Saturday 17 May 2008

Legal and economic incidence of a tax

As I explained before (compare the first and third diagrams here), the imposition of VAT (or any other turnover tax, such as the VAT flat-rate scheme) on most goods and services has the effect that prices paid by the consumer are increased, the net price received by the producer is reduced, and overall economic activity is reduced. That is why I consider VAT to the worst tax. The diagrams presuppose that both demand and supply are price-elastic.

As we know, there are always special cases, which can split into 'Sin taxes' and 'User charges'. This can be explained as follows:

1. For most manufactured goods, supply is relatively price-elastic and the same basic product is sold world-wide, but there are some where demand is relatively price-inelastic. Good examples are petrol or cigarettes. The oil companies or tobacco companies have to sell their goods for a certain minimum pre-tax price (wherever they sell them) to make a profit. Conversely, if you are a smoker or drive a car, you have to pay up, regardless of how high (or low) the tax-inclusive price is.

As we know, different countries have vastly different rates of duty on petrol or cigarettes, but as logic dictates, the net-of-tax amount that the producers receive is much the same (or else they would stop selling in high-tax countries), so the price of petrol or cigarettes also differs vastly between countries (reflecting higher or lower taxes). Therefore, in economic terms, petrol and tobacco duty is borne almost entirely by the consumer.

Summary: sin taxes 'work', not because they actually discourage smoking, gambling, drinking or driving to any great extent, but because they raise money (which cover far more than the external costs to society in most cases) without affecting people's behaviour or dampening economic activity (except to the extent that people spend more on smoking, petrol etc and thus have less money to spend on 'good' things).

2. The other extreme is where demand is price-elastic, but the supply is fixed, and hence price-inelastic. Most of these examples are where the amount is restricted by the actions of the government. For example, land with planning permission or an existing building; landing slots at airports; the exclusive right to broadcast at certain frequencies; licences for pubs or betting shops or even 'cherished' number plates. The value to the owner is to a large extent driven by scarcity value, and in enforcing the restrictions, the state is maintaining the value of the exclusive rights given to incumbents.

In a truly free market, the only type of rationing is price rationing. Where the state seeks to restrict the supply of something (for good or bad reasons) it only seems fair to make the owners (who benefit from the restriction at the expense of those who are excluded) pay market value in return. Whether we call this 'rent', 'licence fee', 'user charge' or 'tax' is neither here nor there. As long as a tax on such things is less than 100% of the value to the owner, the 'market' is not affected, it merely reduces the re-sale value of that right, not its value in use. In economic terms, the tax is borne by the owner of the rights (see example below*)

Summary: if the government (or society) wants to restrict certain activities (be it developing land, opening betting shops or aircraft movements), then taxes (or licence fees, user charges or rent, call it what you will) on the value of those rights 'work' because they capture part of the value to the owner/user (who, under current law, has usually paid very little to the state** for it), who is thus at least indirectly compensating those who are excluded (from building or buying a house, from opening a betting shop or new airlines who want to break into the market and drive prices down). Such taxes do not depress economic activity.

I did a worked example for airline landing/take-off slots here. This is a nigh-perfect tax - air travel has a lot of external costs (so it can be justified as a 'sin' tax). Similarly, the number of aircraft movements is restricted by the number of airports, and the number of airports is restricted by the government (so it can be justified as a 'user charge').

* Example: taxes on land values. In the UK, when you buy land and buildings, the law says that the purchaser has to pay 'Stamp Duty Land Tax' of up to 4% of the agreed selling price. Some politicians think that if they were to reduce SDLT, this would make buying homes cheaper for young people. Wrong. SDLT merely reduces the pre-tax price that buyers are willing to pay - in economic terms it is borne by the vendor.

Consider the following: imagine that the rate of SDLT were set locally, and one town reduced its rate to zero and another town has raised it to 10%. Somebody is thinking about buying a house for £500,000 in the town that has increased the rate to 10%, so he would have to pay a total of £550,000. A more-or-less identical house then comes up for sale in the town that has no SDLT. How much would he be prepared to pay? Answer, £550,000. So the vendor in the first town only gets £500,000, but the vendor in the SDLT-exempt town gets £550,000 for an identical house. Reducing a tax on an exclusive right granted by the government (the right to own or build a house) merely increases the wealth of those who have already been granted that right in the past (usually having paid far less than market value for it).

NB - SDLT (taken in isolation) is a totally evil tax, I just took this example to highlight how stupid politicians are and to illustrate the general point.

** An airline who pays millions of pounds to another airline to acquire landing slots has paid for it - but they have not paid to the state who issued that permit; they have not paid towards the cost of supporting infrastructure (primarily transport links between airport and nearest city); nor have they paid compensation to people whose houses are in the flight path and suffer noise pollution), they have paid to the previous owner for whom this is an unearned windfall gain.

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