Question

Suppose the U.S. government has to raise a given amount of tax revenue by taxing two goods with different elasticities of demand. What policy advice could you provide that would minimize the welfare cost of taxation? Do government excise tax policies seem to follow your advice? Give some examples and/or counter-examples.

Answer 1

ANSWER-

Increasing progressive taxes, such as the higher rate of income tax from 40% to 50%, will take more income from those on high-income levels. This enables cuts in regressive taxes (e.g. VAT/Sales tax) and increased welfare benefits which help increase the income of the poor. This can be an effective way to reduce relative poverty.

• However, critics argue higher income taxes create a disincentive to work., leading to less output. This is because higher tax makes work less attractive and reduces the opportunity cost of leisure. Therefore people work less and enjoy more leisure. This is known as the substitution effect. Similarly higher corporation tax may discourage investment in the UK
• However, this is disputed by other economists, who point out that higher tax reduces incomes and this may encourage people to work more, to maintain their income. (This is known as the income effect)
• Evidence suggests that higher income tax has little incentive on the supply of labor, suggesting labor supply is relatively inelastic. However, it also depends on what level the income tax is set. There is certainly a level where higher income tax will reduce incentives to work.
• Other problems with increasing income tax, include tax evasion and the fact firms may adjust wages to compensate for the higher taxes.

Excise taxes are sometimes used to charge taxes on goods or services deemed by society as unnecessary or even harmful. A "sin tax" is applied to the price of things like alcohol and cigarettes, to compensate governments for the cost of dealing with the use of harmful or luxury items.

There are two main types of excise taxes: Ad Valorem, and Specific.

• Ad Valorem: these taxes are levied on a fixed percentage of the value of a good or service. Property tax is a form of ad valorem tax. Ad Valorem is Latin for "according to value."
• Specific: a tax charged 'per unit sold.' As an example, think of gasoline taxes, which you pay in the price per 9/10 of a gallon, thinking you're just paying for the price of the gasoline.