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These slides are used in a second year undergraduate course, EC201, Microeconomic Principles I at the London School of Economics. Details of the tax system change every year. The slides give sources and websites for the information. The educational objective is to show students how economic analysis, particularly the modelling of budget constraints and income and substitution effects can be used to understand the impact of taxes on households. The models used here oversimplify the tax system, but students find them quite complicated enough. More details models are available on the Institute for Fiscal Studies website.
Margaret Bray LSE 1
Taxes
Start with a brief overview of the UK tax system to give you context. You are not expected to remember the details of this.
Changes in tax rates are usually announced in the budget in the spring.
But some changes are often announced in the pre-budget report in the autumn. See the Treasury website http://www.hm-treasury.gov.uk/index.cfm
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IFS
The IFS (Institute for Fiscal Studies) website http://www.ifs.org.uk/ has a large amount of useful information on taxes. See particularly Fiscal Facts http://www.ifs.org.uk/fiscalfacts.php for details of the system
Labour Supply and Taxes, Costas Meghir and David Phillips at http://www.ifs.org.uk/wps/wp0804.pdf IFS Working Paper IFS Working Papers, W08/04 (March 2008) for an overview of the literature on labour supply, taxes and benefits.
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Stuart Adam, A Survey of the UK Tax System, IFS Briefing Note BN09 This explains the system and gives rates for 20056. You can find it on http://www.ifs.org.uk/bns/bn09.pdf
Taxes on Consumption
VAT (value added tax) charged at 17.5% is the main tax on consumption. Some goods are exempt from VAT. (e.g. childrens clothes) Some goods are subject to additional taxes (e.g. alcohol, tobacco, fuel, these are often complicated as the next slides show)
Source: http://www.hmrc.gov.uk/
Cigarettes Cigars Hand-rolling tobacco Other smoking tobacco and chewing tobacco
22 %retail price plus 105.10 per thousand cigarettes 153.07 per kilogram 110.02 per kilogram 67.30 per kilogram
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Source: http://www.hmrc.gov.uk/
Pence per litre Sulphur-free petrol/diesel Ultra low sulphur petrol/diesel Biodiesel Bioethanol
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Source: http://www.hmrc.gov.uk/
UK Taxes on Income
Income tax is paid on all income including income from employment and income from investments. National Insurance Contributions (NICs) are paid on income from employment only.
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c = consumption, T = total time, n = time outside paid employment leisure W = money wage rate, P = price of consumption w = W/p = real wage rate
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Assume at first for simplicity that the only tax is a proportional income tax of 20% or total earnings. Tax revenue = total tax paid = 0.2 W (T-n) (W = money wage rate, T n = hours worked) Budget constraint with tax Pc = W (T n) 0.2 W(T-n) or Pc = 0.8 W (T n) (P = price of good, c = consumption) Budget constraint with income tax can be written as c + 0.8 wn = 0.8 wT 17 where w = W/p = real wage rate.
Assume that the imposition of the income tax does not change the wage rate W or the price of goods P so the real wage before tax w = W/P does not change. (May not be realistic). Then the effect of the tax is to change the budget constraint from c + wn = wT to c + 0.8wn = 0.8wT. In effect the 20% income tax changes the real wage rate from w to 0.8w.
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c wT
This diagram is distorted to make it easier to follow, 0.8wT should be much closer to wT, and the slopes of the lines should be much closer to each other.
0.8wT
c wT
budget constraint with no tax slope - W/P = - w budget constraint with tax slope 0.8 W/P = - 0.8 w
0.8wT
n20
Tax revenue given T- n* and c* as labour and consumption = 0.20 W (T n*) (0.2 = tax rate, W wage, T n* labour) = W T 0.8 WT - 0.2 n* W = WT (Pc* + 0.8 W n* ) 0.2 n* W (because from the budget constraint Pc* + 0.8Wn* = 0.8WT) = WT (Pc* + Wn*) = WT cost of (c*, n*) at pre tax prices P and W
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wT
c* + wn*
0.8wT
when n = 0 line meets the vertical axis and c = c* + wn* (c*,n*) 0 T n22
wT
c* + wn*
From 2 slides back tax revenue = WT (Pc* + Wn*) = P (wT (c* + wn*) )
0.8wT
=P
(c*,n*) 0 T n23
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wT
Taking away the EV (equivalent variation) from the consumer has the same effect on utility as imposing the tax.
0.8wT
(c*,n*) 0 T n26
wT
Taking away the EV (equivalent variation) from the consumer has the same effect on utility as imposing the tax.
0.8wT
(c*,n*) 0 T
wT EV = P
0.8wT
(c*,n*) 0 T
0.8wT
(c*,n*) 0 T n29
0.8wT
wT
c* + wn*
0.8wT
(c*,n*) 0 T n31
wT
Taking from the consumer as a lump sum gives the budget constraint and the same tax revenue as the income tax but is better for the consumer.
c* + wn*
0.8wT
(c*,n*) 0 T n32
This is a general argument. A lump sum tax that reduces income by a fixed amount that does not depend on anything the consumer does reduces utility by less than a tax where the revenue can be changed by changing consumption, work or saving. (e.g. excise tax, VAT, income tax) The only feasible lump sum tax is a poll tax where everyone pays the same amount. Is a poll tax ethically desirable?
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Now assume at that the only tax is a proportional tax on consumption at a rate of 25% on total consumption. (e.g. a sales tax or VAT) Total tax paid = 0.25 P c (P = price of consumption c) Budget constraint with consumption tax Pc = W (T n) 0.25 Pc or 1.25 Pc = W (T n) or 1.25 c + wn = wT where w = W/p = real wage rate.
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Assume that the imposition of the consumption tax does not change the wage rate W or the price of goods P so the real wage rate before tax P = W/p does not change. (May not be realistic). Then the effect of the tax is to change the budget constraint from c + wn = wT to 1.25 c + wn = wT or dividing by 1.25 and noting that 1/1.25 = 0.8 the budget constraint with a 0.25 % consumption tax is c + 0.8 wn = 0.8 wT. 36
If the only tax is a proportional 20% income tax the budget constraint is c + 0.8wn = 0.8wT. If the only tax is a proportional 25% consumption tax the budget constraint is c + 0.8wn = 0.8wT. A proportional income tax at a rate of 25% has exactly the same effect as a proportional consumption tax at a rate of 20%.
In effect the 20% income tax changes the real wage rate from w to 0.8w.
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In both cases the budget constraint is the same, c + 0.8 wn = 0.8 wT or as w = W/P multiplying by P Pc + 0.8 W n = 0.8 WT so standard consumer theory tells us that consumers behave in the same way with the two taxes. Revenue from consumption tax is 0.25 Pc. Revenue from income tax is 0.20 W (T n). But from the budget constraint Pc = 0.8 W ( T n) so consumption tax revenue is 0 .25 Pc = 0.25 x 0.8 W (T-n) = 0.2 W (T n) 38 = income tax revenue.
c wT
budget constraint with 20% income tax or with 25% consumption tax constraint slope - W/(1.25)P
0.8wT
More generally, we get the same budget constraint with a proportional income tax at rate tm as with a proportional consumption tax at a rate tc if (1 - tm ) (1+ tc ) = 1. Both taxes have the same effect on the budget constraint and thus on consumer behaviour. The revenue raised by the two taxes is the same. All the arguments are exactly the same as before with 0.20 replaced by tm and 0.25 replaced by tc so (1 - tm ) (1+ tc ) = 0.8 x 1.25 = 1.
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Suppose that there are three tax brackets Bracket 1 0 - 5000 Bracket 2 5000 - 20 000 Bracket 3 > 20 000. With an income of 15 000 you have 5000 in bracket 1 15 000 5000 = 10 000 in bracket 2.
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bracket 3
income 15 000
0 in bracket 3
20,000
bracket 2
10 000 in bracket 2
5,000
5000 in bracket 1
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bracket 0 1
Suppose that there are three tax brackets Bracket 1 0 - 5000 Bracket 2 5000 - 20 000 Bracket 3 > 20 000. With an income of 30 000 you have 5000 in bracket 1 20 000 5000 = 15 000 in bracket 2. 30 000 - 20 000 = 10 000 in bracket 3.
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bracket 3
income 30 000
10 000 in bracket 1
20,000
bracket 2
15 000 in bracket 2
5,000
5000 in bracket 1
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bracket 0 1
An income tax system gives a marginal tax rate for each bracket, with higher brackets having higher marginal tax rates. The system described in the next slide has marginal tax rates 0 % bracket 1 20% bracket 2 40 % bracket 3 Total income tax = 0.00 (income in bracket 1) + 0.20 (income in bracket 2) + 0.40 (income in bracket 3).
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> 20000
40 %
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income 15,000
0 in 40% bracket
income 15,000
0 in 40% bracket
marginal tax rate 20% average tax rate 2 000/15 000 = 13%
income 30,000
income 30 000
marginal tax rate 40% average tax rate 7 000/30 000 = 23%
See consumer theory worked example 10 on website for more explanation and details of how to calculate the budget constraint.
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Budget C onstraint
s lope - 2.4 annual consumption () 17000
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Important
Find the kinks by looking at hours and after tax income at tax bracket boundaries.
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With a wage of 4 per hour earning 5000 takes 5000/4 = 1250 hours and leaves annual time outside employment of 8760 - 1250 = 7510 hours. 8760 = 365 x 24 = hours in year. With 5000 income tax paid = 0, so (7510,5000) is the corresponding point on the budget constraint. (5000 = income)
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Budget C onstraint
s lope - 2.4 annual consumption () 17000
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With a wage of 4 per hour earning 20000 takes 20000/4 = 5000 hours and leaves annual time outside employment of 8760 - 5000 = 3760 hours. 8760 = 365 x 24 = hours in year. With 20 000 income tax paid = 0 x 5000 + 0.2 x 15000 = 3000 so (3760,17000) is the corresponding point on the budget constraint. (17000 = after tax income = 20000 3000)
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Budget C onstraint
s lope - 2.4 annual consumption () 17000
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> 38335 40 % The tax rates rarely change. From April 2000 until April 2008 the rates were 10%, 22% and 40%. The tax brackets change every year in April (roughly at the inflation rate), dont try to remember them 62 exactly.
In April 2008 the 10% rate was abolished, and the basic rate was cut from 22% to 20%.
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0 10 % 22 %
* The level at which income starts to be taxed is called the personal allowance which depends among other things on age.
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These function as an additional income tax system. They are determined by weekly income. Income Tax is determined by annual income. The UK tax system
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employees NIC
employers NIC
2006 07 NICs
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employees NIC
employers NIC
2002 3 NIC
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consumption c
The economists diagram has the advantage that indifference curves have their usual shape. But non economists dont understand it.
budget set
leisure n
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Flip the economists diagram horizontally. income after tax indifference curves slope the other way.
hours worked
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You often see diagrams with earnings before tax rather than hours worked on the horizontal axis.
With this diagram the shape of the graph does not depend on the wage rate. 0 Contrast with previous slides. earnings
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Flat Tax
Introduced Russia 2001, and in other transition economies Simpler than the UK income tax structure. Discussed UK, US, Germany
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Flat Tax
Simpler than the UK income tax structure. Exempts a fixed amount of income, then has the same marginal tax rate at all levels of income.
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Simplification of the tax system reduces administration costs and improves compliance.
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Labour supply may or may not increase when a flat tax is introduced.
Analyse the effects on labour supply using income and substitution effects.
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average income tax rate, makes people better off. assume time outside employment normal good income effect labour supply w(1 t)
earnings
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slope budget line w(1 t) earnings after tax t marginal income tax rate Decrease marginal tax rate from t1 to t2 steeper budget line, subst effect labour supply w(1 t2)
w(1 t1)
earnings
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Flat Taxes
The UK has 4 tax brackets (marginal tax rates of 0%, 10%, 22% and 40%). In its simplest form a flat tax has only two tax brackets, 0% and for example 30% marginal tax rates. The next slides compare between a multi rate system with 3 tax brackets and a flat tax system with 2 brackets.
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earnings
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flat tax
earnings
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earnings
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The next slides work through the effects of the change to a flat tax both on utility and on the labour supply and different levels of income. You are not expected to remember the details of this argument. You are expected to be able to analyse a change in the tax system in this way, using income and substitution effects.
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earnings
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In regions the flat tax gives lower average tax rate, utility increases.
earnings
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earnings
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earnings
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lower average tax rate with flat tax, lower marginal tax rate with flat tax
earnings
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both average and marginal tax rates fall with flat tax, effect on lab supply earnings 93 ambiguous (see next slide)
When the average tax rate falls people are better off, assuming leisure to be a normal good the income effect reduces labour supply. When the marginal tax rate falls the substitution effect increases labour supply. When both average and marginal tax rates fall the effect on labour supply is ambiguous
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both average and marginal tax rates rise with flat tax, effect on lab supply earnings 95 ambiguous (see next slide)
When the average tax rate rises people are worse off, assuming leisure to be a normal good the income effect increases labour supply. When the marginal tax rate rises the substitution effect decreases labour supply. When both average and marginal tax rise the effect on labour supply is ambiguous
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average tax rate falls, marginal tax rates rises with flat tax, labour supply decreases (see next slide)
earnings
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When the average tax rate falls people are better off, assuming leisure to be a normal good the income effect reduces labour supply. When the marginal tax rate rises the substitution effect decreases labour supply. When the average tax rate falls and the marginal tax rates rises labour supply falls.
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average tax rate rises, marginal tax rate falls with flat tax, labour supply increases
earnings
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Flat Tax in UK
labour supply effects unclear top and bottom of income distribution better off mid range income worse off
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earnings
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