CHAPTER #17

Taxation Effects
on Capacity Output:
A Supply-Side Perspective
Presented by Sumaira Aslam (roll number# 6)
To
Dr. Rehmat ul lah
Points to discuss:
In this chapter we discuss;
 
• A. Effects on Work Effort: Tax Effects; Expenditure Effects; Magnitude of Effects; Why
do Effects on Work Effort Matter?
 
• B. Effects on Private-Sector Saving: Composition of Private-Sector Saving; Household Saving;
Business Saving; Conclusion.
 
• C. Effects on Private Investment: Nature of Investment Function; Profitability Effects; Loss
Offset and the Return to Risk; Research and Development.

• D. Growth Effects and Tax Incidence.

Continue….
• The preceding analysis dealt with taxation effects on the efficiency of
resource use in the private sector.
• Now we turn to the effects on the supply of resource and the level of
capacity output, i.e., the level of output or GNP which may be
reached under conditions of full employment of labor and full
utilization of capital stock.
Some assumptions on which This
chapter is based are;
• We assume for this purpose that the level of full-employment output
is maintained automatically, i.e., that aggregate demand neither falls
short of nor exceeds the value of this output as measured at
prevailing prices.
• By the same token it is assumed further that demand expands in line
with capacity output.
Capacity output:
Capacity output is the level of output or GNP which may be reached
under conditions of full employment of labor and full utilization of
capital stock.
Major determinants of capacity output :
• Since the supply of natural resources is more or less given by nature the
major determinants of GNP growth are
• the rates of growth of labor input and
• of the capital stock,
• and the speed of technical improvement.
 We begin with the effects of fiscal policy upon these variables
in the private sector.
EFFECTS ON WORK EFFORT

The effects of labor supply on economic growth are twofold.

• An increase in population results in an increase in output; but unless
output rises at the same percentage rate as population,
• per capita income will fall.
Tax Effects

• We begin with the effects of taxation on labor supply

• The tax generates
1. an "income effect"
2. a substitution effect

The tax generates an "income effect" which is favorable to working

more, so as to recoup lost income. But it also generates a substitution
effect which works in the opposite direction.
It can be explain graphically.
Continue…
Continue…..
• the wage rate prior to tax equals OA/OB and the worker may choose positions
on the opportunity locus AB. He or she selects C, the point of tangency, with
indifference curve i' and hours worked equal to DB.
• As a tax at wage rate AE/AO is imposed
• Suppose, however, that the slope of the lower indifference curve is as shown by
i"*. In that case, the worker moves to H, with work rising and leisure falling by ID
• The former case reflects an upward slope in the labor supply schedule, whereas
the latter reflects a backward-sloping schedule.
• If the labor supply schedule is upward-sloping( i.e we are at F), the negative
substitution effect outweighs the positive income effect and work effort is
reduced
Continue………..
• Even though we all seem to know someone who has been discouraged by taxation
and has worked less, most of us seem to respond by working more.
• But this much depends on the marginal rate of tax.
• Any one person will work less under a progressive than under a proportional rate
schedule if the same amount of tax is paid in both cases.
• Yet work effort for taxpayers as a group need not be lower under a progressive
schedule.
• The net effect depends on how wage earners at various points on the income scale
respond. Earners at the upper end (where rates will be higher than under a
proportional tax of equal yield) have more flexibility in hours worked but may also be
less responsive to changes in the net wage rate, since other forms of motivation
(prestige, interest in work, etc.) may dominate.
Sales tax:

But will not the disincentive effects be less severe than under an income
tax?
Note, however, that the comparison must be between taxes of equal yield
• the worker may escape the consumption tax by saving
• Since the consumption base is smaller, the rate of consumption tax must
be higher.
• If the tax rests on goods which are complementary to work (such as
work clothing).
• A tax on "leisure products" such as motorboats or vacation trips.
Expenditure Effects:

• Transfer payments may be treated as negative taxes.

The income effect accordingly is now negative and goes to reduce
effort. The direction of the substitution effect depends on whether
transfers rise or fall with income
• If they are related positively to income, as would be the case with a
wage subsidy or the earned income credit, the wage rate in effect
rises, yielding a positive substitution effect
• Two opposing effects enter so that as in the tax case, the outcome is
uncertain. Again referring to figure 17-1,
Continue…..
• we may now view EB as the pretransfer opportunity locus,
• with the worker at F. Introduction of the income subsidy swivels the
locus to BA, and the response may involve a move to positions such as
C or K.
• Defining now AB as a pretransfer locus, the transfer may be depicted
as a swivel in the opportunity locus to AL, with the worker moving
from C to M. Leisure also rises from OD to ON and work falls to NB.
Public Services
• Similar considerations also apply to the provision of public services.
• A general public service, such as the judicial system, has no particular
bearing on the work-leisure choice, thus leaving a neutral substitution
effect.
• This effect may be negative, however, if the service is in support of
leisure activity, such as improved road facilities to vacation sites; or it
may be work-inducing if the service is in support of work activities,
such as improved access to work locations
Magnitude of Effects:

• As tax and expenditure effects are combined, the difficulty of

predicting the net result further increases.
• In recent years studies have been undertaken, however, to measure
the magnitude of the taxation effect upon labor supply. These
estimates differ by type of worker but, on the whole, are modest in
magnitude
• For example,that the income tax reduces average hours worked by
married men by 8 percent
• Estimates also show that the labor supply effect on women is larger.
Why Do Effects on Work Effort
Matter?
• 1. Substitution of leisure for goods in response to a progressive tax-
transfer system may set an effective limit to redistribution.
• 
• 2. Differences in leisure responses greatly complicate the analysis of
just distribution.
• 3. Tax and expenditure policies which distort the choice between
income and leisure impose an efficiency cost.
• 4. A tax-induced reduction in work effort reduces output and GNP
B. EFFECTS ON PRIVATE-SECTOR
SAVING
Effects of tax policy upon saving in the private sector
matter because
 they bear on the division of resource use between
consumption and capital formation and hence upon
the growth of capacity output, and
 they enter into the effects of fiscal policy upon the
level of aggregate demand. Our present concern is
with aspect 1 only, aspect 2 having been dealt with in
earlier chapters.
Composition of Private-Sector
Saving:
• A large part thereof, however, goes into capital consumption
allowance or depreciation and is thus needed to maintain the existing
capital stock.
• Household savings
• Corporate savings forms one-third of it.
Household Saving:

• Household Saving as a Function of Income:

Based on differentials in the propensity to save, feasible tax structure
changes are not likely to have a major effect on the savings rate of the
economy.
• Household Saving as a Function of the Rate of Return:
Taxation effects on saving may result not only because the taxpayer's
income is reduced but also because an income tax reduces the net rate
of return on saving, thus lowering the rate at which the household can
substitute future for present consumption.
Continue….
• Consumption versus Income Tax:
Consumption taxes tend to be distributed regressively whereas an
income tax tends to be progressive in its distribution.
Business Saving:

• Depreciation Charges:
• much the larger part of business saving is in the form of capital
consumption allowances or depreciation charges. . Since the profits
tax is imposed after the deduction of depreciation, depreciation
reserves are not reduced by the profits tax.
• Retained Earnings:
Provided that the profits tax is not shifted, after-tax profits are reduced
by the tax. This reduction may in tum reduce corporate saving by
lowering retained earnings, or it may be reflected in reduced dividends.
 EFFECTS ON PRIVATE
INVESTMENT

• Saving is a necessary condition for capital formation but it is not a

sufficient one. Investors must also be willing to invest, and taxes once
more enter into this decision.
Nature of Investment Function
Even though theory tells us how investors should behave if they seek to
maximize profits, it does not follow that this describes how real-life
investors do in fact behave.
They may wish to maximize
• sales or
• market shares rather than
• profits, or
• they may apply rules of thumb which do not conform closely with
maximizing rules.
Continue…..
To assess the investment effects of taxation, a model of investment
behavior must be specified. Three major approaches may be noted:
• 1. Investment is expressed as a function of the expected net rate of
return.
• 2. Investment is considered a function of past changes in sales and of
existing capacity in relation to sales.
• 3. Investment is taken to be a function of the availability of internal
funds, including after-tax profits and depreciation charges.
Approaches
• According to approach 1, which • According to approach 2,
reflects the hypothesis of profit- investment responds to the need
maximizing behavior, investors for increased capacity generated
will invest up to a point where by past increases in sales, the so-
the present value of the called accelerator effect. Here
expected income stream equals the major impact of taxation is
cost. The profits tax here enters through its effects on sales,
by reducing the expected net including sales to consumers and
rate of return. to government.
Continue…
• According to approach 3, where the willingness to invest is
conditioned on the availability of internal funds, taxation enters via its
effects on the flow of such funds, whether it is in the form of
depreciation reserves or retained earnings.
Profitability Effects:

• Since economic analysis is typically based on approach 1, we must take

a closer look at tax effects on the profitability of investment or the net
(after-tax) rate of return.
• ASSUMPTIONS OF THE MODEL REPRESENTED BELOW:
1. Given an economy where full employment is maintained
automatically,
2. the levels of investment and saving are determined by the
intersection of the investment and saving schedules,
3. with investment determined as a function of the rate of interest and
saving dependent on both income and the rate of interest.
Model
explanation
• The model is illustrated in Figure 17-2, where II is the investment schedule showing the available
rates of return as investment proceeds at various levels (annual rates) and SS shows the supply
of saving (out of full-employment income) at various rates of interest. Before tax, the two are
equated at an interest rate and investment and saving equal OA.

•Required Return with Tax:

•Now a profit tax at rate DE/DO is imposed. As a result, the investment schedule expressed in
terms of net rates of return swivels downward as shown by I' I'. In the new equilibrium, the net
rate falls to OE, and investment and saving shrink to OC. As may be seen from the figure, the
decline in investment will be the larger the more elastic are both the SS and II schedules.
•In line with our later discussion, we note that the tax rate DE/DO is a function
• not simply of the statutory rate of tax, but also of the speed with which depreciation may be
taken
Continue….
• 1. The change in d and c can readily be limited to new investment and that
in t cannot. Since tax relief for old investment has no pay-off in incentive
terms, a greater incentive can be given (for an equal revenue loss) by
adjusting d or c.
• 2. An increase in c involves a larger immediate revenue loss to the
Treasury than does an equivalent increase in d. Whereas the present value
of the revenue loss to Treasury and investor are identical if both use the
same discount rate, the Treasury may use a lower rate so that raising d is
less costly. However, given imperfect credit markets and preference for
internal finance, some investors may prefer an increase in c.
• 
Continue……….
• 3. Most important, the various adjustments have different effects on
different types of investment.
Loss Offset and the Return

• If the tax worsens the odds by reducing the expected return,

investment will fall.
• However, it is not at all obvious that the tax really reduces the odds. A
tax will reduce the investor's return if he wins, but provided that loss
offset is allowed for, it will also reduce his loss if he loses.
• Given a proportional tax, both probable gains and probable losses
will be reduced at the same rate.
• Depending on the circumstances of the case, the tax may induce him
either to increase or to reduce his risk taking.
Graphical explanation
• The opportunity line OA shows the combinations of risk and return available to him by
choosing different mixes of cash and bonds. With 100 percent cash holding, he will be
located at 0 where he incurs zero risk and receives a zero return.
• If all his funds are invested in bonds, he will be located at B, with risk OC and return OD.
• Each indifference curve shows combinations of risk and return which are equally
satisfactory to him, with i2 superior to i 1 and i3 superior to i2
• Before tax, the investor places himself at E 1 , the point of tangency of the opportunity
line OA with the highest available indifference curve i2 . His risk equals OF and his
return equals OG.
• Now a 50 percent tax is imposed and we assume that full loss offset is assured. If the
investor does not change his portfolio mix, he will now find himself with half the risk
and half the return that he had before, i.e., in a position similar to that provided by
portfolio mix H prior to tax
• he will now choose to move from E 1 to K. At K his gross risk and return have doubled
but his net risk
and return are what they were at £ 1 before imposition of the tax.
• Although his private risk taking has remaineci unchanged, total risk taking, as seen from
the point of view of the economy as a whole, has increased.
 
D. GROWTH EFFECTS AND TAX INCIDENCE:
• In discussing the incidence of various taxes, we have seen that in the longer
run, the distribution of the tax burden will depend on the resulting effects on
factor supplies, rates of return, and growth.
• Viewing this problem in terms of "comparative statics," we have shown that
a tax on labor income, by depressing labor supply, may result in an increase
in the gross wage rate and a decline in the return to capital, so that the net
wage rate declines by less than the tax and capital shares in the burden.
• Although this properly describes the direction of adjustment, it does not
account for the truly long-run interdependence of capital and labor supply in
the context of balanced growth.
• The nature of this problem is complex, but the general conclusions reached
may be described by considering the substitution of a tax on capital income
for an equal-yield tax on wage income and examining the results under
various assumptions regarding factor supplies and savings rates.
Continue…..
I. Suppose first that the supply of both labor and capital is inelastic to the rate of
return and that the savings rates out of wage and capital income are the same.
II. Next suppose that the supply of labor is elastic, while retaining the other
assumptions.
III. The situation differs, however, if the supply of capital is elastic to the rate of return.
IV. Finally, consider a situation where both factor supplies are inelastic to the rate of
return but where the savings rate out of capital income is higher than that out of
labor income.
V. Putting situations 3 and 4 together, we conclude that the remaining share of the tax
burden borne by labor will be the larger (a) the more elastic the supply of capital
relative to that of labor and (b) the higher the savings rate out of capital income
relative to that out of labor income.
SUMMARY

In this chapter, various effects of fiscal measures on the level of

capacity output were considered. They may operate through effects on
work effort, saving, and investment.