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.
2.5. The Role of Elasiticity
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From the course by National Research University Higher School of Economics
Public Economics
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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.
Meet the Instructors
Leonid PolishchukProfessor
Department of Applied Economics
[MUSIC]
Okay, so much, at least for the time being, about personal income taxes.
And let's now talk a little bit about sales taxes.
And that will be a good opportunity for me to introduce to you a very general and
important principle of optimal taxation, which is that
is preferable to tax basis, which are less
elastic to tax rates than those which are more elastic.
The reason for the general rule that I will illustrate shortly, is as follows.
Recall that we want to design tax rates and choose tax basis so that revenue
collection can be accomplished with the minimal damage to the private sector.
Now much of the damage to private sector because of
taxes is caused by distortions which are affiliated with taxes.
Taxes distort signals that the market agents receive in the private sector.
And as a result, resource allocation,
the presence of taxes might be less efficient than it would be without taxes.
Of course, one has to make here an important qualification.
As I mentioned before, there are some taxes whose primary function
is to correct externalities, and, in fact, to improve resource allocations.
These are the Pigouvian taxes.
But this time we are not talking about such taxes.
We are talking about taxes whose main purpose is collect revenues.
And you have to tax areas of activities which do not
feature any externalities, which are not susceptible of market failures.
And in fact taxes introduce distortions, or if you like, some market failures.
And this is the necessary price to be paid for
being able to supply public goods and fix other market failures.
But their objective is to minimize the market distortions
which are caused by taxes.
Now if you tax a tax base which is inelastic to tax rates,
then people do more or less the same things that they did before but
there were no taxes.
And as a result, distortions caused by taxes are not very painful.
You simple withdraw, extract some wealth from the private sector and transfer
it to the public sector where, hopefully, this money will be used properly.
If however your tax base is highly elastic, then
if taxes are introduced, economic behavior would be significantly altered.
It will change economic behavior dramatically, and as a result, distortions
in market signals will be significant, would cause significant welfare losses.
Another way to think about that, and I want you to remember that
because I'll get back to that down the road in this lecture,
is that if tax bases are inelastic, then behavior of economic agents,
as I said, will be more or less the same with or without taxes.
If tax bases are elastic,
it simply means that economic agents will escape these tax basis.
And will transfer their operations, their activities, their income earnings and so
forth, to other tax bases which are less taxable.
Elastic tax base mean that there are good opportunities to find a refuge,
a safe haven from taxes in other areas which are less taxable.
And these changes in behavior will be introduced or
produced entirely by taxes, nothing else would justify such changes.
There would be no market rationales for such changes.
And as a result, the economy would sustain significant losses.
Now let me illustrate to you this general principle by using sales taxes
as an illustration.
What are sales taxes?
Basically, there is a market price that will be payable without a tax.
And then there will be a markup to this market price, a tax, which is a sales tax,
which is paid when a unit is bought and sold.
So the total price will be the total of
the price before taxes and tax rate.
So the total price will go up from p to p + t.
Now there are different types of sales taxes [COUGH] and
although value added taxes and sales taxes are quit different,
when it comes to retail trade they're essential the same.
It's a markup over initial price which include the tax.
And different countries administer their sales taxes or
value added taxes differently.
The European tradition, which Russia follows, is that the price sticker
shows the total of the pretax price plus the tax.
So the buyer doesn't really know what portion of that
unless she looks very careful at her sale receipt.
She pays total price, and that's it.
In some other countries, and this is primarily the North American tradition,
the price sticker shows the price before tax.
And it's up to the buyer to figure out what the full payment will be.
So he or she will have to add the tax to the price, and of course,
this is what she will have to pay at the ticket counter,
but this difference is not really material at this point.
Suppose that you have two markets, okay?
And these are demand curves for both of these markets.
This demand curve is relatively flat and
that means that demand is highly elastic to prices.
As you see, if price goes up, demand shrinks quite dramatically.
In this case, the demand curve is pretty steep.
And that means that this market is much less elastic to price changes,
price can go up and down.
And of course the quantity demand will be changing accordingly but
not nearly as drastically as it were here.
So this is a highly elastic market.
This is a highly inelastic market.
Suppose you have to recall our objective to collect a certain
revenue amount to meet the revenue target from either of these markets.
Which market you would tax in this case, given the choice?
Suppose that the choice is restricted between these two markets.
Let's have a look at his market first, what is your collected revenue?
You get t rubles or
dollars, depending on where you are, per unit of sale.
And the quantity purchased, the quantity bought is here.
So tax revenue is the quantity times the tax rate and
this is the area of this rectangle, all right?
You do the same in the second market and
with the same tax rate, you basically get the same revenue.
Or at least this is what I tried to illustrate.
So revenue collection will be the same here and here.
Which market to chose?
Well, remember we're trying to collect the revenue
while minimizing the damage to the economy.
Let's see what the damage to the economy, in this case the private sector, will be.
If there are no taxes, the consumer Who buys
this particular good, would buy that much an amount,
as you can see, and will enjoy a whole lot of consumer surplus.
These are the gains of this consumer from buying this good at price p,
and I assume that you know what consumer surplus is.
This customer buyers' gain from trade,
this is the surplus that this person earns or
appreciates, enjoys, when the good is sold at the particular price.
So the pre-tax consumer surplus will be
this triangle, when there is a tax introduced
your consumer surplus is reduced, let's see, by how much?
It's reduced first by the amount of tax paid, and this is something that we dread,
but this is not a waste of money, hopefully, because public revenues will
find good use, and will come back to you for example in the form of public goods.
But there is part of the consumer surplus which is lost irrevocably, it's lost for
nothing, it doesn't move to any other use, it just disappears.
Because the market gets much smaller because the trade,
the amount purchased is much smaller.
And this triangle of course is known for
basic microeconomics as the dead weight loss.
These are simply the gains which are not realized
because of the distortions caused by taxes.
And in this case the dead weight loss is quite significant,
in this picture is probably as higher as half of the tax revenues.
And this is because the demand curve is highly elastic,
in this case demand is inelastic and
if you see the amount of reduction of consumers surplus,
the consumer surplus has been reduces by this area.
And it still includes this revenue collection which is the same here and
here, but here, it also included a vast dead weight loss.
And here the dead weight loss is very small, it's basically non existant.
And therefore, these stacks with the same revenue collection
causes much less damage, losses to the economy than this one.
And the policy prediction the policy implication is quite clear,
tax less elastic to tax rates, and this is best illustrated or
demonstrated by the well known Ramsey rule.
Which tells us that tax rates, in proportion to full prices,
inclusive of tax rates, should be inversely related
to the elasticities of demand curves on particular markets.
And these are, of course, the elasticities, and
the motivation of this rule is fairly simple and straightforward.
The elastic tax base is the closure is your tax to the lump sum and
remember that lump sum is first best, nothing beats lump sum.
Inelastic tax bases get you in proximity
to what is best over all taxes, ie to lump sum.
Recall the constraints that I listed while describing
what restrictions should be kept in mind while choosing tax systems.
Those were, informational constraints due to asymmetric information,
administrative constraints reflecting differences in state capacity.
Credibility constraints due to possible time inconsistency, and
political constraints.
Now it's time to talk about credibility constraints,
we've covered information and administrative constraint,
let's talk about poosible time inconsistency of taxes.
Here we go, I explained to you that the problem of time consistency,
rather inconsistency in public finance and in government policies more generally.
Arises because policies are announced at a certain period of time on the expectation
and assumption that such policies would affect behavior in a particular way.
And once the behavior is affected, these policies will actually be implemented,
in particular taxes will be enforced.
And there is a gap in time, a difference,
between ex ante, the time policies are announced, and ex post,
the time policies are implemented and enforced.
And because between these two points in time, ex ante and ex post,
some decisions have been made, some changes have occurred in the economy.
The preferences of government, including tax authorities, could become different.
And that could be a reason to readjust, reconsider change,
amend the policies announced before.
In particular, to revise tax rates or tax rules, and
the thing to be kept in mind is that there is no abuse of power in this case.
It's not because governments are dishonest, or it's not because governments
are driven by seeking personal gains although none of that, of course,
can be ruled out in the modern world.
But it's simply because it would be more preferable for
the society to tax ex post differently from it was preferable ex ante.
So there might be good sound reasons in the public interest to change tax rules.
But in that case it makes it very difficult for
government to choose tax rules ex ante.
That economic agents would believe to be implemented ex post,
in other words, government's promises will not be taken at their face value.
Market agents would have doubts as to whether these rules
will in fact be followed.
And as a result these rules would not have a desired impact, so
we need to think about tax systems that would be considered by a private sector,
as credible, as not suspected because of this time inconsistency
that in fact would be considered as time consistent, and hence credible.
Trouble is the tax rules that would be considered as credible and tax consistent
would not be as efficient as tax rules that you want to announce before.
So there would be efficiency losses, and now I want to illustrate to you the time
consistency problem by using capital fixation as an example.
And it'll be quite appropriate for us to recall at this point the Ramsey rule,
that I just introduced recently, and that is that all else equal,
try to confine taxes to less sufficient tax basis.
Let's see what these rules tell us in relation to capital.
Capital is a factor of production, and you mentioned that you want to raise
tax revenues, this time by taxing two factors of production.
One of which is capital and other one is labor, and
if you want to apply this Ramsey rule then you need to decide which of these two
practice of production is more elastic to taxation and tax accordingly.
Thinking about that, we come to the immediate conclusion that
capital is probably much more elastic tax base than labor.
Well, simply because the capital is fluid.
Capital can be invested in many ways.
Capital can be invested offshore.
And if tax rates on capital are high, much higher than,
for example, elsewhere in the world, the capital owners will decide to
abandon this particular jurisdiction and move their capital elsewhere.
Capital is very fluid, very liquid, very sensitive,
very nervous and as a result extremely elastic to tax rates.
Labor is much less elastic to tax rates.
Because people will have to earn their wages regardless.
Of course, good news is if payroll taxes come down.
But even if they are high, there is no other way to make a living for
a majority of people in modern economies than to earn wages.
And because people have to serve their and their families' needs,
they will be still supplying labor, perhaps less enthusiastically, but
pretty much to the same extent, irrespective of tax rates.
Then, the conclusion is labor is much less elastic than capital.
And therefore, tax labored much more significantly, than new tax capital.
Do you see this rule observed in practice?
Well, no, not entirely.
A capital is tax that pretty high rate, is difficult to compare,
tax rates of laboring capital, but they're more or less comparable to each other.
And the prediction of Ramsey's theory that capital should be,
if not exempt from taxation, then at least taxed much lighter than labor,
it's not confirmed in many countries.
Why?
It's just because of the difference between ex ante and ex post.
On this picture, I have two charts.
The first one shows how capital tax base reacts to capital tax rates.
And on this chart, K, here's the tax base, and tK is
the capital taxation rate.
And because this curve is relatively flat, that's an indication that capital
is very elastic to capital taxation.
Labor is elastic, of course, but not as much.
In fact labor elasticity in response to taxes
depends to a very large extent on whether labor is unionized or not.
And if we assume that labor is not particularly unionized,
then we won't see much of elasticity.
Here we have some modest elasticity, but
the slope of this curve is significantly higher than of this one.
And that means that the labor elasticity is much less than capital.
But the situation changes entirely if we distinguish between ex ante and ex post.
Ex ante is the period of time when no investments are actually made,
when investments are just contemplated.
And as a result the decision to invest will indeed depend very heavily
on the tax rate.
This is what we have ex post.
And ex post, in terms of taxation of labor, there is no difference.
Same schedule showing the dependence of the tax base to the tax rate.
But in terms of taxation of capital, completely different situation.
If capital has already been invested.
And this is what we expect, the capital between ex ante and
ex post then has become much less elastic.
It's becoming less mobile.
It's implemented, it's materialized in factories, in buildings, in whatnot.
And at this point of time, to withdraw capital, to move it elsewhere,
to put it to other uses, it might still be possible.
But it's much more complex ex post than it was ex ante.
And as a result capital elasticity ex post is in fact very low.
Ex ante, it's like quick silver is very high,
ex post it's mobile and it's low elasticity.
And as a result when it comes to implementing tax decisions and
this is the time ex post, you still compare the same two markets.
And you prefer, rationally, to tax capital,
not labor because tax elasticity because capital elasticity
is now lower than the elasticity of labor to labor taxes.
So if I want to attract investors to my country or to my jurisdiction.
I promised them low capital tax rates, and that's my decision ex ante.
And this a rational decision given these two tax curves.
But once they've come, assuming that they believed me, it's an excellent idea for me
to change this decision, because in fact, they will make the society better off.
And to tax capital than Labor.
But, investors are rational through decision makers.
And they can anticipate this about face, that occurs ex post,
of the decisions, to try to invest had been made.
And they act, based not on the government's promises but
on the assumptions of what tax rates in fact will be ex post.
And these assumptions would be that tax rates will be too high and
as a result there will be a reluctance to invest.
And as a result they would justify or
rather would explain sufficiently high tax rates that we observe in modern world.
But is there a way out of this?
Predicament of this credibility restraint.
Well there might be and this is government's reputation.
If the government was able to implement
its premises despite the temptation to change them, this government
earns reputation with investors as a credible, reliable government.
But such repetition is a very available political asset,
it can be easily ruined by some reckless decisions by governments.
And as a result sometimes,
most of the time investors are skeptical about government promises and
this is something that restricts government choices of tax systems and
in fact makes governments to resort to taxes which are less efficient
than it would be possible without this credibility constraint.
[SOUND]
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