TAX 1

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

decisions.

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

 Government Revenue

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

the tax.

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

surplus.

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