0. ECON 635: PUBLIC FINANCE Lecture 7

1. Topics to be covered: Indirect taxes Excise taxes
Reasons for levying excise taxes
Tax rates
Indexation of unit excise tax
Ad-valorem tax rate
Price elasticity of demand of a good
Elasticity of demand
Turnover tax
Determinants of the degree of cascading
The ratio of taxed to nontaxed inputs
The degree of price pyramiding
Indirect taxes that eliminate cascading
Tax at the manufacturing level
Tax at wholesale level
Retail sales tax

2. INDIRECT TAXES Types of Indirect Taxes 1. Excise Taxes Turnover
2. Sales Taxes Single Stage Taxes
VAT
3. Import Tariffs

3. Indirect Taxes
Indirect taxes are the most important source of revenue in developing countries.
Mix of indirect taxes differs widely across countries. Ranking in terms of importance for LDCs is (1) import duties, (2) excise tax, and (3) sales tax.
Developed countries ranking is (1) sales taxes, (2) excise taxes, and (3) import duties.

4. Indirect Taxes (Cont’d)
Indirect taxes are levied on the consumption of certain goods and services.
Individuals can avoid taxes to some extent by changing their consumption behavior.
Indirect taxes can distort the market and cause inefficiency in production and consumption of goods.

5. Composition of Tax in North Cyprus
2003
Type
Amount (000,000 TL)
% of Tax Revenue
% of GDP
Direct taxes
197,988,800
24.95%
8.93%
Indirect taxes
366,680,000
46.20%
16.54%
VAT
170,000,000
21.42%
7.67%
Customs
17,480,000
2.20%
0.79%
- Banking & Insurance
7,200,000
0.91%
0.32%
- Fund Rev (price stability fund)
172,000,000
21.67%
7.76%
Social Security Contributions
115,664,000
14.57%
5.22%
Other Non-tax Revenue
113,331,200
14.28%
5.11%
Total Revenues
793,664,000
100.00%
35.80%
GDP
2,216,802,000

6. Excise Taxes
Excise taxes are levied on specific goods and services e.g. alcoholic beverages, cigarettes, gasoline, airline tickets.
The International Monetary Fund (1974, p. 166) defines excise taxes as taxes “levied on particular products, or on a limited range of products may be imposed at any stage of production or distribution and may be assessed by reference either to the weight, strength, or quantity of the product, or by reference to the value.”
They are one of the earliest forms of taxation.
Excise means an exit tax. Usually levied when goods leave the door of the manufacturing firm’s warehouse.

7. Reasons for Levying Excise Taxes
1) Revenue generation: Excise taxes are specific, they are usually levied on goods and services with inelastic demand. To reduce the cost of collection, products which are homogeneous and have a small number of producers could be easily taxed. (eg. gasoline, diesel fuel)
Progressivity: Excise duty can be made progressive to some extent by levying taxes on those goods which are consumed by people in high income groups. For example, higher tax on cars with larger engines. Unfortunately often levied in goods consumed by the poor. For example, alcohol and tobacco.
Easy to administer As excise taxes are imposed on selected goods, it is easy to administer. Number of producers is small and the goods are often produced by state monopolies. (gasoline, alcoholic beverage)

8. Tax Rates
Excise taxes can be levied either as a per unit tax or as an ad-valorem tax.
If the tax is levied as an amount (dollars or cents) per unit of a good, the tax is called a per unit or specific tax. The unit of the good can be measured in weight, volume, or length.
Tax liability = Quantity x Tax per unit = Q x T

9. Disadvantages of a Unit Tax
As prices of goods and services increase (with inflation), the tax revenue remains the same in nominal values.
The tax revenue decreases in real terms.
LDCs may experience frequent drops in tax revenue from unit excise tax since most of them have periods of high inflation.
A per unit tax rate needs to be adjusted from time to time in keeping with the general price increase to maintain a certain level of revenue.
Advantage of Unit Tax
Easy to administer because one has only to estimate the quantity of goods and services transacted.

10. Indexation of Unit Excise Tax
The unit tax can be indexed as follows:
Ttn = Tt0 x (Ptn Pt0)
Where
Tt0= unit tax in year "o"
Ttn = unit tax in year "n"
Ptn = price of commodity in year “n"
Pt0 = average price of commodity in year “0"
If it is not possible or it is inconvenient to index the unit tax due to frequent price increases or some other reasons, it is better to adopt an ad-valorem excise tax system.

11. Tax liability=Quantity x Tax rate x Price of the good = Q x P x t
Ad-valorem Tax Rate
In an ad-valorem tax system, the excise tax is levied on value of sales not the number of units sold.
The tax rate is a percentage of the price of the good or service.
When the price of the good or service goes up, the tax revenue also goes up.
Tax liability=Quantity x Tax rate x Price of the good = Q x P x t
t is the ad-valorem tax rate.
Q is the quantity sold.
P is the price of commodity sold.

12. Tax on producer = Q x P x tax rate (ad-valorem)
Advantages of advalorem tax
The ad valorem tax takes care of the frequent increases in prices and does not require indexing of the rate as is the case with the unit tax rate system.
Disadvantages of advalorem tax
In the ad-valorem system, the tax point to be used has to be chosen carefully.
Should the excise tax be levied on price or the manufacturer’s price?
A manufacturer can lower the amount of tax due by selling the good at a very low price to a distribution company he also owns.
Hence transferring the profits to distributions company.
The manufacturing price would be lower than the retail price and the tax revenue would also be lower.
To avoid the loss of tax revenue, the excise tax at the producer level could be levied using the retail price:
Tax on producer = Q x P x tax rate (ad-valorem)
where Q = the quantity produced (including inventories) and P = retail price.

13. Price Elasticity of Demand of a Good
As an excise tax is specific to a good, the consumers can avoid the tax by changing their consumption behavior.
Consumers can switch to substitutes and thus, the tax base may be eroded.
The price elasticity of demand of the good, becomes an important consideration.
Excise taxes should preferably be levied on goods which have inelastic demands.

14. Elasticity of Demand Inelastic Demand Elastic Demand T1 T1 Q1 Q0 Price
Tax Revenue
Tax Revenue T1 T1 Q1 Q1 Q0
Quantity (Output) 
Quantity (Output) 

15. Turnover Tax
The turnover tax is a multistage tax which is imposed on every transaction or sale between firms and also to final consumer.
Since this tax is imposed on all sales, the tax base is large and the number of taxpayers is also large.
The cost of administration and compliance increases as the number of taxpayers increases.
As the tax base is large, the tax rate can be low and still it will raise a certain level of revenue.
Typically, export sales are exempt from the turnover tax.

16. Example: Level/Stage Cost Tax (with tax rate "t") Producer price 110
110 x t
Wholesale margin 15
125 x t
Retail margin 25
150 x t
Total Cost
150
385 x t
If a 10% tax were levied at the retail level (single stage tax), the tax revenue would have been $15.
To realize the same $15 in a multistage tax system, we would need:
385t = 15 t = 3.9%
So, in case of a turnover tax, the rate is low but the tax has to be collected at all levels.
Level
Tax
Producer $4
Wholesale $5
Retail $6
Total
$15

17. Disadvantages of the Turnover Tax
The tax base for the turnover tax is large as there are a large number of taxpayers.
This increases the administrator and compliance cost of the tax system.
If a firm can integrate its activities, the tax can be avoided. In the above example, if all the three activities of producer, retailer and wholesaler can be integrated in a single firm, then the total tax paid would have been $6 =(150) (0.039).
This reduces the tax revenue.

18. Disadvantages of the Turnover Tax (Cont’d)
A multistage taxes the same item more than once causing a cascading of the effective rate of tax.
A Turnover tax can cause effective tax rates to differ across commodities creating economic efficiency costs.
Advantages of the Turnover Tax
A turnover tax can collect large amounts of tax revenue as the tax base is large.
In Bolivia, where the VAT is 13%, and the turnover tax is only 3%, the collections from the turnover tax are half the total collections from VAT.

19. Determinants of the Degree of Cascading
The degree to which the true burden of a cascading tax is passed on to the final consumer depends the demand and supply elasticities of items i.e. the degrees which the tax can be shifter forward to consumers.
(a) Number of production and distribution stages prior to retail level
(b) Proportion of taxed vs. exempt goods at each stage of production and distribution

20. (a) Complete forward shifting (b) Partial forward shifting
Demand and Supply Elasticities and the Forward Shifting of the Tax Burden P P D T’ D T’
 * P
 * P P1 S’ P1 S’
P =  * P0
P <  * P0 P0 P0 T T S S D’ D’ Q Q
(a) Complete forward shifting
(b) Partial forward shifting
D = 0

21. (c) No forward shifting (d) Complete forward shifting
Demand and Supply Elasticities and the Forward Shifting on the Tax Burden (Cont’d) P P T’ D
 * P T P1 S’ P1 T’
P = 0
P =  * P0
 * P D
P1=P0 D’ P0 S’ S T S D’ Q Q
(c) No forward shifting
(d) Complete forward shifting
D = -
S = 

22. The Ratio of Taxed to Nontaxed Inputs
The magnitude of the tax burden contained in the producer prices at each stage along the production-chain depends on the ratio of taxed to nontaxed inputs at that stage, as well as such ratios at earlier stages.
The lower these ratios, the smaller the tax burden.
Food prices, normally contain a relatively low tax component, as most agricultural inputs used in food production are tax-exempt.

23. The Degree of Price Pyramiding
Price pyramiding at any given stage of production or distribution occurs when the seller raises his output price in excess of the tax burden on his inputs, for example, if he has some monopolistic power and is, therefore, able to engage in that kind of pricing behavior. P > MC
Very little evidence that such pricing behavior occurs in long run.
The number of stages in the production-distribution chain
The greater the number of stages of production and distribution a commodity passes through before reaching the final consumer, the greater the number of times taxed inputs would be subject to multiple taxation, and the higher the degree of the resultant cascading

24. Although turnover tax has obvious weaknesses, it is a powerful instrument for raising revenues in a country lacking a sophisticated tax administration.
Sometimes a low rate of turnover tax (2 or 3%) is used in addition to a VAT.

25. Indirect Taxes that Eliminate Cascading Single Stage Sales Tax
Can be levied either at the manufacturing stage, or the wholesale stage or the retail stage.
Single stage tax avoids cascading and also reduces the problem of tax evasion.
The tax base in a single stage tax is small as compared to a multistage tax, the tax rate has to be high.
This can encourage tax evasion.
In a single stage tax system, while the small number of taxpayers reduces administrative costs, the high tax rate may encourage evasion.
These two factors work in opposite directions.
Adoption of a multistage tax system or a single stage tax system may depend upon the country’s level of development and the tendency of evasion among the taxpayers.
Important issue to determine where is the tax point i.e. who will be a registered taxpayer.

26. Tax at the Manufacturing Level
If the tax is levied at the manufacturing level, all sales to other producers must be tax exempt while sales to wholesalers, retailers or final consumers must be taxed.
This is called ring-fencing.
This exemption raises the problem of determining those genuine manufacturers who should be issued licenses that will allow them to purchase inputs free of tax.

27. Tax at the Manufacturing Level (Cont’d)
A tax at the manufacturing level also creates an incentive for the firms to reduce their manufacturing prices and increase the wholesale price that they charge to the distributors which they will also own.
This will not reduce the retail price but the tax base would decrease due to an artificial reduction in manufacturer's prices.
The manufacturers can pass on to the wholesalers they own a part of the additional profits due to the lower amount of taxes.

28. Alternative Sales Prices of Manufacturer
Since Pwp would be more than Prp and Pcp, the lower prices Prp or Pcp can encourage erosion of tax base.

29. Tax at Wholesale Level
The tax base will be usually larger than in the case of tax at manufacturer level, as some additional costs are incurred by the wholesales in packaging and transportation.
A smaller tax rate will bring in the same tax revenue.
The tax on the sales prices wholesalers will encourage some manufacturers to sell their goods to retailers or final consumers directly, thereby increasing their own margin on sales.
A major problem is that there is no homogeneous wholesale sector. It is being estimated by direct sales of manufacturers to retailers.
Impossible to design and administrate an effective wholesale level single stage sales tax.

30. Retail Sales Tax Advantage
As it covers higher value added, the tax base is larger and the tax revenue would increase.
Disadvantage
As the number of retailers is larger as compared to the manufacturers and wholesalers, the administrative costs are higher.

31. Retail Sales Tax
In this case the ring fence around the taxpayers is different than in the case of manufacturers level tax.
Everybody is exempt from tax except the final consumers.
Manufacturers can use tax free goods as inputs.
All the retailers have to be registered as taxpayers in order to keep records of the taxes paid.
If the economy is well developed and the retailers keep proper records/ accounts, it is effective to tax at the retail level.

32. Retail Sales Tax
Large retailers need to have a good sales recording system in order to prevent their employees from stealing.
If there are a large number of informal sector retailers and record keeping is not satisfactory, there could be a large scale tax evasion. In this case it is better to tax at manufacturers level.
It is difficult to apply a multiple rate structure with a retail sales tax.
As the number of taxpayers is large, the administration of a multiple rate system would be more costly.