Among all the government’s revenue sources available, taxes are definitely the most effective one. This explains the straight relation between economies with high level of public debt (such as Portugal nowadays) and taxes increase policies. However, do all taxes provide the same government revenue? Are consumer’s welfare modified in the same way for all kind of taxes? This post’s purpose is to clarify these questions.
In order to guarantee the validity of the reasoning that will be presented, some microeconomic conditions must be verified. First, the argument was based on the idea that individuals behave rationally, that is, consumers are able to choose the combination of goods which provides them the highest level of welfare. One immediate implication of rationality is that consumers know the exact amount of money that they are willingness to save and spend every period. Second, it is required to ensure that consumers prefer to expend their income with small quantities of several goods than only consume large quantities of few of them (in microeconomics, it is stated that individuals hold “convex preferences”). Third, individually, consumers do not have bargain power for negotiate the price of the goods. Finally, the taxation system works perfectly: consumers know clearly the amount of taxes they must pay and they take it into account when deciding how to allocate their income.
It is possible to observe that governments rely on two sorts of taxation: the direct and the indirect. The first type is characterized by the immediate transfer from economic agent to the government, without intermediation of any other agent. It is the case of the income, patrimony and heritage taxes, for instance. Presumably, indirect taxes are observed when transaction costs for transferring resources to the government are involved. In Portugal some examples of these duties are the value added tax, the tobacco tax and the stamp tax.
It is desirable to analyze, first, the impact of an indirect tax applied to specific good of the economy, say cigarette. On the one hand, everything else held constant, smokers’ welfare may be diminished, since it is expected that they will opt to buy less quantities of cigarette, due to the fact that its price is relatively higher comparing to all other good – that is why economists state that these taxes create distortions in relative prices. On the other hand, government will acquire tax revenue which is given by R=tx, where t represents the amount per unit of cigarette and x, the amount of the good purchased after the tax implementation.
Now, we will assume that the government imposes a direct tax – an income tax for instance – in such way that the amount of revenue generated is R, as described in the previously. In this circumstance, consumers will have less income available to spend, however no distortion in relative prices will be established. These types of taxes are known in the economic literature as Lump-Sum taxes.
Therefore, in one case a tax applied to a given good reduces consumer’s purchase power, leading to a distortion of his or her choices. In the other, an income tax allows the individual to decide how to allocate his or her remaining wealth. Considering both situation, which one is less harmful for the economy? Through the use of microeconomics tools, we can ensure that Lump-Sum taxes can provide the same amount of government revenues, but enables consumers to achieve a better level of welfare. Resorting to the economic jargon, we can state that taxes of the type Lump-Sum eliminate the excess of tax burden existing in taxation of a specific good.
There is no doubt that, either direct or indirect taxes, lead to a decrease in consumer’s welfare. However, repute that they are equally hurtful for economic agents must be consider a misconception. Governments should decrease indirect taxes an increase income tax in order to let consumers better allocate resources.