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lecture2 - Lecture Note 2 Tax Incidence Part 2B Paper 1 Dr...

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Lecture Note 2: Tax Incidence Part 2B: Paper 1. ° Dr. T.S. Aidt University of Cambridge Michaelmas 2010 1 Introduction Tax incidence is the study of the e/ect of taxes on the distribution of welfare. The question is who really pays the cost of a tax in the sense that their real after tax income is lower than their real before tax income. This note provides a short introduction to the important topic. It also introduces a number of important tax equivalence results, i.e., general results about what sort of tax structures are really the same in the sense that they have the same tax incidence. 2 Lump sum taxes A lump sum tax is a tax where the taxpayer cannot a/ect his or her tax liabilities by changing behavior. The incidence of a lump sum tax, therefore, falls directly on those from whom the tax is collected and the analysis of the tax incidence is trivial: the real after tax income of the agent who pays the tax is simply lowered by the amount of the tax payment. Hence, incidence analysis is only interesting if taxes are distortionary, i.e., if taxpayers can do things to a/ect their tax liability. This opens up the possibility that the incidence may be shifted through the economy via changes in relative prices and thus for the possibility that the real burden of the tax is felt by someone else than the person or °rm on which the tax is levied in the °rst instance. There is a fundamental reason why lump sum taxes cannot be used for redistributional purposes as the Second Welfare Theorem would like to have it. This is what motivates the study of distortionary taxes and their welfare e/ect. The reason is private information. An optimal lump sum tax must be levied on the unchangeable endowments of individuals and if the purpose of the tax is to redistribute income from individuals with a "good" endowment to individuals ° Disclaimer: These notes are not guaranteed to be error free. Please bring any problems to my attention. 1
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with a "poor" endowment, tax liabilities must depend on the characteristics of these endowments. The leading determinant of the "quality of the endowment" of an individual is his or her ability. But this is private information and the individual will have no incentive to reveal the quality of their endowment to the government if they can reduce their tax liabilities by concealing it. This rules out the use of optimal or person-speci°c lump sum taxes and forces governments to tax characteristics which they can observe (e.g., income or purchases of goods). Unfortunately, this gives individuals ample opportunities to reduce their tax liabilities by changing their behavior and this makes taxation distortionary. Of course, the government could raise revenue through poll taxes, i.e., lump sum taxes where all citizens pay the same amount, but this is generally considered to be unfair and regressive (not to mention the political fall-out!). So, at the end of the day, most taxation is distortionary, a/ect behavior and thus have implications for prices throughout the economy.
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