Last week’s column briefly examined four of the nuts and bolts considerations which inform tax reform, namely, tax expenditures; tax level and structure; tax buoyancy and elasticity; and tax volatility. Today, I treat with the remaining five: tax stability; taxation and economic efficiency; tax burden (incidence); the costs of taxation; and taxation and fairness (equity). Together, these nine items constitute the minimum basic analytical constructs that underlie all tax systems. They are, therefore, essential building blocks required for successful re-design of Guyana’s tax regime.
Two additional comments are warranted about the nuts and bolts matters previously considered. One, where the value of tax revenue is measured in relation to a base (say GDP) it is absolutely essential that the values used are real, and not nominal; that is, these are adjusted for price increases. If nominal values are used mathematical bias will result. Two, the requirement to isolate the effects of tax policy changes before calculating tax elasticity (as against tax buoyancy) is stringent. This procedure requires a counterfactual analysis (as economists term it). That is, an analysis which hypothesizes an outcome that did not occur (assuming what happened, did not take place). Of course this manipulation is far easier to do for individual taxes, as opposed to the total tax system.
Revenue from taxes varies from year to year. Governments therefore, prefer taxes that do not yield significant annual revenue changes, for the obvious reason that this makes forecasting and planning annual budgets easier. For this reason also governments are wary of taxes that affect revenue stability. I do not wish to unnecessarily complicate this column, but in recommending tax policy changes economists would be careful to indicate the level of projected tax stability by calculating coefficients of variation (CV) for various tax revenue flows.
Taxation and economic efficiency
As I had observed in my analysis of the 2011 Budget (March 6, 2011):“laypersons are wont to confuse economic efficiency with such notions as economic growth, poverty reduction, wealth increase, and productivity enhancement”. However, this is a technical term that specifically refers to an outcome in private markets where the marginal cost of producing an additional unit of any good or service just equals the marginal benefit or satisfaction to be derived from consuming it. This outcome is always assured where perfectly competitive market conditions prevail. This in turn requires several conditions to be present, including 1) many sellers and buyers in the market place and 2) no barriers to entry for new sellers. In such a situation production and consumption are optimized in a private economy, ensuring that the lowest opportunity costs prevail. This is economically efficient because scarce resources are not wasted. Wasted resources indicate market failure. As we shall see below taxation can waste resources through generating market failure.
Tax burden (incidence)
Readers should realize that those who have the legal liability to pay taxes to the Guyana Revenue Authority (GRA) are not necessarily the same as those who feel the economic burden of the taxes. Thus retailers pay over VAT to the GRA, but purchasers carry the burden of the VAT.
Tax burden or incidence refers to the allocation of the burden of paying a tax between buyer and seller. As a rule, most of the burden is borne by the seller if 1) its supply is inelastic or unresponsive to price reductions and 2) demand for the product is highly elastic or sensitive to price changes. The reverse would apply. That is, the smaller the price elasticity of demand and the larger the price elasticity of supply, the greater the burden of the tax on the buyer. Tax burden or incidence therefore describes the effect of taxes on products traded in the marketplace between buyers and sellers. This in turn depends on the elasticities of supply and demand for the taxed items.
Cost of taxation
To the average Guyanese the cost of taxation is seen in financial or accounting terms; that is, the amount of money paid over to the GRA. From an economic standpoint, however, taxes result in the transfer of resources from the private to public sector of the economy and are not a cost per se. Economic costs are incurred if, and only if, this transfer entails a reduction in the economy’s resources. This reduction can in fact occur in a variety of ways, as indicated below.
First, taxpayers usually utilize scarce economic resources in fulfilling their tax obligations, separate and distinct from the taxes they pay. A good example is the time and effort involved in preparing tax returns. Second, the GRA also utilizes scarce resources to run the tax administration system. Third, over and beyond the resources used by taxpayers and the tax authorities, the general public (or “third parties”) also use resources to facilitate the administration of the tax system. Good examples are when 1) employers withhold employee taxes under PAYE for payment to the GRA; 2) banks and other organisations facilitate the collection and payment of taxes; and 3) the media provide public information on taxation.
Furthermore, there is resource distortion (market failure) occasioned by taxes. Taxes create wedges between prices in the market place and those that sellers and buyers receive and pay. Thus, in so far as relative prices efficiently guide economic behaviour, taxation alters this, and hence people’s economic behaviour. Economists refer to this as ‘deadweight‘ costs, because buyers and sellers are guided by relative prices in the market place and would suffer welfare losses (surplus) when the market price is raised somewhat by the tax.
Additionally, taxes do not only alter relative prices of products in the market place, they also affect income and indirectly therefore, the incentive for productive factors to engage in economic activity.
I have run out of space and next week I shall continue the discussion from this point.