Matt Nolan explores how tax distorts behaviour and who ends up bearing the actual cost of a tax

Part two of a six part series on tax

By Matthew Nolan*

In my previous article, we touched on the idea of what tax was.

We noted that the mix of spending and tax was a way of redistributing resources within society.

Today, in part two of a six part series, we are going to focus in on tax. We are going to take spending as given – where spending exists to achieve a series of goals that government aims to achieve on behalf of society as a whole – and focus on how we use taxation to pay for that spending.

This will allow us to think about the related costs of taxation.  After this, we will be ready to spend the next four articles looking at different types of taxes.

(Note:  I had previously said there would be five articles on tax rather than six. However, I’ve now decided to write about four types of taxes, rather than three, leading to an additional article.)

What are distortions?

While it is obvious to think of the cost of tax as being the direct funds used to support government spending, in truth the cost of raising $1 of taxation will be more than the $1 for two reasons.

· Resources are required to raise the tax (ie the IRD, compliance costs).

· Taxation can change prices, and thus decisions about what to consume and produce.

In this article, we will concentrate on the second point (ie the way people’s choices are “distorted” by taxation).  These distortions depend significantly on how people who demand goods and services, and people who supply goods and services, respond to the tax system.

Let us take your income tax as an example.  Your cost to your employer is your gross salary. However you only receive a salary that is net of tax.

Taxation of this type creates a “wedge” between the price paid by the consumer (your employer in this case) and the price received by the person making/selling the product (you in this case).

The wedge means that taxation causes what economists call a “dead-weight loss”. Fundamentally, a dead-weight loss occurs when, in the absence of the tax, buyers and sellers would have been willing to trade – but once the tax is imposed they are no longer willing to.

The size of the distortion/dead-weight loss depends on how responsive people are to tax changes.

When we talk about how people respond to the imposition of a tax, we are talking about how people change the quantity they offer/demand based on a change in the price they receive/have to pay.  In economics, this concept is known as price elasticity.

The more elastic supply or demand is (so the more heavily people respond to a change in the price of a good they are trading), the greater the change in the production/consumption of that good and service will be in response to a change in price.

Therefore, the more elastic a demand or supply for a good is, the bigger the drop in transactions that will occur when a tax is put in place. 

The value placed on the lost transactions in this case represent the dead-weight loss.  The larger this dead-weight loss is, the less efficient a tax is stated to be.

The issue of efficiency becomes more complicated when we start to think of the fact that we are transferring resources over the broad economy (not a single market).

In this case even if demand for a good was perfectly inelastic (so that the quantity did not change with the tax), a tax hike would still drive a drop in consumers’ net income – which would lead to a change in demand for other goods and services.

If we then compensated people for this change, the relative price of our good is still higher – and as a result, over the economy as whole we still experience a form of dead-weight loss/inefficiency from tax.

Who bears the burden?

As we said last week, and discussed above, it is difficult to work out exactly what resources are shifted, and who ends up bearing the burden of a tax.  However, we can use some broad principles to help us understand what influences where this burden of tax falls.

Let us go back to the income tax example. In this case, the gross wage you see in your payslip is set given the knowledge that some tax will have to be paid – it is not the wage you would be given if you, and everyone you competed with for the job, didn’t have to pay tax!

The tax bill is in fact split between you and your employer, and we need to figure out a way to work out how this split takes place.

In economics we use the idea of “tax incidence” to figure out who pays the tax on a market transaction.

The concept of tax incidence comes back to the aforementioned idea of elasticity.  If, for example, the seller of a product will respond relatively less than the buyer to a change in prices (so that they are relatively price inelastic), the imposition of a tax will fall proportionally more on the seller!

For example, think about the ways you may respond in your workplace to a decline in you take home pay.  Your reaction to a drop in your take home pay depends on your outside options (eg how easy is it for you to find other work). 

If you are currently being paid far more than you would get from the benefit and other income while unemployed, but you have no other job options if you left your current job, then it will be unlikely you will try to change your job or rock the boat at work.  In economist lingo this means that your labour supply will be relatively inelastic – and as a result much of the burden of tax will fall on you!  However, if it was easy for you to find another job or adjust your hours of work (so your labour supply is elastic), the employer is likely to take on a lot of the burden of the tax themselves.

When we move out of a single market this issue gets more complicated again.

After all, if a tax reduces household incomes to spend on a range of products, some products will experience more of a drop in demand than others. 

Furthermore, taxes that may have small impacts on the allocation of goods now may have large effects down the line – due to the cumulative impact of changes in the level of capital and distortions in investment relative to their underlying best use.  As a result, the full burden of a tax is never clear – and thinking in terms of the tax incidence for a single market only helps to illuminate part of the underlying issue.

Tax principles, and a way forward

On the face of it, this suggests two broad principles when looking at tax that may conflict.  When a tax is imposed, we need to think carefully about who the burden falls on.  Furthermore, we should take into account this idea of “dead-weight loss” and as a result we should attempt to keep the overall loss of efficiency from taxation as small as possible for a given target level of government revenue/spending.

In the next article, we will take these principles and use them to think about a couple of tax systems poll taxes, and taxes on factors related to ability.







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I hope you are going to cover offshore investors who don't pay tax in NZ and the effects that has on the NZ economy and the tax residents here.
Most offshore investors have the benefit of using a tax treaty from the Country of Origin of their head offices.  Tax treaties offer incentives that local tax paying residents do not get - what distortion does this have on local investment and prices?

Matt you have a simplistic view of taxation and spending. The purpose of tax historically was not about redistributing resources within society. It was about about paying for the institutions of state needed to protect society. The biggest government deficits, debts and hence tax burdens were accumulated when society was most threatened. Think Britain during the Napoleonic era and the Second Worrld War.
Even today much of government spending is about making society work rather than redistributing resources. Would any developed country last long if the state completely opted out of educating its citizens for instance?

Did you actually read the article?  It clearly states at the beginning that it is not about what the tax gets spent on.  It is about the impact on economic activity of the way in which the tax is collected.  
Certainly there is a discussion to be had about what Government does, and should, spend money on.  But that would be a different article.

2nd paragraph Matt wrote "We noted that the mix of spending and tax was a way of redistributing resources within society."
I remember attending an economics lecture once with an engineer. It was about all the assuptions needed to mathematically model the free market. His comment was rubbish in rubbish out. You see if you make bad assumptions in engineering bad things happen -buildings collaspe etc and the engineer loses his job. In economics it doesn't seem to matter, in fact it is probably a bonus to your career.
It is obvious that Matt is going to waste our time with 4 or 5 articles with his false assumption straw man argument. You see he is going to say with lots of big words that spending is about taking your resources and giving it to someone else. That there is a cost for society in doing this so the optimum level of the taking (government taxation) and giving (government spending) is some minimal amount. But if you change the assumptions to some government spending is needed to make society function and there is a cost in not providing it then the conclusion is that there is some non minimal optimal level of government taxation and spending.
You would think in a country with towns and cities call Nelson and Wellington we would know this.

MdM - what the tax gets spent on has an economic effect. If the Government is investing taxes in a particular area of business for example then there will be changes in that area.
People will choose to either privately invest in that area or not too depending on what the consequences will be.  An example would be an industry/area that receives a subsidy of some description e.g.the effects of WFF has at a glance allowed those who were struggling to pay mortgages. However looking closer at WFF the effects have had far wider implications on economic activity and investment.
If you are a foreign investor and know that you don't have to pay income taxes in NZ it is a sensible move to invest here as your investment return is higher than what local investors can achieve.
Much has been written about the lack of competition in the building supplies market in NZ. Will this lack of competition improve in the near future - not likely would be my answer. Why - simply because the largest shareholder in Fletchers is the RBNZ. How many other Government organisations have large investments in private enterprise that are being protected? 
Wherever taxation and other Government revenues are channelled there will be an impact on economic activity and investment patterns.

There is an inference from your article that taxes generally only have a negative impact on long term consumption by society (assuming maximising that is the definition of success, which is debatable in its own right). You talk of dead weight loss of a tax for example, but don't seem to consider any dead weight gains (in this article anyway) that taking away the provision of services by a government might have a negative impact on consumption behaviour. Or that some of the redistribution effects of tax might actually increase overall society's consumption (in that if one person had all the income, overall consumption would presumably be very low indeed)- that is without getting into any ethical issues surrounding redistribution. Separately a high cigarette tax may well increase spending on say restaurants, as some people choose to stop smoking, and spend their money elsewhere.
To explain it better in my mind at least, at a macro level, if you assume a society has the real capacity in its farms, factories, and other workplaces, to produce $x in goods and services, including some optimal level of essential government services, then dropping all taxes overnight (and so giving everyone more money) will not increase that capacity at all, and would only be inflationary. The corollary is that if there is spare capacity in either unemployment, or underused capital, then lowering taxes (or even having negative taxes like WFF) to those most likely to spend more, or produce more to use up that capacity, would seem a good idea.
Am being a little contrarian.
Another good article, and will look forward to the rest.
Hopefully they will not quickly get buried under budget or other news, as this week's understandably has been.