econ 635: public economics lecture 1. overview and principles of tax reforms 1
TRANSCRIPT
ECON 635: PUBLIC ECONOMICS
Lecture 1
Overview and Principles of
Tax Reforms
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Four Functions of Public Finance
• Allocation
• Distribution
• Stabilization
• Growth
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Allocation
• An organized society requires the consumption of
public goods and services that would be unprofitable
to produce privately
• Public goods include:
– Defense,
– Law and order, justice
– Infrastructure
– Taxation is used to raise funds to pay for
production of these goods and services
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Redistribution• Very difficult to do in a short period of time
• Redistributing wealth does not change individual
incomes much.
• Redistribution is impossible to do via the tax system
alone.
• Redistribution through expenditure system is much more
promising.
• Redistribution should be related to the role of
governments in promoting growth.
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Redistribution (cont’d)• Only through growth can people in developing countries
be lifted out of economic backwardness
• Public education, health services
• Rural roads, rural telephone, electricity and public water
supplies all ways that people can change their position in
life overtime
• Important to consider changing income distribution
between generations
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Stabilization• A short run objective
• Outgrowth of the Keynesian revolution in
economics.
• The main objective to keep actual level of
income close to its potential.
• The target is full employment and price
stability.
• Inflation extremely damaging to poor and
reduces the efficiency of market system.
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Growth• Probably the most important objective when per capita
incomes are low
• Sources of Per Capita growth
– Capital accumulation, Human capital (education, health), and
Productivity change
• Tools of taxation and public expenditure need to be focused
on how to promote growth
• Need policies that encourage investors to reinvest their
business surpluses not take them out of country
• Government budget surplus important for providing savings
for private sector to borrow
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1. Avoid false technicism in economic policymaking.
2. Keep budgets under adequate control.
3. Keep inflationary pressures under reasonable control.
4. Take advantage of international trade.
5. Recognize that some types and patterns of trade restrictions
are far worse than others, and work both to liberalize and
rationalize them. (For example, uniform tariff rates are not as
damaging as import quotas)
6. If import restrictions are excessive, and reducing them is
politically impossible, mount an indirect attack on the
problem by increasing incentives to export.
Twelve Lessons of Economic Policy
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7. Make tax systems simple, easy to administer, and (as much
as possible) neutral and non-distorting with respect to
resource allocation.
8. Avoid excessive income tax rates 35 to 40% are
representing a plausible marginal rate that should not be
exceeded).
9. Avoid excessive use of tax incentives to achieve particular
objectives.
10. Use price and wage controls sparingly, if at all.
11. Rarely can an economic justification be found for quotas,
licenses, and similar quantitative restrictions on output,
imports, exports, etc.
Twelve Lessons of Economic Policy (Cont’d)
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12. The borderline of public-sector and private-sector activity
should be clear and well-defined. When the two compete in a
given area, the same rules should govern their operations.
Twelve Lessons of Economic Policy (Cont’d)
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Five Important Innovations of Tax Policy
a) It is a possible to introduce more progressivity in a value
added tax system, but that its benefits have to be weighted
against significant extra vulnerability to evasion.
b) Significant differentiation among rates of import tariffs can
lead to huge economic inefficiencies by giving vastly
different degrees of effective protection to different
activities.
c) Personal income tax rates above 35 to 40 percent are very
hard to justify in light of their efficiency and incentive costs.
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d) Labor is likely to bear the burden of any unilateral rise
in the rate of tax on the income of corporations (or
businesses in general), once an open-economy setting
is put in place.
e) It is much easier to index a tax system for inflation than
people think. By its nature full indexation promotes
both equity and efficiency.
Five Important Innovations of Tax Policy (Cont’d)
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Pattern of Tax Revenue Collection(Approximation)
Category of Countries Ratio of Tax Revenue to GNP
i) Low Income countries 15%
(per capita income Less than $400)
ii) Low Middle income 20%
(per capita income $400 to $1,600)
iii) Upper Middle income 30%
iv) High Income Industrialized countries
45%
(Source: Wagner's Law – State takes an expanding share of GNP as per capita incomes rise.)
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Composition of Government Revenues (2010)
Thailand South Africa Turkey Cyprus UK US
GNI per capita, PPP (current international $) 8,410 10,260 15,810 30,300 36,020 48,880
GNI per capita, Atlas method (current US$) 4,320 6,100 9,980 28,570 38,690 48,960
Revenue Categories (% of GDP)
Taxes on Income, Profits, & Capital Gains 6.88% 13.20% 5.81% 11.11% 13.14% 10.77%
Taxes on Payroll and Work Force _ * 0.32% _ 0.98% 0.24% _
Taxes on Property _ 1.39% 0.27% 0.65% 4.21% 3.15%
Taxes on Goods and Services 8.33% 9.96% 12.58% 13.30% 10.86% 4.25%
Taxes on International Trade 0.94% 0.97% 0.30% 0.21% _ 0.20%
Other Taxes 0.12% _ 2.10% 0.31% 0.06% _
Social Contributions 1.33% 0.48% 7.49% 8.96% 8.41% 6.83%
Grants 0.02% 0.07% 0.28% NA 0.22% _
Other Revenue 3.09% 6.33% 7.51% NA 3.00% 6.46%
Total 20.71% 32.72% 36.34% 35.52% 40.14% 31.66%
* _ indicates that a figure is zero or less than half of a significant digit.
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2010 Composition of Government Expenses (% of GDP)
Thailand South Africa Turkey Cyprus US UK
Expenses Categories
Compensation of Employees8.56% 13.30% 8.55% 15.91% 10.82% 11.36%
Use of Goods and Services7.43% 10.85% 5.97% 5.64% 8.99% 13.04%
Consumption of Fixed CapitalNA 0.66% 0.97% 0.65% 1.53% 1.03%
Interest1.27% 2.60% 4.18% 2.26% 2.75% 2.87%
Subsidies0.46% 0.89% 0.81% 0.21% 0.39% 0.68%
Grants 0.02% 0.63% 3.01% 4.11% 0.40% 0.42%
Social Benefits1.23% 4.05% 11.48% 14.42% 15.55% 15.08%
Other Expense0.23% 2.54% 1.31% _ 0.75% 4.35%
Total19.20% 35.52% 36.28% 43.20% 41.18% 48.83%
* _ indicates that a figure is zero or less than half of a significant digit.
Source: Government Finance Statistics Yearbook , IMF 2011
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2010 Composition of Government Outlays (% of Total Outlays)
Thailand South Africa Qatar Turkey Cyprus US
Outlays by Function
General Public Services 17.96% 54.98% 38.03% 30.09% 27.24% 15.99%
Defense 7.90% 4.56% 4.79% 5.06% 5.32% 29.42%
Public Order and Safety 5.72% 9.72% 4.73% 6.36% 6.22% 2.27%
Economic Affairs 20.54% 8.03% 24.66% 14.32% 9.99% 9.20%
Environmental Protection 0.21% 0.35% 0.47% 0.12% 0.10% NA
Housing and Communities Amenities 2.03% 4.36% 1.32% 2.22% 8.82% 4.96%
Health 9.59% 2.45% 4.96% 5.47% 8.57% 17.39%
Recreation, Culture and Religion 0.96% 0.73% 9.22% 1.85% 2.48% 0.23%
Education 20.04% 2.87% 11.12% 14.12% 19.28% 5.59%
Social Protection 15.05% 11.96% 0.70% 20.40% 11.98% 14.96%
Total 100% 100% 100% 100% 100% 100%
* _ indicates that a figure is zero or less than half of a significant digit.
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• Rapid growth in size over the past 50 years• Two reasons:
a. Desire to increase rate of growth and industrialization
- growth in state owned enterprises.
- this trend is reversing
b. Growth in social program
- social security
- health expenditure
- unemployment insurance
- welfare programs• Need to think how these objectives and programs can be
more effectively delivered. E.g. public-private partnerships.
What is the Appropriate Size of the Public Sector?
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1. Current expenditures on personnel explode ?
2. Investment expenditures have huge cost over runs ?
3. Crop failures ?
4. Exchange rate fluctuations ?
5. Rapid increase in military expenditures ?
6. A contingent liability comes due
- e.g. Guarantee of bank deposits
- Guarantee of exchange rate
- Guarantee of state enterprise loans
What are the most frequent causes of Government Budget Crisis ?
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Principles to Evaluate a Good Tax System
Revenue Adequacy
• The taxes introduced should be sufficient to finance and fund the
government expenditure requirements over time.
• Tax revenues should increase at a rate equal to or greater than the growth
of GNP.
• The entire tax system should evolve as the economy changes.
• Inadequate revenues will force the government to resort to borrowing,
selling state assets or printing money (inflation).
• Deficit financing by domestic borrowing leads to the crowding out of
private sector credit given by commercial banks.
• Deficit financing by foreign borrowing is limited and economically
expensive.
• Deficit financing by Central Bank borrowing leads to inflation.
• High inflation usually leads to financial crises.
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Principles to Evaluate a Good Tax System (Cont’d)
Stability
• The stability of tax revenues is important for good government.
• Revenue instability will cause new programs to be poorly implemented.
• Stability in the tax rules and rates over time allows the private sector to make long term plans more efficiently.
For the stability of a tax system, it is necessary that:
a. the legislation be well written to eliminate unintended tax exemptions or deductions (loopholes)
b. the statutory rates of tax for each of the taxes are not so high as to create powerful incentives to promote tax avoidance schemes or to stimulate tax evasion activity
c. the tax revenue is adequate and grows in a consistent fashion
d. the tax system is simple and the combined cost of administration and compliance is low
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Principles to Evaluate a Good Tax System (Cont’d)Simplicity • A Tax system should be simple so that it is easy to comply with by
taxpayers. • Simplicity must apply to the administration of the law as well as its
legal structure. • A complex tax system imposes high level of compliance costs on tax
payers and a high cost of administration on the government.
• Tax neutrality needed for growth.• Growth comes about primarily through the expansion of savings and
expansion of investment into high return activities.• The tax system should not create major distortions in consumption
and production behavior. • A tax should not change the investment decisions by favoring one
set of investments over the others.• The tax system should not create a disincentive to work.• Well-designed tax systems should encourage competitive growth in
all sectors of the economy.
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Principles to Evaluate a Good Tax System (Cont’d)
Economic Efficiency • A tax is efficient if the dead weight loss or efficiency cost is small.
• High differential tax rates create larger economic efficiency costs.
• The economic efficiency of a tax is an important consideration when designing a tax system.
• Estimates of efficiency cost range from 5 to 150 percent of additional tax revenues.
Low Administration and Compliance Costs
• A good tax system has low administration and compliance costs.
These costs are part of the economic cost of having a tax system.
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Tax Systems Before and After Reforms
• Design of a tax reform depends on the existing elements
of the tax system
• Considerable differences in the existing tax policies and
economic systems of various countries
• The legislative and administrative set-up also vary from
country to country
• For the former Socialist economies of Eastern Europe
and the former Union of Soviet Socialist Republics a
completely new tax system has had to be created
PRINCIPLES OF TAX REFORM
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Tax Systems Before and After Reforms (Cont’d)
In many developing countries tax reforms need to
concentrate only on redesigning the existing tax system.
• Where reforms are extensive, their implementation could
spread over a number of years.
• Appropriate tax rules for the implementation is an important
component required for the success of a tax reform.
• A general understanding or consensus must be reached
among concerned economists, lawyers, and legislators for
successful legislation and implementation of these rules.
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Implementation of Reforms
• The actual implementation of a tax reform depends on the will of the political leaders and the capabilities of the tax administration of the country
• Political leadership has a major role in legislation of acts and rules
• Difficult to produce an integrated tax reform which has the support of all the interest groups.
• Political leadership often seeks to influence the tax administration in order to favor special interest groups, and this destroys tax systems
• The tax administration in a particular country may be slack and inactive
• For effective implementation of tax reforms, a prime requisite is that reforms in the administrative setup keep pace with the changes in the tax system and in the way the tax clients operates.
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• Design of tax reform will also depend on the type of tax which is the object of reform
• Main categories of taxes:
a) Direct Taxes
* personal income tax
* business or corporate tax
b) Indirect Taxes
* sales taxes (Value Added Tax)
* excise taxes
• trade taxes
c) Property Taxes
* wealth tax
* estate and gift tax
* asset tax
d) User Charges
* users charges
* environmental taxes
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Direct Taxes
A) Income Tax:
Before Reform After Reform
High top rates (40%-75%) (Statutory Tax)
Top rates falling (20%-35%)
Many rates Very few rates
Many exemptions Most exemptions eliminated
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Direct Taxes (Cont’d)
B) Corporate Income Tax:
Before Reform After Reform
High marginal tax rates Convergence of top statutory tax rates for personal and corporate tax systems
Incentives with tax holidays
Elimination of special incentives
Double taxation Integration of corporate and personal taxes
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Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets)
Country Individuals Corporations
Before After Before After
Australia 60% (5) 49%(4) 46% 39%
Canada 34%(10) 29%(3) 28% 23%
Finland 50% 43% 52% 40%
Germany 56% 53% 56% 50%
Portugal 41/48% 37% 60/68 45%
Barbados 60% 50% 45% 35%
Colombia 49% 31% 40% 30%
El Salvador 60% 35% 30% 35%
Guatemala 42% 34% 48% 34%
Jamaica 58% 33% 45% 33%
New Zealand 66% (5) 33%(3) 45% 28%
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Reduction of top marginal income rates since 1984 (Number in parentheses indicates the number of tax brackets)
Country Individuals Corporations
Before After Before
After
Zambia 80% 35% 50% 35/45
Denmark 73% 68% 40% 50%
U.S.A. 50% 28% 46% 34%
Indonesia 45% 35% 45% 35%
Singapore 45% 33% 40% 33%
Botswana 75% 50% 35% 40%
Mauritius 70% 35% 66% 35%
U.K. 60% 40% 52% 35%
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Indirect Taxes
A) Sales Tax:
Before Reform After Reform
Many rates Value Added Tax (one positive rate and zero rate)
Many exemptions Small number of exemptions
Narrow base Broad base plus a selective number of excise taxes (cigarettes and liquor etc.)
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Indirect Taxes (Cont’d)
B) Trade Taxes (Import Duties):
Before Reform After Reform
High tariff rates Top rates loweredTarget around the world for a single rate. In free trade areas the target rate is zero.
Wide dispersal among rates (in India 90 different tax rates on steel alone)
Fewer rates
Quantitative controls No quotas
• While in 1950 no country had a Value Added Tax, by 1993 more than 80 countries had adopted some form of VAT Tax
• By 2001, over 120 countries have introduced VAT
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• Evolution of the tax system of South Cyprus 1990-2001 after it began preparations to enter into the European Union.
• South Cyprus had a history of a very old fashion tax system that was badly in need of reform.
• Tax system was full of exemptions and incentives
Tax Reform Process in South Cyprus
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South Cyprus Fiscal Issues in 1990:
Public sector deficit – 5.3% of GDP
Individual Income tax – 3.9% of GDP
Corporation Income tax – 1.4% of GDP
Import duties – 3.4% of GDP
Selective excises – 0.0% of GDP
VAT – 0.0% of GDP
Other Indirect Taxes – 8.1% of GDP
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• South Cyprus 1991 began reform process with changes to income tax to reduce burden.
– Introduced VAT in 1992 at a rate of 5%.– 1993 raised VAT rate to 8% – Income tax changes in 1996– 2000 raised VAT rate to 10% – 2002 raised VAT rate to 13%– Major reform of Income Tax System– 2003 will raise VAT rate to 15%
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Direct and Indirect Taxes as Share of GDP.
0,0
2,0
4,0
6,0
8,0
10,0
12,0
14,0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Year
GD
P %
Direct Taxes
Indirect Taxes
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Direct Taxes as Share of Total Tax Revenues.
0,0
10,0
20,0
30,0
40,0
50,0
60,0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Year
% T
ota
l T
ax
Rev
en
ues
Direct Taxes / Total Direct & Indirect Taxes
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Composition of Indirect Taxes as Share of GDP.
0,0
1,0
2,0
3,0
4,0
5,0
6,0
7,0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
Year
GD
P % Import Duties
Selective Excises
Value Added Tax (VAT)
Other Indirect Taxes
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South Cyprus Fiscal Situation 2001:
Public sector deficit – 2.8% of GDP
Less distortionary tax system
Individual income tax – 4.4% of GDP
Corporate income tax – 3.9% of GDP
Import duties – 1.3% of GDP
Selective Excises – 3.0% of GDP
Value Added Taxes – 5.9% of GDP
Other indirect taxes – 2.1% of GDP
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Revenue Buoyancies of South Cyprus Taxes, 1990-2002.
Total Taxes 1.59
Total Direct Taxes 1.77
Total Indirect Taxes 1.46
Individual Income Tax 1.07
Corporation Income Tax 3.46
Other Direct Taxes 1.32
Total Indirect Taxes 1.46
Import Duties -1.56
Selective Excises 1.25
Value Added Tax 3.72
Other Indirect Taxes -.93
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South Cyprus 2001:
Per capita income – US$ 13,500Real growth rate 1995-01 – 4.2%Tourism makes up – 20% of GDPImports – 41.1% of GDPExports – 11.9 of GDPDomestic Savings – 14.0% of GDPDomestic Investment – 18.5% of GDPRate of inflation – 2.0 %Unemployment rate – 3.0%
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The Challenge Facing North Cyprus
• Total Tax Revenues - 35 % of GDP
• Total Expenditure - 63% of GDP
• Deficit - 28% of GDP
• Substantial Public Sector Budget Deficit
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Tax Collections 2003 as Percentages of GDP.
Direct Taxes 10.24% 8.93%
Indirect Taxes 14.85% 16.54%
- VAT 7.75% 7.67%Import Duties (tariffs) 0.51% 0.79%Selective Excises 4.60% 7.76%Other 1.98% 0.32%
Social Security Contribution 5.22% 5.22%
Other non-tax revenue 6.01% 5.11%
Total Revenue 36.67% 35.80%
Total Revenue (Excluding SSC) 31.10% 30.58%
South Cyprus
North Cyprus
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Public Sector Expenditures, Excluding Social Security and public pensions, 2004 as percentages of GDP
SOUTH CYPRUS
NORTH CYPRUS
Wages & salaries 10.96% 17.19%Capital Expenditure 3.77% 7.87%Debt Service 4.96% 5.09%
Others (excluding social security
and public pensions) 14.96% 16.46%
Total Expenditures 34.65% 46.62%
Total Revenue (Excluding SSC) 31.10% 30.58%
Cash Deficit -3.55% -16.04%
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Cash Deficits of Social Security and Public Pension Systems of North and South Cyprus
SOUTH CYPRUS NORTH CYPRUS
Cyprus Pounds % of GDP Cyprus Pounds % of GDP
Social Security Contributions 368 5.22% 36 5.22%
Social security payments 418 5.93% 67 9.76%
Public Pensions (Pre 1987 employes) - - 48 6.99%
Cash Deficit of Pension System -50 -0.71% -79 -11.53%