Question:
- Do raising tax rates necessarily raise tax revenue? What factors affect how tax revenue changes when tax rates change?
- Using the 'human capital' investment model, analyse the ways in which increases in university fees will affect participation in higher education for students with different abilities and students from different backgrounds. How will loans affect this?
- If incentive contracts are really effective, why do so many workers receive flat rates of pay?
Answer:
More often than not, it is a general perception that increasing tax rates will lead to an increase in the revenues accruing to the government in the form of tax collection. However, the validity of this statement can be question and, in fact, can be negated. Tax revenues are not just dependent upon the tax rates, but also the tax base. Now, as we all know, an increase in the tax rates has an adverse effect on the output of the economy, through the multiplier effect. This decrease in the output is of course associated with a decrease in the sales, purchase, and most importantly, income. Now, on one hand the tax rate has rise, but on the other, the tax base has declined. It is the interaction of these two opposing forces which decides the net outcome, i.e., whether there will be an increase or decrease in the tax revenue accruing to the government. Furthermore, the coverage of the tax net and the changes in the expectations in the economy, following a tax cut or raise, is also a major determinant of the tax base and hence the tax revenue generation. Below we discuss the interaction between the tax rate and tax revenue in details. The first section will talk about the basic formula of the tax revenue. Second section will talk about the Laffer curve and in the third section; we discuss other theories apart from the Laffer curve theory. Finally we conclude with our observations and possible policy implications.
Tax rate and tax revenue: the basic relationship
Tax revenue is generated through taxing various kinds of flow of transactions: it might be the point of sale of goods and services, in the form of sales tax or it may be the taxes on the corporate profits, or it might be the most general form of the taxation-the income tax. Therefore, we can put down the calculation for tax revenue in simple form as given below:
Tax revenue = tax rate X tax base
Here, tax base can be income of an economic agent, or volume of sales, or total corporate profits, or the valuation of property, etc. The tax rate can take the form of sales tax, income tax, excise tax, corporate profit tax etc.
Now, looking at the formula, there are several combinations of events which could happen:
- The tax rate declines and tax base also declines: in this case the total revenue will decline.
- Tax rate increases and the tax base increases: in this case there will be an increase in the tax revenue.
- Tax rate increases and the tax base declines: in this case the effect on the tax revenue will be ambiguous.
- Tax rate decreases and the tax base increases: in this case again, the effect on total revenue will be ambiguous.
In the first two cases, there is a clear change in the tax revenue, whether it is increase or decline. However, in the other two cases, the effect is ambiguous and depends upon the relative volume of each effect.
All the discussion of the four cases in this section till now was based on the assumption of ceteris paribus. However, this is not the scenario in the real world. A tax rate increase is typically associated with the fall in the tax base, as production and hence income of the economy decreases. This happens because of the additional income provided to the consumers and firms by the fall in the taxable amount. This, in turn, increases consumption, and investment. An increase in consumption and investment then has positive effects on the total output, through the multiplier effect. Similarly, a tax rate decrease is associated with a rise in the tax base. Thus, there is clear trade off between tax rate and tax base which makes it difficult to determine the optimal level of tax rate in order to achieve the desired tax revenue level. In this regard, Laffer curve gives us an insight into the working and interaction between tax rate and tax base and the revenue maximizing level of tax rate.
Laffer curve: the optimal tax rate
The Laffer curve describes the relationship between the government tax revenues and the tax rates applicable. The Laffer curve is the interaction between two effects: "arithmetic effect" and "economic effect". Here, the arithmetic effect refers to the calculation of tax revenue by the multiplication of the tax rate by the tax base. The economic effect reflects that the tax base will fluctuate with the change in tax rate.
An implication of the arithmetic effect is that a tax rate of 0% will produce tax revenue of 0. Similarly, the economic effect assumption implies that when the tax rate is 100%, all the economic activities will cease to exist, as the economic agents will have no incentive to work and earn. Therefore, at a tax rate of 100%, again the tax revenue will be zero. Therefore, the tax revenue raising tax rate lies in the range of 0 to 100%. Though the presentation of the Laffer curve typically shows that the optimal tax rate happens at around 50%, there is no reason why this cannot be otherwise. The shape of the graph can differ, depending upon the variety of variables.
Initially, when the tax rate is zero, an increase in the tax rate is associated with a larger increase in the tax revenue. As the tax rate keeps on increasing, there are adverse effects on the tax base through decline in output and incentive for the economic agents to earn and produce more. Therefore, the marginal increase starts happening at a slower rate. After a certain point, any increase in the tax rate leads to a fall in the tax revenue. This is because of the fact the decline in the tax base becomes very high.
Therefore, there are two phases in this mechanism. During the first phase, i.e., during the phase when the tax revenue keeps on increasing, the marginal increase due to the rise in tax rate is higher than the marginal decrease due to the fall in the tax base. However, with rising tax rate, this difference keeps on decreasing and eventually turns negative. This is the second phase, when an increase in tax rate leads to a relatively higher fall in the tax base as compared to the rise caused by the increase in the tax rate. Again, the difference keeps on increasing with the increase in the tax rate, but in the negative matter. Eventually, the tax revenue reaches 0 as the tax rate reaches 100%. Here the assumption is that at 100% tax rate, people do not have any incentive to work as all there earnings are taken away in the form of taxes.
Therefore, based upon the Laffer curve hypothesis, we can say that tax revenue initially increases with the increase in tax rate then reaches its optimal level and then it starts declining. This optimal level of taxation is subjective and may differ from state to state. However, this theory is not without its own flaws and that is the topic of discussion in the next section; along with the discussion of other possible explanations and theories.
World beyond Laffer curve
The theory given by the Laffer curve is simplistic and seems appealing. However, there are many limitations and drawbacks of this theory. To begin with, the world is not a simple place and taxes are definitely not. Contrary to the assumptions of the Laffer curve, the taxes applicable in the real life are not single tax, as assumed by the above mentioned theory. Furthermore, empirical and other research has revealed that the zero tax revenue hypothesis of Laffer curve at the 100% tax rate is not valid. So, like any other theory, the Laffer curve has its own limitations. What then can determine the true nature of interaction between the tax rate and the tax revenue?
To begin with, the response will depend to a major extent on the current tax rate. This statement is endorsed by the Laffer curve as well. So, if the tax rate is 5% and it is increased, possibly there will be less severe effect on the tax base then if the tax rate is 30% and it is increased further. The point here to emphasize is that the economic agents operate for incentives and any economic phenomenon depends upon how these incentives are affected.
Secondly, the infrastructure of the economy has to play a major role here. By infrastructure I mean the way the multiplier operates. Suppose the economy is operating quite well and the investment demand for the industries are well fulfilled. In this case, raising the tax should have less severe effect on the investment demand then an economy where there is a paucity of investment.
Thirdly, the response depends upon the responsiveness of the taxpayers. If the taxpayers' base is strong and the tax coverage is good enough, then the effect of an increase in the tax rates shall be less adverse than the case when there are few tax payers.
Fourthly, expectations play a major role in today's time. If the taxpayers believe that the increase in tax rates is temporary, then there is no reason for them to cut back on their economic activities. However, the consumers are known to smoothen there consumption over the entire length of their lives. Therefore, a higher permanent tax increase can lead to a fall in the economic activities, as it does not make sense for most of us to earn more and give it away as taxes. Similarly, for the producers, expectations play a major role in taking investment decisions. If the producers believe that the tax raise is temporary then there will not be any slump in the short run. However, if the producers believe that the tax raise is permanent, then there might be a slowdown in the production activities, which might lead to a slump and recession in the economy.
Lastly, implementation of the tax collection procedure is very important. Raising taxes may backfire if the tax net is not strong. This will lead to a straightforward decline in the tax collection as people who are paying taxes are few and people who are evading taxes have no incentive to start paying taxes at a higher rate. This is discussed quite extensively in the literature that an increase in taxes usually dissuades the marginal tax payers and tax evaders. Increased tax rates only work as an incentive for them to stay away from the tax net.
Conclusion
As discussed above, taxation is a complex phenomenon. Tax rate by itself cannot decide the volume of revenue accruing to the government in the form of tax collection. Any tax rate change triggers a chain of complex changes, which apart from affecting the real economy, also affects the expectations of the consumers and producers equally. An increase in tax rate leads to a slowdown in the economic activities and reduces the real output of the economy. This, in turn, affects the tax base and leaves the ex-ante prediction of the tax revenue changes to be ambiguous. A fall in the tax rate, on the other hand, increases the economic activity and hence broadens the tax base. However, here, the tax rate is lower so the effect of the tax rate cut on the revenue collection is again ambiguous. Laffer curve analysis, though simplistic and appealing and relevant to a large extent, has its own drawbacks and it is tough to predict the actual Laffer curve. This prediction becomes even tougher in current times when consumer confidence is affected by many things apart from the real economic activities. Furthermore, expectations play a major role in the today's world. Fluctuations in expectations may decide the expansion or contraction in the production of the economy and the volume of change. This gain will affect the tax base.
Therefore, the changes in the tax revenue following a tax rate change is something which cannot be predicted with too much accuracy and the tax revenue definitely does not increase always with an increase in the tax rate. This phenomenon is subjective to an economy, its development level, its taxpayers base, the effect of speculative activities, and last but not the least, the practice of tax collection.