2.3. Selecting Tax Schedule

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From the course by National Research University Higher School of Economics

Public Economics

69 ratings

National Research University Higher School of Economics

Public Economics

69 ratings

This course offers an introduction into the public economics theory. It does not aspire to cover theories of taxation, public expenditures, regulation etc. at length and in-depth. Rather, our ambition is to give a bird's-eye view of central themes of public economics and related disciplines, and teach concepts, logic, and ideas, rather than methods of analysis, which would require an entirely different course format. Our choice of topics covered by the course reflects a trade-off between salience and centrality, on the one hand, and suitability for a brief online introductory course, on the other. The course content is neither comprehensive (which would be a "mission impossible" for virtually any public economics course"), nor representative of other such courses. With these limitations and caveats in mind, we encourage our students to continue their public economics studies in a more regular fashion, and see our role inter alia in motivating interest in such "continued education". The central theme of the course is the role of government as a mechanism of resource allocation which complements and augments markets. Governments are viewed as public agencies set to correct market failures. Such agencies however are prone to failures of their own, and hence markets and governments are two imperfect alternatives. We deal with government's limitations, with particular emphasis on those that have to do with informational asymmetry, limited administrative capacity, and imperfect accountability to society. Otherwise the course's man themes are economics of taxation, regulation, politics of public economics, incentives in government, and government vis-à-vis (civil) society.

From the lesson

Design of Government: A Tax Theory Primer

This lecture covers the positive and normative theories of taxation, ways and means to collect public revenues, and existing informational, administrative, political constraints governments have to deal with. We consider lump sum tax as first best option which implementation in practice, unfortunately, is severely restricted by informational asymmetry. Then follows a cursory introduction into one of the most beautiful (but also most technically complex) parts of public economics which characterizes optimal tax schedules minimizing welfare losses subject to information constraints; such analysis is carried out in the so-called Mirrlees economy. Another focal point of the lecture is the role of elasticity in selecting taxes and how the concept of elasticity can be applied to the analysis of time inconsistency in taxation.

2.1. Government Design14:47

2.2. Power and Limitations of Lump-Sum30:25

2.3. Selecting Tax Schedule8:09

2.4. Complexity vs. Simplicity12:43

2.5. The Role of Elasiticity22:40

2.6. Political Constraints4:15

2.7. Protection from Leviathan6:34

Meet the Instructors

Leonid Polishchuk
Professor
Department of Applied Economics

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Okay. So, we saw that there are some very severe

limitations on practical use of lump sum taxes, and these

limitations are due to asymmetric information.

And we concluded that the way out of this restriction would be to link taxes to

something which is, at least in principle, in theory, observable and verifiable.

Come income taxes.

Why income taxes are realistic, why they are practical?

Because individual's income in modern societies

is oftentimes, in principle, observable to tax authorities.

If it's your wages, then if you are employed by a company which is officially

registered, this company has to report the tax authorities your employment income.

If you receive some other income, for example, if you receive

interest from a bank or dividends from investments, this is also

reportable to the government, and, as a result, again in theory,

governments have the ability to learn a whole lot about individual's incomes.

Unless individuals engage in tax evasion, which

is a criminal activity, and is punishable

by law or unless there is a large informal sector in economy where people's incomes

are unreported and non-taxable, and this is one reason of why economists with the

big informal sector are relatively poor economies because

governments in such economies cannot collect revenues to

make this economies more prosperous.

So, let's suppose that an agents' income is publicly observable,

and this income is z. This is pre-tax income.

A portion of this income has to be paid to the government, and it

has to be paid to the government according to a certain function, T of z.

And this function is oftentimes called tax schedule.

Your consumption, or post-tax income, x is the difference between z and T of z.

And, of course, the big question is how you calculate T of z,

how you calculate tax schedule.

Tax base is clear, it's individual's income. What is tax schedule?

There is a variety of tax schedules in a modern world.

And the simplest one, perhaps, is what is known as linear or flat income tax,

whereby your tax is just a certain percentage of your pre-tax income.

Russia is an example of countries which have

flat income tax. And the personal income tax rate

in most cases, there are some exceptions, is 13%.

It's a very easy, simple tax schedule to administer.

It has certain limitations though, but it might still be an

optimal choice, and most likely it was the case in Russia.

So, there were reasons to introduce this particular type of tax system.

But let's talk a little bit more about that.

More generally, the tax schedule is a certain function which is non-linear.

And it's important to keep in mind

the distinction between different types of taxes.

Taxes could be progressive or regressive.

Here is a definition of what is a progressive tax.

Tax is progressive if tax liabilities per income which

is the difference T of z over z is monotonically increasing.

It means that the more wealthy an agent becomes, the larger

portion of this agent's income will be paid as taxes.

Notice that for linear, flat income tax T of z over z is constant.

There is another way to, to describe progressive taxes which

is slightly different from the definition I gave you before.

So, these two definitions are not equivalent but they convey

the same idea. And the second definition is that what is

known as the marginal tax rate T prime of z which

is the derivative of T of z is also monotonically increasing.

What is the marginal tax rate? Suppose you make an extra $100, marginal

tax rate shows how much of that amount will be paid as taxes.

And if an income tax is progressive,

then this marginal tax rate would be increasing as well.

If you have look at actual tax schedules in modern world,

in developed nations, then

real life tax schedules work approximately as follows.

There are certain thresholds of individuals income, most

of the time we're talking about annual income.

If your income is below the lowest of this thresholds, usually you pay no taxes.

This is what is known as tax credit.

It's a certain minimal amount of income where no tax liability ensue.

If your income is above this threshold, if you are in this

interval, then you pay taxes according to this rate which is fairly low.

Then if income exceeds this threshold, your tax rate goes up, and

then, there are two or three what is known as tax brackets.

These intervals are known as tax brackets.

There are several tax brackets and in the end you

hit the highest tax rate, highest tax bracket and if

your income is above this highest threshold and beyond,

then you pay taxes at the fairly high marginal rate.

And again in developed nations, this

top marginal tax rate could be fairly high.

Russians enjoy a remarkably low personal income tax

rate of 13%, and elsewhere in the world

you can easily find marginal tax rates which

might be close to 50%, sometimes they're above 50%.

But anyway, this is how progressive taxes work in modern countries.

Let's talk a little bit how to choose a

particular income tax schedule because obviously there is a variety

of ways to calculate tax liabilities, and even if you

confine yourself to this simple schedule with several brackets,

the question is how to choose these brackets, and

what would be a marginal tax rates in those certain brackets.

This is an outcome of fairly complex political choice.

And this political choice is usually

something that reflects redistributional considerations.

Societies want to reduce inequality, and to reduce inequality

you have to reallocate tax liability so that wealthy agents pay higher share

of their income than agents which are poor. And as you

saw, agents with really low income pay no taxes.

In fact, sometime they can get even subsidies.

So, in choosing a tax schedule, you have to first be aware of the political

pressure towards redistribution which explains progressive taxation.

But for an economist, there is

another important rationale of choosing tax schedules.

And that again, has to do

with informational asymmetry and tax payers incentives.

You can manipulate with tax schedules, so that it enables you to address the

asymmetric information problem, and I can show you very briefly how and why.

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