Series on tax: Part 4 – A primer on income taxes

Over at Rates Blog they have popped up part 4 of the series on tax I’m popping together.  Here are the blog posts linking to part 1, part 2, part 2b, and part 3.  I would note this will at least be an eight part series, instead of six now, as I’ve split up this specific article.

Originally I wanted to talk about income tax, consumption tax, and ideas of progressivity and implementation all at once.  Now I realise it will have to be 3-4 articles on these issues.

The main trust of this piece was to ask “why is income tax distortionary when a poll tax is not”.  Given this idea, we can talk about the “relative efficiency” of types of income tax (namely labour and capital) and point out the idea of time – and how this impacts on the “accumulation” of capital, and thereby the “stock” of capital.

Personally, these things make more sense IMO, and are more closely related to our idea of “transfering goods and services” when we look at output taxes – specifically consumption taxes.  Next time, this is exactly what we do!  Originally I couldn’t bring myself to seperate the income and consumption articles … but at 3k words I sort of had to.  As a result, I’d suggest reading next fortnights article as an extension to this.

Also, I plan a “part 4b” for here.  I can imagine some people may get confused why I view the deadweight loss through the “price wedge” – when if we had perfectly inelastic demand we would “sell” just as much but the price would be higher.  Doesn’t this mean there is no deadweight loss, and that this tax is just like our poll tax?  Well no, but to explain this we need to actually dive into some of the economics they do in first year university.  We will look at indifference curves and budget constraints (we are comparing Marshallian and Hicksian demand) – we will introduce the tax, then assume an income transfer that brings our person to the same level of utility (compensating variation).   The reason we don’t see it in the single good case is that we are not considering the impact on income/wealth from the tax – and what “perfectly inelastic demand” means in terms of income and substitution effects (pro-tip – they must be canceling each other out to leave the quantity demanded at the higher price unchanged!).  Anyway, I’ll leave that to the post.