[SOUND] So, let's discuss how we should equip governments with different taxes, Wwat are pluses and minuses of particular taxes, and how best to choose such taxes. First of all, let's review the available choice. Taxes are everyday features of our life, and it's hard to find an activity of human beings which do not entail certain tax liabilities. Modern nations use and deploy panoply of taxes, and they're combined with different proportions. Perhaps, the best known and oftentimes the most important is what is known as personal income tax whereby individual incomes, individual households are taxed according to a certain formula. Same can be said about companies, legal entities. Corporations pay corporate income tax. This is another example of income tax. Another example is sales tax and related taxes. These taxes are paid when you buy and sell either in retail trade, and this would be the case of sales taxes occur in trade and that occur in retail trade, or they can occur also in trade between firms. There are different types of sales taxes: conventional sales taxes, and they are applicable in the final stage when goods and services have sold by retailers to consumers, related taxes are applicable throughout all the chain of production and exchange, and in this case what is taxed is value- added at a certain stage of production. In the case of payroll taxes, it's wages that you earn from your employers which are taxable and sales taxes are used primarily to fund social expenditures such as health care, retirement programs, so on and so forth. Important part of taxes especially at lower level jurisdictions, local governments is what is known as property taxes where property that people own and then primarily we're talking about real estate, about land about houses, apartments, and so forth are taxed according to a certain rate. Investment taxes. If you're an investor and you make investment income, that income can be taxable, at least in some cases. Dividends that you earn as an investor, as a shareholder can be subject to a dividend tax. Capital gains that you realize when you dispose of your assets can be subject to capital gain taxes. Each of these taxes has what is known as a tax base, and tax base is an area of economic activity which entails tax liabilities. And tax schedule, tax schedule is a formula according to which taxes due are calculated. In case of income taxes, tax base is income. We're talking about personal income tax, and let's assume that's the case unless I tell otherwise. Tax base is the income that individuals or households, families earn. In case of sales taxes, tax bases are tax bases trade. In case of payroll taxes, tax base is employment. In case of property taxes, tax base is property, so on and so forth. Now taxes can be combined in different proportions, and, in fact, if you look at modern countries, you can see that different kind of taxes play different roles in public revenues. A common feature of well developed market economies is that predominate portion of government revenues is earned by personal income tax. Sometimes 50% and more. Some other countries rely more heavily on trade taxes. Some other countries including Russia, for example, relies quite heavily on taxes from natural resources. So, these taxes are indeed combined in different proportions. And, therefore, the question is what is the optimal mix of taxes, and why we chose one taxes over the others? To answer this question, let's get to discussing optimal taxation principles. Recall that the general premise of this lecture is that according to the normative view, societies select their governments and assign different taxes tools and so forth to their governments, so that they can best serve societal needs. And, therefore, this selection of taxes from this point of view is an optimization problem, whereby tax bases and tax scales chosen so that the tax system is optimal from the point of view of the society. And this problem of optimal taxation might have two formulations. Let me describe both of them. The first one is what is known as the general optimization of public finance, whereby we select taxes simultaneously when selecting public expenditures. This is a very important thing because it might be pointless to discuss whether a certain level of taxation is appropriate or not. Taxes are burdens, taxes are liabilities, taxes are costs imposed in this society. But taxes at the same time are essential to equip government with proper revenues. And we decide the level of taxation, it's important to keep in mind how tax revenues will be used. So, in this case, variables of your "optimization problem" will be tax rates, tax bases, tax scales, and public expenditures. And, as a result, it will combine costs and benefits of taxation. Costs of taxation are the costs imposed to taxpayers, imposed on the private sector. The benefits would be the benefits of society and the economy from governments being able to provide essential public goods. This is, however, a more complex problem. I will give an example of this approach but, perhaps, not in this lecture. For the rest of this lecture we'll be dealing with so called partial optimization of public finance. In the case of partial optimization of public finance, we assume that we have a certain revenue collection target. We don't ask at this point where this target came from. Perhaps, it came from a general tax optimization problem, and our objective at this point is to hit this target, is to raise the certain amount of public funds for the government, and to do it in a way which is the least damaging for the society. We want to enable the government to collect its revenues up to a certain subject. We want to enable the government to be able to collect this revenue up to a certain level, up to a certain target, while trying to minimize the costs that taxes impose on the society. This is the essence of the partial optimization of public finance and I will show you in several examples how this partial optimization of public finance can be done. Let's see how we can collect the required amount of revenues while minimizing social welfare loss. Of course, when we are trying to answer this question, we need to be cognizant and aware of the restrictions upon the government that I mentioned to you before. And let's talk about this description at this time at some greater length. It would be quite unrealistic indeed foolish to assume that governments are fully benevolent, that governments can do everything they like, in other words, they're omnipotent, and that governments know everything they need to know, in other words, they are omniscient. In reality, governments, as we mentioned before, are faced with multiple constraints, including those which are informational, administrative, and political. And, therefore, when you try to choose optimal taxes these are essentially the constraints that you have to take into account in your optimization problem. This is a good point to introduce to you a very important distinction between different kinds of optimality in economics. The first one is what is known as first best. The first best is an ideal solution, I should say the ideal solution which is the best of over all other alternatives irrespective of these alternatives are feasible or not. In other words, when I talk about the first best you ignore at least some of the constraints which otherwise would be restricting your choice. This is the ideal solution. Now, if we take into account the constraints that we ignored up to this point, then you can still ask what would be the optimal solution given these constraints. But in this case, the optimal solution won't be first best, it will be the second best and if you apply constraints sequentially then after the second best, you can talk about third best, fourth best and so forth. So, to be realistic we need to talk about second best. However, it might be quiet useful to first ask, just out of curiosity, what would be the first best. Before we do that, let's briefly review the constraints that I mentioned before that would be applicable in the case of optimal tax selection, and you've heard these constraints from me before except for just one, and I'll talk about that one a little bit longer. The first one, as I said, is informational constraints, and this is due to asymmetric information, for example, if I want to tax individuals, it would be great to know how capable these individuals are, how wealthy they are, how much money they can earn. If I want to deploy social safety net programs, then it would be great for me being a government official to know whether this individuals are capable of taking care of their problems or, perhaps, for some reasons they are in desperate need of social assistance, so on and so forth. But, as I said, these are all examples of privately held information, and oftentimes governments have no access to such information. And if you want to realistically design optimal taxes, this informational constraint has to be kept in mind. Administrative constraint is about state capacity, and I mentioned in introductory part of this lecture that governments differ from each other in their ability to implement more or less complex expenditure programs, tax systems, regulatory systems, so on and so forth. And again, if there is a government that, for some reasons, perhaps, it's an emergent market economy, with no experience, no corporate culture in the in the public sector, so on and so forth, there's other constraints that have to be taken into account because what would be optimal in some countries, would not be optimal for that matter, would not be even feasible in some other countries because of differences in administrative capacity. So, make sure you keep in mind administrative capacity. This is something new in this list, this is the credibility constraint, and I'll get back to that later in this lecture. But just to give you an idea of what we're talking about this time, let me explain briefly what the credibility constraint means. Problem is that governments operate over time, and in particular, government tax overtime, governments announce their tax rules, their tax programs and so forth in one moment of time, and this is what is known ex ante. This is before activities that entail tax liabilities occur. And in making this announcements governments expect that their promises will be taken at their face value, and that economic agents will be making their choices in accordance with the announced rules. However, once the choices are made, and tax bases have been created, the government has to implement its promises, its declared tax intentions. And that would be already not ex ante that would be ex post. And as we'll... as I will illustrate, governments might have entirely different preferences ex ante and ex post. And it cannot be ruled out that governments will hold different views ex post from those that they were holding ex ante. And they will propose to amend their tax rules that were announced ex ante. If taxpayers anticipate this change of mind, they wouldn't take government's promises as believable or as economists say as credible, and in this case you have credibility problem and that also, as we will see, restricts tax choices available to governments. Last but not least, I want to mention this least, political constraints. Political constraints are because society has different abilities to make sure that governments indeed serve their societies, that is needs. That governments are sufficiently accountable to the society, that governments are not captured by narrow interests, that governments are not self-serving. And societies could have different degrees of confidence in their ability to hold there governments accountable. There are two alternative ways of having the government operating. One is what is known the benevolent government. And the benevolent government is a metaphor of a government which is indeed a public servant, a government which serves public interest, a government which is an agency created by a society to serve its needs. It's a social contract government. Another alternative would be what is known as Leviathan. Leviathan is a biblical metaphor from the Old Testament. It's a monster, a huge sea monster, I believe, that has enormous powers, and as such it might be a threat to the society. A government which is not properly controlled by the society is known as the Leviathan government. And, therefore, in choosing tax systems societies have to be cognizant that at least with some probability they might be governed by Leviathan. And that we will see effects the choice of taxes. [BLANK_AUDIO] All right, that's it. I just listed to you a bunch of constraints. But, as I said, let's ignore all of these constraints for the time being, and let's see what would be the best way to collect a certain amount of revenues for government while minimizing the damage, caused to the society and to the economy. And I listed you some of the taxes. You might think that this problem is very complex because you have to review a broad array of taxes, tax bases, tax rules, and so forth to find the best one assuming that you can implement pretty much everything that you like. But, in fact, this problem has a surprisingly simple solution, a beautiful solution, an incredibly powerful one but sadly quite an unrealistic one because it violates a number of just specified constraints including first and foremost the informational constraint. And this solution is known as the lump-sum tax. Now what is the lump-sum tax? As you probably know or heard that expression, it's a fixed tax. Every taxpayer is required to pay a certain amount of money and this certain amount of money is prescribed by the government. It's not an outcome of taxpayer's choices. It's something that is imputed. It's something that has to be paid. I'll get back to this slide in a moment but let's have a quick look at the next one, a sneak preview. Oftentimes, lump-sum taxes are somewhat misinterpreted by saying that lump-sum taxes are taxes which are fixed, and hence, they do not affect behavior. Well, that's not quite accurate. It's close to what it is, but, in some instances, lump-sum tax is still pretty much affect behavior. Imagine, for example, a firm that would be required to pay a lump-sum tax on it's activities. How this tax could have affect the behavior of the firm? Well, in a very simple fashion. If the tax liability is larger than the profit that the firm is expected to make, then the firm would simply go out of business. So, that's the simplest example as to why a lump-sum taxes could affect behavior. The more appropriate way to describe lump-sum taxes would be to say that these are taxes which do not depend on behavior. They might affect behavior, but they don't depend on behavior. They are the same no matter what choices taxpayers make. The tax amount does not depend on behavior. This is an accurate formulation of what the lump-sum is all about. I told you before that taxes differ from each other in tax bases and tax rules, tax schedule that is. So, a good question to ask what is a tax base for the lump-sum tax? And the simple answer is everything. Because an individual has to, a taxpayer has to pay this tax no matter what he or she does. This is essentially a tax on all the activities, all the resources that this individual is engaged with or owns. And, therefore, it's a tax with the broadest possible tax base. Now, let me get back to the previously slide, and let me explain to you why this simple lump-sum tax is so powerful. I can give you a specific illustration, but let's be aware that this is just for the sake of an illustration, and the logic that I'm presented to you is quite universal. And it is applicable to a more general class of situations where lump-sum taxes are about to be introduced. So, imagine that there is a representative taxpayer and this taxpayer has a utility function U which depends on this taxpayer's income and this tax payers leisure, the time that taxpayer does not use the earned income. So x is income, l is leisure. And the income x equals to x0 which is some initial endowment of income, non-labor income that the tax payer has, plus these agents earnings, salary. w is the wage rate, L capital is the total endowment of time that the agent has. L capital minus l small is the time spent on work, and the wage rate w times this time gives you the wage income. So x is the total of these two amounts. Suppose that the government wants to collect a certain amount of revenue from that particular tax payer. And this revenue is R. Let's see what is the best way to collect this revenue, and quite obviously, the answer is lump-sum. Let us just require the taxpayer to pay this amount upfront without relating this amount to any of the agent's activities. Another option would be to introduce a personal income tax. And in that case, you will have a certain tax rate, and you will have to choose this tax rate, so that the actual revenue collected will be equal to the revenue target which is R. You're not going to have to do that. See what's happening. Suppose first that there are no taxes. And this line, this straight line is the budget line of the tax payer when tax liabilities are equal to 0. This point is x0, and then x increases as long as leisure diminishes from L to 0. So, this is your budget line and if there are no taxes, the agent will make her choice on this budget line at this point. This is, of course, this agent's indifference curve. Suppose that you've been able to collect the required amount of revenue which is R, and this point, I don't ask you how you do that, but it's lump-sum tax, or any other tax, I don't care. In that case, your after tax income x-tilda will be equal to w times (L minus l-tilda.) Where x-tilda is your income, and l-tilda is your leisure plus what you had before which is your endowment minus the tax, the tax liabilities. And that puts on this line. This is your initial budget line, and it's simply shifted down by R, and that is quite clear. Now, what point of this line we will choose, depends on what is the tax system you that you choose: could be here, could be here, could be here, could be here. The bottom line, almost literally, is that you have to end up somewhere on this line. Now, what I suggest to you instead is just pay me R, and I don't ask any other questions. And that means the agent then can screen all of this new budget line shifted down by R, it's available to her in its entirety, and to make the best possible choice over here. Right? It would be better than, for example, choosing this outcome here which might be the case if you deploy some other taxes with the same revenue collection, or here, this is the best that you can do. And this is lump-sum. So, nothing beats lump-sum. And I'm trying to recall examples of lump-sum taxes, they are really very few and far between. In the UK the government charges a head tax to fund the famous BBC, British Broadcasting Corporation. This is an often quoted example of lump-sum taxes. Sometimes governments to simplify business taxation opt for small businesses the option to pay lump-sum taxes instead of doing full accounting and pay all the required taxes, but this is basically about it. Otherwise, taxes are much more complex, much more difficult to administer, much less efficient, I should say. And nontheless, they're prevalent. And this wonderful option is almost not used in real life. Why? Well, because of the differences between the first best and the second best. Lump-sum taxes are first best optimal. They're not feasible second best. And first and foremost oftentimes they're ruled out by informational asymmetry, by asymmetric information. In example I just presented to you, taxpayers in reality differ from each other, they differ by their non-wage income x0, they differ by their productivity, and as you can easily figure out, taxpayer's ability to pay lump-sum taxes could be very different. A lump-sum tax that would be quite affordable for a more productive agent or, perhaps, for a better endowed agent with either higher w, higher x0, could be completely out of reach for a poorer agent which has no endowment, and who for some reasons, perhaps, she lacks education, is not as productive as the first one. So, if it tried to impose the same lump-sum tax on all individuals, you're faced with a very dark choice. Either the tax rate is going to be, the tax liability's going to be high, and in that case a number of individuals will simply not be able to pay it, but then the tax rules loses its purpose, and if you accept no for an answer, then quite obviously very many people will be tempted to say no even if they can't pay this tax; or if you want to be 100% certain that people are indeed able to pay this tax, then you will have to make sure that even the poorest among the taxpayers will still be able to do that, and in that case, the tax requirement, the tax liability tax rate, we should say, would be extremely low, and it will not be sufficient to fulfill tax revenue targets. Is there a way out of this predicament? Well, you can considerably say yes because lump-sum taxes don't have to be the same for every individual. Taxes can still be lump-sum, but they can be different for different individuals. In fact, government, the government can try to impute different lump-sum taxes to different agents, and these differences will, perhaps, reflect this agents abilities, productivities, endowments, so on and so forth. But then here you have this asymmetric information problem. Taxpayers are very different from each other, and, as a result, imputed lump-sum taxes should be different as well. But to do this differentiation properly you need to know this taxpayers individual characteristics. Where do you get that from? That is a very difficult question, it has no immediate and simple answer. Here is a simple illustration. That gives you an idea of how serious and how really difficult this problem is. Suppose that we have a number of agents and i is agent's index which varies from sum 1 to n, x0i is the wealth that this agent has. And in this case I don't ask where this wealth comes from. For simplicity's sake, I don't even consider employment income. Our agents are different only in their endowments. And for agent i, you impute the tax rate ti, so this agent ends up with the after-tax income of x0i minus ti, and bear in mind ti could be negative in which case lump-sum tax becomes a subsidy. Now, if you're trying to allocate this tax burden across agents and at the same time maximize some social welfare function, then this is an appropriate formulation this problem. U is an individual utility function, and this the slope of the graph of this function is getting flatter and flatter. This is the case of diminishing margin utility. And by applying this kind of social criteria, you simply try to take out the fact that the same increase of income is available to the society to a different extent depending whether this increase occurs at relatively poor income level in which case it will have a higher rate or at a very high income leve, in which case the rate of this increase would be quite lower. So, you solve this constraint optimization problem, and for those of you who know how to do elementary calculus, you can immediately come to the simple conclusion, and that is in this problem, the marginal utility of income, of after-tax income for every agent should be the same. And because we have the same utility function, that basically means that after tax income of every agent will have to be the same as well. A very simple solution. It's what is called the egalitarian solution My mistake, it says here equation solution. what I meant was egalitarian solution. Egalitarian solution means that every person gets the same post-tax, after-tax income. And here's an illustration of this egalitarian solution. Suppose I measure agents, taxpayers, along the horizontal axis. Suppose I measure their income along the vertical axis and this is the distribution of income before taxes across agents. So, this is x0. This is the post-tax income that every agent has, and as you see, these poor agents with lower endowments, they get subsidies after this level. These wealthier agents with endowments above this level of level of x there, they actually pay taxes. So, this shaded area are subsidies, and this shaded area are taxes. Now, if you want to implement this scheme, then quite obviously to properly assess lump-sum taxes for this agent, for example, the lump-sum tax would be that high and for this agent, the lump-sum tax would be a subsidy that large. You probably need to get information about pre-tax income which is x0i. You can ask agents, tell me what your pre-tax income is, but as you can see, there will be a very strong, very powerful incentive for agents to manipulate this information because they realize that, for example, their income is high and they will tell you that your income is high, my income is high, and then this agent will receive a very high tax bill. So truthful revelation of information in this case would not be incentive compatible and, therefore, you cannot rely on that to occur in real life. This is why lump-sum taxes, no matter how powerful, no matter how first best, optimal, are rarely used in modern life because they meet the information constraint that tax systems we have to observe. What is a way out? Well, the way out is to relate taxes to something that you can actually see, to something you can actually verify, to relate taxes to something which is observable, to relat to observable behavior, to observable outcomes. And here income taxes or sale taxes come. And that's something that we'll discuss next. [SOUND]
