EIB Papers Volume 13. n°1/2008 - European Investment Bank

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92 Volume13 N°1 2008 EIB PAPERS Box 2. Burden and excess burden of taxation – modified approach The diagram below replicates Figure B1, but shows a rightward swivel of the labour supply curve to S , indicating the increase in time households allocate to work because of the 1 spending effect of expenditure such as the road-safety improvement project considered here. As a result of this induced rise in labour supply, hours worked increase from L to L 1 * , while the 1 gross wage and the net wage remain unchanged at BO and CO, respectively. With an increase in hours worked, output rises too. Figure B2. Burden and excess burden of taxation – modified approach Wage B C D F O E M A J N L1 L1 * S0 S1 D0 D1 L0 Labour supply and demand (in hours worked) In analyzing the welfare effect of the induced increase in output, there are two equally useful perspectives. One is to compare the benefit and cost of the additional output resulting from an increase in hours worked from L to L 1 * 1 . As the labour demand curve D continues to indicate 0 the (constant) marginal product of labour, the economic benefit of the extra output is L L 1 * 1 ME. The economic cost to households of producing this output, measured at the after-tax wage CO, is L L 1 * JD. Hence, the net benefit associated with the increase in hours worked is DJME. The 1 other perspective follows from simply measuring the extra income tax revenue, which is DJME. They accrue to the government, but can be thought of as flowing back to households or – which is the same thing – reducing the net financing needed to carry out public expenditure. The area DJME pictures the positive welfare effect that needs to be compared to the negative welfare effect associated with the excess burden, which is DAE. Thus, the net welfare effect is the difference between DJN and NAM. Although Figure B2 suggests a positive net effect, it must be stressed that this is merely because the rotation of the labour-supply curve has been drawn with a view to keeping the graphical exposition traceable. In other words, in contrast to what the diagram suggests, the labour-supply curve might swivel very little, making the area DJN (NAM) much smaller (larger) than in Figure B2. In any case, simple graphical illustrations of what are general equilibrium effects have their limitations. That said, a positive net welfare effect is possible. In Figure B2, the difference between the conventional excess burden DAE and the additional tax revenue DJME pictures the modified excess burden. This difference equals NAM − DJN, which is smaller than the conventional burden DAE. What is more, because of the spending effect and the increase in hours worked induced by it, modified tax revenues amount to CDEB + DJME rather than CDEB. Hence, when expressing the excess burden and the cost of funds per unit of tax revenue, both are set relative to higher tax revenue than under the conventional approach. More specifically, using Figure B2 and definition (B3) from Box 1 yields
(B4) α M = This compares with (B5) α C = decline in private surplus additional tax revenue (modified) decline in private surplus additional tax revenue conventional ( ) = CDEB + DAE CDEB + DJME = CDEB + DAE CDEB = 1 + NAM − DJN CDEB + DJME = 1 + DAE CDEB > < 1. for the conventional approach. Comparing the conventional approach with the modified approach can thus be summarized as: (B6) α C = 1 + β C > 1+β M = α M , with DAE/CDEB = β C > 0 whereas ( NAM−DJN ) ( CDEB + DJME ) = β M > < 0. Strictly speaking, we have illustrated the case of introducing a tax rather than raising the tax rate of an existing tax. It is straightforward to develop a diagram similar to the one above for an increase in the tax rate. What does all this mean for the excess burden of taxation and, thus, the cost of public funds? Clearly, there is a positive welfare effect that needs to be compared to the negative welfare effect associated with the excess burden. The net welfare effect might be negative, zero, or positive – in which case the indirect project benefits, triggered by the spending effect, would outweigh the excess burden of taxation as defined so far. One could stop here. But one can go further. The modified approach does not simply compare the excess burden as defined so far – that is, the conventional excess burden – with indirect benefits that might counterbalance this burden. Rather – as Jones (2005) has worked out in an exemplary manner – it modifies the very definition of the excess burden and the economic cost of public funds. A strippeddown version of this modification is (2) Economic cost of public funds = α M = 1 + β with if M α M > < 1 β M > < 0 The structure of Equation (2) is identical to that of (1). However, because of indirect project benefits, the modified excess burden and cost of funds are smaller than their conventional siblings (β M ≤ β C and α M ≤ α C ). What is more, the modified excess burden might be negative (β M < 0), implying that the cost of raising one euro might be less than one euro (α M < 1). This is in sharp contrast to the conventional approach where the excess burden of a distorting tax β C is always positive and the economic cost of raising one euro is always greater than one euro. 2 An observation of utmost importance is due: Modifying the definition of the excess burden and the cost of funds does not change the difference between the benefits and the costs of the project financed by a distorting tax. Rather, with the modified definition, indirect project benefits are counted as cost-reducing factors in the cost-benefit equation whereas with the conventional definition they are counted as benefits. This will be made explicit in Section 3 where it will become clear, too, that the practical implication of this difference is less innocuous than it appears. But before getting there, a few conclusions, extensions, and caveats should be noted. 2 More precisely, the conventional excess burden is always non-negative and the conventional economic cost of raising one euro is always at least one euro. The conventional excess burden might be zero and the conventional economic cost might be one euro if taxation does not affect the taxed activity. For a wage tax, this would be the case for a vertical labour-supply curve. > 1 Modifying the definition of the excess burden and the cost of funds does not change the net benefits of the project financed by a distorting tax. EIB PAPERS Volume13 N°1 2008 93
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Preface This year the European Inve
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Infrastructure investment, growth a
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Government investment is not the sa
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Different types of government inves
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Infrastructure accounts for one-thi
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A common feature for the new member
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The share of transport in governmen
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The proxies are subject to caveats.
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Page 48 and 49: There have been marked differences
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Page 126 and 127: Where fiscal positions were sound,
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Additional fiscal reporting - even
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Fiscal adjustment and reforms need
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