Guest Post: Peter Greagg — The policy implications arising from the economic costs of taxation.

The imposition of a tax raises the price of things being taxed, and thereby generally reduces the amounts sold. This reduction in the amounts sold, relative to the situation before the things were taxed, is called the efficiency cost of the tax. This efficiency cost of the tax is usually shared between the sellers and buyers, in inverse proportion to market power of the sellers relative to the buyers.

The efficiency cost of the tax is best thought of as the sales that would have taken place, but for the imposition of the tax. These ‘lost sales’ represent things the seller could have produced (and therefore sold) but didn’t because of the imposition of the tax raised the price of the things. Therefore the seller couldn’t sell some of these things because of the price increased by the tax. In other words, the tax reduced the sellers production possibilities.

These ‘lost sales’ also represent things the buyers would have bought but didn’t because of the imposition of the tax raised the price of the things. In other words, the tax reduced the buyers consumption possibilities.

To summarise, imposing a tax raises the price of the things being taxed. And, as a consequence of the tax increase in price, both sellers and buyers are made worse off to the extent of the ‘lost sales’ – the so called ‘efficiency cost’ of the tax.

Consider income tax  — it is obvious that firms would offer more jobs if labour was untaxed. In this case, the cost of labour would be lower than otherwise, thereby lowering the firms’ prices. Similarly, workers would be prepared to work more hours if they didn’t have to pay income tax because they would get to keep all of the additional income the extra hours generated. So, income tax reduces the amount of things produced as well as reducing the number of hours worked.

This efficiency cost of a tax (expressed in dollars and cents) is usually stated relative to the last dollar of tax revenue raised by that tax. For example, let us assume a very small change in an income rate produced one extra dollar in tax revenue. Also, assume  that the efficiency cost of that change in income tax resulted in a loss of, say, thirty cents. Then you can say, broadly, that it costs the economy thirty cents to raise one dollar of income tax.

This result leads directly to the following implication for government spending. Governments should only spend tax revenue on things that provide a benefit greater than the sum of the tax revenue itself, and the associated efficiency costs of raising that revenue. (As an aside, technically, one should include the costs of collecting and enforcing the tax collection system. But we will ignore those for simplicity sake.)

To demonstrate the point, we will consider the example of the Commonwealth’s ‘investment’ in the NBN, using the numbers from recent articles by Kohler and Gottleibsen, and our example of 30 cent efficiency cost of one dollar of tax. By the way, I am not arguing that this scenario is correct. I am just using the scenario to demonstrate how the efficiency costs of taxation impact on the well being of the economy.

The original Commonwealth setup spending was of the order of $30 bilion. Recently, because the NBN couldn’t borrow from commercial banks the $20 billion it says it needs to fully roll out the network ,the Commonwealth has agreed to provide that as well as the initial $30 billion. However, according to Kohler, when it comes time to sell the Commonwealth’s equity in the NBN, commercial buyers will only pay $30 billion. This assumes that the NBN develops in accordance with its own corporate planning.

So the Commonweath has spent $50 billion but in this scenario but will only receive $30 billion from the eventual sale of the NBN. Now in addition to this loss of $20 billion, we also need to add the efficiency costs of raising that $20 billion. In this example, it is $6 billion (20 x 0.3 = 6). Accordingly, the all-up cost to the Commonwealth from the decisions associated with the NBN are likely to exceed $26 billion (20 + 6 = 26). From the Commonwealth’s perspective, not only has the NBN cost $20 billion in tax revenue but also the economy has suffered the ‘efficiency loss’ of $6 billion associated with raising the $20 billion in tax. And the Commonwealth has no income producing asset justifying such huge expenditures.

To put that amount in context, it is reported that the submarines to be constructed in Adelaide will cost in the vicinity of $50 billion. Hopefully the Commonwealth will end up with some operational submarines for that expenditure.

In finishing, I just wanted to point out another fairly obvious implication arising from the efficiency cost of taxation. In the context of fiscal consolidation, there are two polar opposites available to reduce a budget deficit. One is raising taxes, while the other is cutting spending. Here I just want to compare the different impacts of these opposites, but I recognise that both would likely be used.

Raising taxes can reduce the budget deficit, if the policy is correctly designed and the costings of the policy change are also correct. However, these additional taxes will cause efficiency losses in the economy making the economy poorer by these extra efficiency losses.

Cutting spending can also reduce the budget deficit, again assuming the change in spending is correctly designed and the costings of the policy change are correct as well. Provided the spending that is cut is of low quality (meaning that the spending doesn’t provide much that is highly valued), closing the budget deficit this way is superior to raising taxes because there is no or little efficiency cost, unlike with raising taxes.

I recognise that these efficiency issues have not been considered against the politics of either raising taxes or cutting spending. I leave those issues for others to consider.

Finally, given the efficiency costs of taxation, it is hard to agree with the Keyenesian approach of attempting to ‘create jobs’ by spending on anything without regard to the value purchased by such spending. Spending on Pink Batts and School Halls caused the ‘efficiency losses’ associated with the raising of the tax revenue to actually fund the spending. In addition, it also actually destroyed value in the economy because, I argue, that those that received the benefits of that spending, valued it less than the purchase price. If that wasn’t the case, they would have made those purchases themselves. In addition to that waste (the difference in the amount spent and the value to those that received the spending), you must add the efficiency cost of the taxes raised to fund the spending.

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15 Responses to Guest Post: Peter Greagg — The policy implications arising from the economic costs of taxation.

  1. Rococo Liberal

    Can we hear more from Peter Greagg please. He has a wonderful way of precisely and clearly explaining the concepts that make things clear for non-economists.
    That’s not to say that the other economic whizzkids on the Cat don’t do the same: but the more the merrier.

  2. Entropy

    Wot about elasticity?

  3. Joe

    All pre-supposes that the state of the economy remains as it is. Robots will eliminate labour. No Australian economists seem to be interested in the effects of this on the economy. Come back when you have something useful to say.

  4. Entropy

    Also, the insulation scheme basically doubled the price on home insulation as suppliers maximised their rent to the maximum value of the subsidy. People got a lot of ‘free’ insulation that miraculously retailed at $1600.

  5. jupes

    One is raising taxes, while the other is cutting spending. Here I just want to compare the different impacts of these opposites, but I recognise that both would likely be used.

    LOL

    Since when has a government cut spending?

  6. Ray

    The excess burden of a tax (efficiency cost) is dependent upon price elasticity. Where demand is perfectly elastic, the increased price resulting from a tax will have no impact upon quantity such that both the consumer and producer surplus are zero.

    Labour markets are a prime example here. Since households have relatively fixed commitments for mortgages, car repayments, energy and food, all essential commodities and so relatively inelastic themselves, then the supply of labour is unlikely to shift given a marginal change in income tax rates. That may not be the case for vert high earners who have can easily meet their regular bills or for very low earners who can rely upon welfare but the mass of middle earners, labour is relatively inelastic.

    As a result, an efficient tax system requires more than just an acknowledgment of the existence of excess burden as the inputs being taxed has a major impact upon efficiency.

  7. Diogenes

    lso, the insulation scheme basically doubled the price on home insulation as suppliers maximised their rent to the maximum value of the subsidy. People got a lot of ‘free’ insulation that miraculously retailed at $1600.

    Many people also got insulation worth more than 1600 for 1600.

  8. Rob MW

    gawd, what a long read to simply say that taxation (up or down) sends price signals to individuals and investors that govern their habits. Mal Shorten believes that raising the excise on ciggies sends a price signal to smokers for them to think about quitting, on the one hand, but on the other believes that increasing corporate taxes does not influence investment. I would have written this post in two words, *we’re fucked* and linked it to a loony tunes cartoon.

  9. Cynic of Ayr

    An interesting article.
    My recollection is that a GST was essential, because it was a “Consumption Tax.” I.E. a Tax on Spending (The populace – not Govt) rather than a Tax on “Income.” Another benefit was that the present taxes on “Income” could be reduced (hahaha) and enable the populace to spend more, thus paying more GST. And around and around the argument went.
    I was in business at the time, and I welcomed the GST with open arms, and promises of continual reverence to any Deity that came along and demanded it, because it replaced the insidious, mind numbing, complicated and troublesome Sales Tax. Does any one remember the Sales Tax? This Tax could be dodged by presenting a form to the vendor, claiming exemption under Section 23.345[/iee.](1) that the purchased string was to be used for tying up tomatoes, and not grapes. Other uses for the exact same string were Secti0ns 23.345[/iee.](2) through (107). As I recall, there was not a section number for tying up crabs, which caused consternation in the fishing industry at the time. This was resolved by adding another 7 numbers, one for each species of crab. ) Then, of course, every couple of years, a Tax Inspector would come knocking, and go through “a few invoices” Usually an agreed amount was paid, which was cheap for the vendor, and a sop for the Inspector, as he had something to show for his vehicle and motel expenses. Horror stories abounded!)
    But I digress.
    In recent times, when silly Turnbull had another of his brain explosions, and hinted at an increase in the GST, there followed a myriad of “experts” braying that this was a good thing, as it was a tax on spending etc etc. See above.
    Now, there seems there is another cost to add to the Tax (and BTW, I don’t think the cost of collecting it is all that minor! Have you seen the Tax Building and offices? The gyms? The cars? The furniture? The carpets?) and that is the believable cost to the Economy because no one buys anything, because no one can afford the Tax.
    The study of Economics is truly a wonderfully obscure and weird career.

  10. Peter Greagg

    Rococo Liberal
    #2321091, posted on March 10, 2017 at 9:27 am
    Hydra
    #2321119, posted on March 10, 2017 at 10:04 am

    Thanks

  11. Chris

    This cannot stand.
    the Great Henry has established Treasury practice to assume every dollar in the economy is the Government’s, and not to tax it at 100% is a ‘tax expenditure’.

  12. Art Vandelay

    Nicely explained, Peter. You would think that the government would take the efficiency costs of taxation (also known as the deadweight loss of taxation) into account when developing new proposals for spending our money. However, they don’t.

    In fact, they resist any attempts to get them to even conduct rudimentary cost-benefit analysis of new policies. And they certainly don’t conduct ex post assessments once the money is spent to ensure that the taxpayer got good value. I wonder why?

  13. Tim Neilson

    Hopefully the Commonwealth will end up with some operational submarines for that expenditure.

    Optimist.

    Contracting for delivery of a sub in 50 years’ time?

    Like Billy Hughes’ government contracting to get Sopwith Camels delivered in time for the Vietnam War.

  14. rickw

    All pre-supposes that the state of the economy remains as it is. Robots will eliminate labour. No Australian economists seem to be interested in the effects of this on the economy. Come back when you have something useful to say.

    Joe clearly has had fuck all to do with Robots. Who will service them, program them, maintain them, fault find them, monitor them, etc. etc.? There is always plenty of work, all technology does is multiply the output of that work and therefore reduce the cost of that work.

    The fundamentals are the same since there was a debate over the hand loom versus automated loom. Technology does not change the fundamentals of economics.

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