Taxes and Transfers

Abstract

Thus far, we have taken an unrealistic view of governmental operations by assuming lump-sum taxes and transfers. In our model, the amount that a household or firm pays as taxes or receives as transfers has nothing to do with the household’s or firm’s income or other characteristics. In the real world governments levy a variety of taxes and pay out a lot of transfers, but none of them looks like the lump sums in our theory. Generally a household’s or firm’s taxes and transfers depend on its actions. But this dependence motivates changes in behaviour. For example, income taxes deter people from working and discourage businesses from investing. Similarly, transfers to the unemployed or the poor may motivate people not to work. Overall, the system of taxes and transfers creates a variety of substitution effects on work effort, production, consumption, and investment. In this chapter we extend the theoretical analysis to incorporate some of these effects. But before considering the theory, it is useful to start with an overview of the various tax instruments most commonly used in industrialized countries.