Lecture 9

Fiscal Policy and Taxation

Fiscal policy
• Policies undertaken by a government to influence
macroeconomic conditions, and therefore
economic activity, through the use of taxation and
spending.
Fiscal policy
A fiscal policy can be of two types:

• Expansionary Policy: A macroeconomic policy that

seeks to increase the rate of economic growth.
• Contractionary Policy: A macroeconomic policy that
seeks to slow down the rate of economic growth.
Fiscal policy
Expansionary policy
• An expansionary policy can be applicable not just to
fiscal policy, but also for monetary policy.
Nevertheless in this case there are a number of
policies that a government can undertake to boost
the rate of economic growth such as:
• Tax cuts
• Tax rebates
• Increased government spending
Fiscal policy
Contractionary Policy
• If an economy is suffering from high inflation, it
may be that the country’s financial department
looks to halt the high level of growth that occurs.
This can be done through some of the following
policies:
• Increase taxes
• Reduce subsidies
• Decrease Government spending
Government Payments and
Receipts
Government payments
• Governments need to spend money on a number of outlays of
a current or long term nature. These can be analyzed into the
following categories:
(a) Government purchases of goods and services
Short term: Expenditure on current goods and services such as:
1. Salaries of government employees
2. Repairs, maintenance of public buildings
3. Payments for goods and services needed to carry on daily
government activities (e.g. heat and light)
Medium and long term: Investment on infrastructure such as
building roads, schools and hospitals.
Government Payments and
Receipts
Government Payments
(b) Transfer payments
• These are payments made for which the
government received no goods or services in
return. Examples
• include:
• Unemployment and welfare payments
• Pension
 Government Payments and
Receipts
To pay for expenditure governments collect revenues,
mainly taxes. There are four main types of government
revenues.
(a) Taxes on income and capital gains
(i) Taxes paid by individuals (income tax)
(ii) Taxes paid by companies such as corporation tax
(b) Indirect taxes on expenditure or sales taxes whereby
consumers pay a tax on their consumption of goods and
services.
Government Payments and
Receipts
Other revenues
• One of the main elements of this category is
income from government corporations such as the
Post Office, Railway, PIA, Steel Mill, WAPDA and Sui
Gas etc. in Pakistan.
 Government Deficit and
Surplus
• A Government Budget is an estimation of expected
Revenues and Expenditures for the coming time period.
• The government budget deficit is the difference between
government expenditures and revenues in any one period,
normally a year referred to as a fiscal year.
• A fiscal year is the period over which the government revises
its revenue and expenditure plans.
• Government expenditure is very unlikely to be equal to
government revenues in each fiscal year, and so a
government is likely to have either a budget surplus or a
budget deficit.
• When revenues exceed outlays there is a budget surplus.
When outlays exceed revenues there is a budget deficit.
 Government Deficit and Government
Debt
• The Government deficit represents the excess of government
spending over government revenues in any one period. As such,
the government deficit is a flow concept, just like the profit and
loss is a flow concept in the financial statements of a company.
• In any one year, the Budget deficit represents the amount of
new borrowing that the government must undertake in next
coming year.
• Government debt is the accumulation of government deficits
over time and represents all the debt issued to fund the deficits.
• In UK, deficits are funded by issuing government bonds (known
as gilts), government debt is the total outstanding amount of
gilts issued.
Taxation
Functions of taxation
• Taxation has several functions.
1. To raise revenues for the government and to finance
the provision of public and merit goods such as
defence, health and education.
2. To manage aggregate demand. Aggregate demand
could be boosted by lowering taxes, or it could be
reduced by increasing taxes.
3. To provide a stabilizing effect on national income.
Taxation reduces the effect of the multiplier, and so
can be used to dampen upswings in a trade cycle – i.e.
higher taxation when the economy shows signs of a
boom will slow down the growth of money GNP and so
take some inflationary pressures out of the economy.
 Functions of taxation
4. To cause certain products to be priced to take into account
their social costs. For example, smoking entails certain social
costs, including the cost of hospital care for those suffering
from smoking-related diseases, and the government sees fit
to make the price of tobacco reflect these social costs. In a
similar way, taxes could be used to discourage activities
which are regarded as undesirable.
5. To redistribute income and wealth. Higher rates of tax on
higher incomes will serve to redistribute income. UK
inheritance tax goes some way towards redistributing
wealth.
6. To protect industries from foreign competition. If the
government levies a duty on imported goods, it will
ultimately protect local industry.
Canons of Taxation
• The canons of taxation refer to the qualities that a
good taxation system must possess. These are in
fact associated to the administrative aspect of the
tax system.
• Adam Smith contributed greatly on the matter. He
described the following canons of taxation
Canons of Taxation
1. Canon of Equality
• “The subjects of every state ought to contribute
towards the support of the government, as nearly
as possible, in proportion to their respective
abilities, that is, in proportion to the revenue which
they respectively enjoy under the protection of the
state.”
• Equality or justice is the most imperative canon of
taxation. It means that the tax paid should be in
proportion to the ability of the tax payer i.e. the
amount of revenue.
Canons of Taxation
2. Canon of Certainty
• “The tax which each individual is bound to pay
ought to be certain, and not arbitrary. The time of
payment, the manner of payment, the quantity to
be paid ought all to be clear and plain to the
contributor and to every other person.”
• All the tax payers should be informed as to why and
when they have to pay a particular sum of tax
which is why tax budgets are given so much
publicity and transparency. There should not be a
single element of uncertainty in a tax.
Canons of Taxation
3. Canon of Convenience
• “Every tax ought to be levied at the time or in the
manner in which it is most likely to be convenient
for the contributor to pay it.”
• The time and manner of payment should be
convenient. Tax on land is to be paid along with the
rent due. Similarly, consumer taxes are paid when
consumers purchase a good or service as the tax is
included in the price of the commodity.
Canons of Taxation
4. Canon of Economy
• “Every tax ought to be so contributed as both to take out and to
keep out of pockets of the people as little as possible, over and
above what it brings into the public treasury of the state.”
• Tax is economical when the cost of collecting it is small and
when the amount of tax collected is equal to the treasury which
means no amount gets lost in the middle of the tax collection
process.
• A tax is also economical when it does not hamper the economic
progress of the country. While heavy taxes on income
discourage savings, taxes on harmful drugs and intoxicants are
considered economical. Whereas, taxes on raw materials is
considered uneconomical because it increases the prices of
manufactured goods.
Canons of Taxation
5. Some other Canons
• Taxes should be such that the government is able to
meet the expenses with the taxes collected by the
citizens. Hence, fiscal adequacy or productivity is a
canon for taxation. However, the economic resources of
the country or the productive capacity of the community
should not be sacrificed to gain excess tax revenue.
• Elasticity is another canon which means that the tax
revenues should increase as the state expenditure
increases. Also, when in the case of emergency, the state
should be able to augment its financial resources.
• The tax system should not be rigid which means it should
be able to adjust to changing conditions; this is the
canon of flexibility.
Canons of Taxation
Moreover,
• simplicity is another rule which states that the system of
taxation should be simple enough for everyone to
understand without which corruption or oppression might
prevail because it would be too complicated for the
common man and the power will go to the tax gatherers.
• Furthermore, there should be diversity in taxes which
means there should be a large variety of direct and indirect
taxes so that every citizen who is able to pay can do so.
• Finally, the effects of taxation should be compatible with
the social and economic objectives of the community such
as accelerating economic growth and reduction of
inequalities of income and wealth.
Types of Taxes
• Within an economy, taxes can be raised in a
number of different ways. In order to generate a
substantial level of taxation, the government has
different options at their disposal. Taxation can be
classified into three categories on the basis of what
is being taxed.
(a) Income – income tax, corporation tax.
(b) Expenditure – sales tax, Import duties.
(c) Capital – inheritance tax, capital gains tax
Types of Taxes
Taxes can also be categorized according to the
percentage of income which is paid as tax by different
groups in society.
• Regressive Tax: A regressive tax takes a higher
proportion of a poor person's salary than of a rich
person's. Television license's (the annual license fee
people have to pay in Pakistan to watch television) are
an example of regressive taxes since they are the same
for all people.
• Sales taxes are also regressive because they are the
same for all people, regardless of a person's income.
Types of Taxes
• Proportional Tax: A proportional tax takes the
same proportion of income in tax from all levels of
income. So an income tax with a basic rate of tax at
5% is a proportional tax, (although it then becomes
a progressive tax if higher income earners have to
pay a higher rate than this basic rate).
Types of Taxes
• Progressive Tax: A progressive tax takes a higher
proportion of income in tax as income rises.
Income tax as a whole in Pakistan is progressive,
since the first part of an individual's income is tax-
free due to low income and the rate of tax
increases in steps.
Below are details of three taxation systems, one of
which is regressive, one proportional and one
progressive. Which is which?
Income Income
Before Tax After Tax

Rs. Rs.

System 1 10,000 8,000

40,000 30,000

System 2 10,000 7,000

40,000 28,000

System 3 10,000 9,000

40,000 39,000
Below are details of three taxation systems, one of
which is regressive, one proportional and one
progressive. Which is which?
Income Income After
Before Tax Tax

Rs. Rs.

System 1 10,000 8,000 Progressive

40,000 30,000

System 2 10,000 7,000 Proportional

40,000 28,000

System 3 10,000 9,000 Regressive

40,000 39,000
 Direct Tax Vs. Indirect Tax
• A direct tax is paid direct by a person to the
Revenue authority. Examples of direct taxes in the
UK are income tax, corporation tax, capital gains tax
and inheritance tax. A direct tax can be levied on
income and profits, or on wealth.
• An indirect tax is collected by the Revenue
authority from an intermediary (a supplier) who
then attempts to pass on the tax to consumers in
the price of goods they sell.
Advantages of Direct Tax
• Equitable: people with higher income pay more
into society than those with less income, creating a
more equitable distribution of (net) wealth.
• Cost of collection is low: meaning it is an
economical way of raising revenue, saving expense.
• Relative certainty: the government can estimate
how much it will receive allowing better planning of
projects.
• Flexible: if a government needs to raise revenues
quickly, it can do so by raising direct taxes.
Disadvantages of Direct Tax
• Possible to evade: it is possible to falsify tax claims
meaning the correct amount is not always paid.
• Unpopular: it is very obvious when a direct tax is
being paid meaning the end user will often try to
find ways to avoid paying it.
• Discourage savings/ investment: if too high, then
it would leave consumers and firms less money to
put to other causes that could reap reward.
Advantages of Indirect Tax
• Change the pattern of demand: the government can
alter the demand for a product (say, alcohol or
cigarettes).
• Can correct externalities: if a product causes direct
external costs (e.g. health costs associated with alcohol
or cigarettes), the tax can be used to mitigate these.
• Less easy to avoid: often these are part of the final
price, ensuring taxes are paid.
• Allows people greater choice: consumers make choices
and then tax is paid, rather than having income taken
away immediately.
Disadvantages of Indirect Tax
• Increases inequality: regardless of income, people are still
faced with the same tax on a good
• Cause cost-push inflation: by increasing the price of inputs for
goods.
• Establish a “black market”: if taxes make prices too high, can
incentivize people to source the goods from alternate
(sometimes illegal) markets.
• Higher uncertainty: if in a recession, people are buying less
goods, then this means the revenue received will decrease
much more.
• Distorts the market: can lead to disequilibrium in the market
for products that have been taxed.
The Laffer Curve
• The Laffer Curve is a theory developed by supply-
side economist Arthur Laffer to show the
relationship between tax rates and the amount of
tax revenue collected by governments.
• The curve is used to illustrate Laffer’s main premise
that the more an activity such as production is
taxed, the less of it is generated. Likewise, the less
an activity is taxed, the more of it is generated.
Explanation
• Suppose income is Rs.1000/-
• If tax rate is 50%, the producer is getting 50% income and pay
50% tax. Tax is 500 and income is 500.
• If tax is 25%, the producer is getting 75% income. It means
Rs.250/- is tax and Rs.750/- is income
• While if tax rate is 75%, in this situation the producer will only
get 25% of the income. So at this point Rs.750 is tax and
Rs.250 is the income. In fact till this stage, producer will not go
for production as most of the income is going into the tax.
• Psychologically as tax rises, to some extent producers will
continue its production but as will stop its production at some
stage near 50% tax.
Thank You