CHAPTER 12
Tax efficiency, administrative efficiency and
flexibility
Introduction
Looking at the second property of a good tax → impact of the tax on efficiency.
Taxes cause inefficient resource allocation through the distortionary impact on
prices = measure the efficiency cost of the tax through the excess burden it
causes.
All taxes have a burden → that cannot be escaped.
o Inefficient taxes → cause an additional burden in excess of the
inescapable burden that all taxes inevitably have → more costly to society
than an efficient equivalent (for a given revenue)
Excess burden → burden in addition to direct tax burden → greater than
necessary to generate certain amount of tax revenue.
12.1 Excess burden of taxation: indifference curve analysis
Excess burden of a tax → welfare/deadweight loss to society due to suboptimal
resource allocation caused by a tax.
o Excess burden arises → tax has distorted relative prices = resources get
reallocated in an inefficient manner → proves costly to the welfare of
society → would have got more out of their resources had they been
employed more efficiently.
This efficiency loss → deadweight loss of a tax.
Assume 2 products (x and y).
o Pareto efficient equilibrium is assumed → MRSxy=MRTxy=Px/Py.
Px/Py → relative price ratio → the equalizer in this equation.
o Levy a tax on product x → price of x becomes (1+t)Px.
o Equalizing price ratio no longer holds → Pareto efficient equilibrium no
longer holds.
, o Price ratio changes from Px/Py to (1+t)Px/Py → ratio makes x more
expensive relative to product y → consumers reallocate resources towards
y.
Substitute y for x in consumption → more of y is consumed and
produced, and less of x.
o Resources have shifted from production of x to the production of y →
product y is affected by the tax.
o Resource allocation → efficient before the tax on x → implies no welfare
gains occurred when shifting resources between x and y
After tax → shift away from x towards y → implies less efficiency
and a welfare loss.
Signifies a move from optimality in resource allocation to
suboptimality.
Use indifference analysis → illustrates the welfare losses and price distorting
effects of different taxes.
o After that → use consumer surplus approach → measure the magnitude of
excess burden under different conditions.
12.1.1 Lump-sum taxes and general taxes
o Lump-sum tax → fixed amount that an individual would have to pay in a fiscal
year → independent of income, wealth, or consumption.
Like a head tax (levied on each member of society/on all
breadwinners in a household) or a poll tax.
o Lump-sum taxes → do not distort prices → do not affect people’s
consumption decisions.
General/lump-sum taxes → do not cause substitutions in
consumption → have no substitution effect → do not induce
substitution = neutral taxes.
Reduce everyone’s disposable income → have an income
effect.
Relative prices not distorted, and no substitutions arise = no
excess burden.
Direct tax burden that is seen in the income effect.
Tax efficiency, administrative efficiency and
flexibility
Introduction
Looking at the second property of a good tax → impact of the tax on efficiency.
Taxes cause inefficient resource allocation through the distortionary impact on
prices = measure the efficiency cost of the tax through the excess burden it
causes.
All taxes have a burden → that cannot be escaped.
o Inefficient taxes → cause an additional burden in excess of the
inescapable burden that all taxes inevitably have → more costly to society
than an efficient equivalent (for a given revenue)
Excess burden → burden in addition to direct tax burden → greater than
necessary to generate certain amount of tax revenue.
12.1 Excess burden of taxation: indifference curve analysis
Excess burden of a tax → welfare/deadweight loss to society due to suboptimal
resource allocation caused by a tax.
o Excess burden arises → tax has distorted relative prices = resources get
reallocated in an inefficient manner → proves costly to the welfare of
society → would have got more out of their resources had they been
employed more efficiently.
This efficiency loss → deadweight loss of a tax.
Assume 2 products (x and y).
o Pareto efficient equilibrium is assumed → MRSxy=MRTxy=Px/Py.
Px/Py → relative price ratio → the equalizer in this equation.
o Levy a tax on product x → price of x becomes (1+t)Px.
o Equalizing price ratio no longer holds → Pareto efficient equilibrium no
longer holds.
, o Price ratio changes from Px/Py to (1+t)Px/Py → ratio makes x more
expensive relative to product y → consumers reallocate resources towards
y.
Substitute y for x in consumption → more of y is consumed and
produced, and less of x.
o Resources have shifted from production of x to the production of y →
product y is affected by the tax.
o Resource allocation → efficient before the tax on x → implies no welfare
gains occurred when shifting resources between x and y
After tax → shift away from x towards y → implies less efficiency
and a welfare loss.
Signifies a move from optimality in resource allocation to
suboptimality.
Use indifference analysis → illustrates the welfare losses and price distorting
effects of different taxes.
o After that → use consumer surplus approach → measure the magnitude of
excess burden under different conditions.
12.1.1 Lump-sum taxes and general taxes
o Lump-sum tax → fixed amount that an individual would have to pay in a fiscal
year → independent of income, wealth, or consumption.
Like a head tax (levied on each member of society/on all
breadwinners in a household) or a poll tax.
o Lump-sum taxes → do not distort prices → do not affect people’s
consumption decisions.
General/lump-sum taxes → do not cause substitutions in
consumption → have no substitution effect → do not induce
substitution = neutral taxes.
Reduce everyone’s disposable income → have an income
effect.
Relative prices not distorted, and no substitutions arise = no
excess burden.
Direct tax burden that is seen in the income effect.
