Incidence of a Tax

Abstract

A tax may be levied on a firm or individual but its final burden—what economists term ‘incidence’—may be shared by another economic entity. Thus, a tax on the supply of Laptops may be shifted partially to consumers if consumer demand is less than fully elastic if Laptop is a relative necessity, not a luxury. Incidence analysis of a product market alone is referred to as ‘partial incidence’ of a tax. The Laptop supplier may pass on some burden to the labour he hires, in other words, to inputs he uses in production. When all actors in the production process—inputs and output—are considered together, the final distribution of the burden among them is called ‘general incidence’ of a tax. This has been analysed in the context of the corporation income tax. It is a ‘partial’ tax collected from the income of capital in the corporate sector alone. Resource use decreases in the sector and they move out from it. They will be absorbed in the non-corporate sector though the relative returns—wages and rental of capital—to factors will change in the entire economy reflecting various product and factor substitution elasticities. These incidence outcomes are analysed here.

Appendix 9.1: Method of Elasticity Calculations

1.1 Elasticity of a Tax System

Now that we have become familiar with the concept of elasticity, this Appendix takes the opportunity to make a digression and examines how the elasticity concept is used to assess tax revenue response to growth in the GDP of an economy. Elasticity is estimated with a log-linear equation, which simply means the percentage response in the dependent variable such as tax revenue to a percentage change in the explanatory or independent variable such as the Gross Domestic Product (GDP) of an economy.

The above response is usually called the ‘buoyancy’ of a tax system. If we cleanse the data of any tax revenue that has been collected from discretionary tax measures that the government announces in its central budget, then we get a tax revenue series that represents only the automatic response of the prevalent tax structure to GDP—or economic—growth. In the elasticity formula introduced in Sect. 9.1, p would represent the tax revenue series, and q would represent the GDP series. When we estimate the coefficient of response of the former to the latter, we obtain the elasticity of a tax system.

1.2 Deconstructing Elasticity

The elasticity formula can be de-constructed if we view it as a product of two underlying elasticities:

$$ \mathrm{Elasticity}\kern0.17em \mathrm{of}\;\mathrm{a}\;\mathrm{tax}\;\mathrm{with}\kern0.17em \mathrm{respect}\kern0.17em \mathrm{to}\;\mathrm{GDP}=\mathrm{Elasticity}\kern0.17em \mathrm{of}\;\mathrm{a}\;\mathrm{tax}\;\mathrm{with}\kern0.17em \mathrm{respect}\kern0.17em \mathrm{to}\;\mathrm{its}\;\mathrm{a}\mathrm{ppropriate}\kern0.17em \mathrm{base}\times \mathrm{Elasticity}\kern0.17em \mathrm{of}\kern0.17em \mathrm{the}\kern0.17em \mathrm{base}\kern0.17em \mathrm{with}\kern0.17em \mathrm{respect}\kern0.17em \mathrm{to}\;\mathrm{GDP} $$

First, it is of primary importance to define the base as closely as possible to the source from which a tax is collected. For example, corporate income tax is collected from corporate profits. GST or VAT is collected from the consumption of goods and services. But taxes involve exclusions, exemptions and deductions. As a result, data on broad categories of bases obtainable directly from the national accounts have to be modified by including approximations of the elements that cause tax base erosion. That yields usable proxy bases for the theoretically correct bases. Usually, despite taking all possible actions to cleanse a data series, estimates of the elasticity of tax systems may be somewhat imprecise.

Nevertheless, appropriate substitutions may be made in order to improve the elasticity estimates so that meaningful policy conclusions could be drawn. For example, if agriculture falls virtually outside the income tax net, the GDP of agriculture should be removed from the income tax base. Thus, the elasticity of an income tax on wages should use as its base, domestic wages and salaries–net of agricultural wages. Appropriate definitions for such bases for major taxes appear in the Appendix Table 9.1.

Table 9.1 Method of elasticity calculations

Second, the most commonly used method of elasticity estimation¹⁰ has its shortcomings. While the numerator in the tax-to-base elasticity—the tax revenue series in question—is adjusted for discretionary changes in both the tax base and the tax rates, the denominator—the base itself—is not adjusted for the impact it undergoes due to any of the discretionary measures. Not even the discretionary measures with respect to the tax base are incorporated directly as an addition or subtraction to the base and, its consequences, in turn, are not applied to the tax revenue series.

Discretionary measures taken on tax rates are assumed not to affect the tax base, either through the natural reactions of taxpayers to the resulting changes in relative prices or through a change in the degree of evasion or of administrative efficiency. For example, a significant increase in the import tariff could affect taxable imports, which is the tax base, adversely; unless this is taken into account, the potential yield from the increased duty rates would tend to be overestimated. Similarly, a large increase in income tax rates, especially in the upper-income brackets, could increase the occurrence of tax avoidance or evasion, again adversely affecting the income tax base.

All attempts at elasticity estimates to date ignore these elements. When using elasticity estimates for policy conclusions, therefore, one needs to bear their shortcomings in mind.

1.3 Elasticity of Tax Structure

Discretionary measures usually take the form of tax increases rather than tax base expansions; as a result, they contribute little to enhancing the revenue elasticity of the tax system. In fact, a close examination of discretionary measures often reveals that many of the measures in the income tax area erode the tax base and, therefore, its revenue elasticity is reduced. Also, the structures of customs duties and selective excises, which often account for significant portions of tax revenue in several African and some Asian countries, use rate changes rather than base expansion in making discretionary changes. Finally, unchanging patterns of consumption and production may explain to a good extent why elasticity is difficult to raise.

1.4 Improving Tax Elasticity

Despite the various limitations to increasing the elasticity of developing country tax systems, it is obvious that any improvement in tax elasticity would have to come from a sustained expansion of the tax base. This would entail an expansion of coverage, that is minimising tax incentives that erode the base, a sustained effort in enhancing the taxpayer base, a regular modification in the tax rates to adjust for inflation, possibly a conversion from specific to ad valorem rates wherever feasible, as well as a reasonable degree of progressivity in the system as a whole.