance) or a flow measure (income, sales
major sources of government revenue in the Kenya over
time. The major sources of revenue are:
(1) Individual Income Tax: This is the tax you are most familiar with. Individuals must
pay this tax by April 15. During the year the government withholds a portion of each
paycheck as tax payments. Table 1 shows that individual income tax has been and still is
the single largest component of federal revenue over time.
(2) Social Insurance Taxes: These taxes are levied on income to pay for Social Security
(retirement fund for the elderly) and Medicare (health care for the elderly). Note how
these taxes has increased over time. In 1960, social insurance taxes comprised only about
16% of total revenues, by 2008 that amount had reached almost 35%
(3) Corporate Taxes: The corporate tax is a tax levied on the earnings of corporations.
This tax was an important source of revenues in the mid-20th century, but has become
less important over time. The existence of tax shelters, laws to stimulate R&D, and
complex rules regarding taxing multinational corporations have all led to a decline in the
importance of corporate taxes as a source of federal revenue.
(4) Other Taxes: The other sources of government revenue are relatively minor. Excise
taxes are taxes that are levied on the sale of certain products such as gasoline, cigarettes,
alcohol, etc…Estate taxes (sometimes called the “death tax”) are levied on estates of
individuals when they passed away. Custom duties are taxes levied on goods imported
to the Kenya, such as foreign cars or wines. Combined, these sources of federal
revenues accounted for only 6.6% of total revenues in 2008.
B. Types of Taxes
A tax can either be proportional, progressive or regressive.
(1) Proportional Tax (Flat Tax): A proportional tax is a tax whose burden is the same rate
regardless of the income earned by the household. For example under a proportional tax
system, if the income tax rate is 13%, then a household who earns $10,000 will pay 13%
of the their income in taxes, while a household who earns $10 million will also pay 13%
of their income as taxes.
(2) Progressive Tax: A progressive tax is a tax that exacts a higher percentage of income
from higher income households than from lower income households. The current income
tax system in the Kenya is a progressive tax. For example, under a progressive tax
system, a household that earns $10,000 would pay a 5% income tax while a household
that earns $10 million would have to pay a 35% income tax.
(3) Regressive Tax: A regressive tax means that higher income households pay less in taxes
as a percentage of their income than lower income families. Excise taxes and retail sales
taxes are examples of regressive taxes.
Household Income Savings .
Illustrates how a retail or consumption tax can be regressive. Suppose that tax reform
eliminates the income tax and imposes a national sales retail tax of 5% on the purchase of all
goods. We have two families the Smiths and the Jones’. The Jones’ have an annual household
income of $100,000 while the Smiths are not so well off and earn only $10,000. Suppose that
the Smiths have to spend all of their income to pay for basic necessities such as food, shelter and
clothing and they have nothing left over to save (their saving rate is 0%). The Jones’, on the
other hand, are able to save some of their income (their saving rate is 30%). Thus the Jones’
total spending is $70,000 while the total spending for the Smiths’ is $10,000. If the retail tax is
5%, the Smiths will pay $500 in taxes while the Jones’ will pay $3500 in taxes. As a percentage
of income, the Smith’s will pay a higher tax rate ($500/$10,000 = 5%) than the Jones’
($3500/$100000 = 3.5%). Thus a sales tax is a regressive tax.
C. Marginal vs. Average Tax Rates
Average tax rate is the total amount of tax paid divided by income.
Example: Suppose that your total income is $50,000 and that you pay $10,000 in taxes. Your
average tax rate is $10,000/$50,000 = 20%.
Marginal Tax Rate is the tax rate that you pay on any additional income you earn.
Example: Suppose that you have a part-time job that earns you an extra $1000 a year. If you
have to pay an additional $250 in taxes on that extra $1000 in income, then we say that the
marginal tax rate is 25%.
Marginal tax rates are important because they play a key determinant in household decisions on
working extra hours and/or making contributions to charity. In order to see why marginal tax
rates determines these factors we have to look at how our current tax system works.
The taxes are marginal taxes.
Let’s work through a numerical example to see how taxes are paid. Suppose that Stacy earned
$60,000 in income last year (before paying any taxes). Taxpayers are allowed to make
deductions (reductions in their income) in the form of standard deductions ($5350) and in
personal exemptions ($3400). These deductions lowers the amount of taxable income.
Before Tax Income = $60,000
Standard Deduction= -$5,350
Personal Exemption = -$3,400
Taxable Income After Deductions = $51,250
Now we can see how marginal tax rate can affect decisions to work and to contribute to charity.
(1) Incentive to work: If Stacy’s decides to take a second job, her income from that second
job will be taxed at the 25% bracket. At that rate, Stacy may decide it might not be worth
it to work that second job. If the marginal tax rate is very high, it might provide a
disincentive for workers to work overtime hours or work the second job.
(2) Incentive to contribute to charity: One of the features of charitable giving is that the
donations are tax-deductable. That is if you give $1000 to your local church, you may
deduct that contribution from your income and thus lower your taxable income. For
example, suppose that Stacy also contributed $2000 to the Red Cross last year. We
would add that contribution to her standard deduction and thus lower her income after
deductions to $49,250. Stacey has to pay less in taxes due to the charitable donation.
She pays 25% on now $17,400 (instead of $19,400) at 25%. The taxes she must pay on
her last slice of her income is now $4,350. Stacey has saved $500 in taxes owed. High
marginal tax rate would increase the incentive for individuals to contribute to charity so
they can take a higher deduction.
II. Tax Incidence: Who Pays?
When the government passes tax laws, the laws clearly indicates who has the responsibility to
pay the tax. For example, an excise tax on cigarettes might impose a tax that cigarette
manufacturers must pay per pack of cigarettes sold. However, as we will soon see, the burden of
a tax might not always be borne by those who the law saws have a responsibility to pay for it.
For most taxes, the burden of payments is often shifted, either directly or indirectly to others.
A. Tax-Shifting: Tax on Producers
Let us use our supply and demand framework to look at how taxes affect economic behavior and
how the burden of taxes can shift from one party to another. Figure 1 below looks at the market
for 12 pack of Cokes. Initially, the market supply and market demand curves intersected at Point
A. Thus the market equilibrium price is at $3 while the market equilibrium quantity was at 900
packs of sodas.
Tax Incidence and Elasticity
As we have seen both graphically and algebraically, an increase in taxes will result in the tax
burden being shared by consumers and producers. If a tax is placed on producers, how much of
the tax can be shifted forward on to the consumers? The answer depends on the price elasticity
of demand for the taxed good. If the demand for the taxed good is very inelastic (in other words
consumers are not very responsive to price changes) then consumers will pay the large bulk of
Consider the example of the extreme case of a good with perfectly inelastic demand. Recall that
if a good has perfectly inelastic demand, consumers will not alter the amount purchase no matter
what the price of the good. In other words the demand curve is vertical.
Taxes and Inefficiency
A. Calculating Deadweight Loss with Taxes
In our two examples where we looked at tax shifting, the one thing both had in common was
that the equilibrium quantity decreases after a tax is imposed. There is an underproduction of
the good compared to the original socially optimal level. We know from Chapter 4 that
when there is underproduction, economic inefficiency will result in the form of deadweight
losses. Let’s calculate the deadweight loss that would result from a tax.
Figure 5 looks at a situation where a tax will be imposed on firms. Without a tax, the
equilibrium price will equal $10 and the equilibrium quantity will be 30,000. Given this
initial equilibrium, let us calculate (a) consumer surplus, (b) producer surplus, and (c) total
Deadweight Losses and Elasticity
As we saw earlier, the price elasticity of demand is important in determining the ability of the
firm to shift the tax burden to consumers. If demand for a good is relatively inelastic, the firm is
able to shift a majority of the tax burden to consumers, while if the demand for a good is
relatively elastic, the firm will not have the ability to shift much of the tax to consumers. It turns
out that price elasticity of demand can also be used to determine the size of the excess burden or
deadweight loss that will occur if a tax is imposed. To see why, let us recall why deadweight
loss exist in the first place.
The presence of a deadweight loss means that society is either under-producing or overproducing
the socially optimal level of output. In the case of a tax, fewer output will be
produced than otherwise would have been in the absence of a tax. The loss to society is the loss
in consumer and producer surplus from units of good that should have been produced but was
not due to the tax.
With that in mind, let us consider what price elasticity of demand can tell us about deadweight
loss. Let us consider two cases: (1) relatively elastic demand and (2) relatively inelastic demand
(1) Relatively Elastic Demand: By definition, if a good has elastic demand, that means that
consumers are very responsive to changes in price. An increase in taxes will cause an increase
in price that consumers have to pay (unless demand is perfectly elastic). Consumers will respond
to this increase in price by cutting back their consumption of the good and the quantity will fall
drastically. As a result, equilibrium quantity after the tax will be significantly lower than the
quantity that was consumed prior to the tax. Since there is significantly less goods being
consumed than what is socially optimal, there will be a greater loss to society. The loss to
society will be all the units of good that would have been produced and consumed in the absence
of the tax. In short, the more responsive the consumer behavior to a change in price (the
more elastic the demand), the greater the deadweight loss (or excess burden).
Relatively Inelastic Demand: Consider the opposite case where consumers are generally
irresponsive to changes in price. An increase in price that consumers pay due to a tax will lower
the quantity demanded, but not very much. Since the quantity demanded will be very close to
the initial pre-tax level of quantity demanded, the “lost production” will be small. Since the new
equilibrium quantity is close to the initial socially optimal level of output, the deadweight loss or
excess burden will be small (especially compared to the case of elastic demand). Figure 7
illustrates the case of inelastic demand. A good that has inelastic demand will have a demand
curve that is relatively steep. As we can see in Figure 7, new equilibrium quantity that results
from the tax increase is lower than initial equilibrium, but it’s not far from the initial level. As a
direct result the area of the deadweight loss is small. If the demand for the good has inelastic
demand, then the deadweight loss or excess burden will be relatively small