Public Sector Economics

Taxes and Market Distortions – Theory

Main Lessons• rational foundations of policy distortions• how policy distortions are a result of “incomplete

markets”• why labor supply is so important• tax equivalencies• wealth vs. substitution effect of a tax• compensated vs. uncompensated• rigorous definition of deadweight cost• the “taxable income elasticity”• measuring marginal tax rates• applications of the results to other economics

fields

Rational Foundations• Olson’s Logic of Collective Action

– people do not voluntarily and unilaterally pay taxes (in the amount they are forced to pay) or otherwise contribute to collective goods, even if they appreciate the way tax revenues are used, because they rely on others to make the contribution

– restaurant example– is this logic correct?

• in large groups?• how else can tax distortions be explained?

• tax payments vs. user fees– eg., Feldstein-Samwick on SS “contributions”– mandatory employee benefits

• voluntary contributions– what is their motivation? how fast are they “crowded out?”– might business taxes be more distortionary?

• “excessive” tax compliance, “insufficient” take-up

Rational Foundations (cont’d)How complete are markets in Public Finance?

• complete enough that:– profits are zero

– goods (factor) prices equal marginal cost (product)

• not so complete that there are contracts on untaxed goods (otherwise lump sum taxation is possible)

• not a complete set of policy contingent claims @• insufficient substitutes for complete markets. eg,

– altruism

– voluntary provision

Labor Tax Conversion FactorsWealth vs. Substitution Effects

dg

c

n0

dg

combined effect

wealth effect

substitution effect

Table 5.1. Sliding Scale Exchange Subsidiesas a function of household income for the calendar year

Income as a ratio to FPL

Percentage of income owed as premium

Discount on out-of-pocket cost (jumps when crossing thresholds) Notes on interval

1 2% 80% premium percentage is constant on this interval, jumping at 1.331.33 3% 80%

1.5 4% 57%2 6.3% 10%

2.5 8.05% 0%3 9.5% 0% premium percentage is constant on this interval4 9.5% 0%

4+ full premium 0% premium jumps here because the premium cap is eliminated

Notes: (a) the first column indicates the bottom threshold of the income interval(b) income percentages change continuously between thresholds unless otherwise noted.(c) FPL = federal poverty line.(d) Income percentages for 2015-18, and any year thereafter in which the exchange subsides are less than 0.504% of GDP, are indexed to the excess of health cost inflation over income growth.

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family income, ratio to FPL

Figure 5.1. 2016 health payments as a function of family income and policy type

family of 4, parents aged 50, actual

full price

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family income, ratio to FPL

Figure 5.1. 2016 health payments as a function of family income and policy type

family of 4, parents aged 50, actual

family of 4, 28% approx.

full price

Table 5.3. The ACA can erase the reward to work for exchange plan participantsAn example of how unemployment can be "free" under the ACA

Difference =

10 months employed Employed all yearIncome sourcesEmployment 10 months 12 months 2 monthsUI (only replaces half) 1 month 0 months -1 monthAll sources 11 months 12 months 1 month

Work-related expense bases (number of months where expenses accrue)IIT 11 months 12 months 1 monthPayroll tax 10 months 12 months 2 monthsWork expense 10 months 12 months 2 months

Expense amounts at the marginIIT (including exchange subsidies) @ 64% 0.6 monthsEmployee payroll @ 7.65% 0.2 monthsWork expense @ 10% 0.2 monthsAll expenses 1.0 months

Income sources net of work-related expenses 0.0 months

consequence of working 12 months rather than 10

Scenario for the calendar year

Notes: IIT denotes individual income taxes. UI denotes unemployment insurance benefits. To illustrate simply the economics of a 50 percent UI replacement rate, UI is assumed to fully replace employment income for half of the time unemployed rather than replacing half of the income all of the time. The marginal rate is 15 percent for normal federal and state taxes, plus 21 percent for EITC phaseout, plus 28 percent loss of exchange subsidies that are based on calendar-year income. UI is taxable by the IIT, but not by the payroll tax.

Nonlinear Budget ConstraintsInstances of Nonlinear Taxation

• deductions• employment-related tax breaks

– tax exempt savings– health expenditures– consumption at work, fringes

• tax evasion• EITC [Earned Income Tax Credit]• “progressivity”

[continuous and kinked versions]• “compliance costs”• effort

Table 3.2. The distribution of marginal penalty amounts among employees not offered coverageCoverage year 2016. Dollar amounts in 2014 $.

number amount w/o ACA w/ ACA average< 49 0 0 0.650 0.650 0.650

49 10 $31,630 0.033 0.094 0.06350 10.5 $33,212 0.022 0 0.011

51+ 1 $3,163 0.296 0.256 0.276Employee-weighted average $ amount: $2,684 $3,783 $3,233

Number of full-time

employees

penalties triggered by the marginal employee possible frequency distributions

Notes: Assumes zero part-time employees and ignores the "look back" for determining large-employer status. The possible frequencies are employee-weighted and are for purposes of illustration.

first 30 are exempt

Deadweight Loss• also known as deadweight cost, excess burden• 5 definitions

– effect of policy on indirect utility (measured in “utils”)

– area under the Marshallian demand curve (measured in $)

– area under the Hicksian demand curve

– additional income required to achieve old (pre-policy) utility at new prices

– income change required to achieve new utility at old (pre-policy) prices

• equivalence results• the “taxable income elasticity”

Nontaxed Activity as a Composite Good

• tax avoidance can occur on many margins– hours per week– weeks per year– work or not work– cheat or not cheat– occupational choice– compensation composition– …

• taxable income elasticity as a summary statistic

Measuring “the Marginal Tax Rate”• MTR = statutory tax rate?

– on a particular margin – substitution between tax base and untaxed activities

– “tax base” may be of limited interest economically. eg.,• model may be about “capital,” but only some capital income is taxable• model about “cigarettes,” but there are legal and illegal cigarette sales

• MTR = average tax rate?– “progressivity”– marginal vs. average substitution

• MTR’s in dynamic stochastic economies– the entire stochastic process for MTR governs behavior, but

only a single realization can be measured. eg., anticipated MTR– taxation of old capital can generate revenue but, if

unanticipated, not affect behavior