Introduction to Economics –ECO401
VU
If i>ii: the government is said to be running a fiscal or budget deficit and so the government must borrow (or raise debt) to cover the deficit; if i<ii: the government is said to be running a fiscal or budget surplus and so the government can pay-off or reduce its debt; if i=ii: the government is said to be running a balanced budget and the government’s net debt may remain constant. Fiscal deficits and debt are often reported as a ratio of GDP. Although, there is no theoretical benchmark for what constitutes a sustainable fiscal deficit or public debt ratio, the Maastricht criteria (for countries in the European Union) is an important practical guide. It stipulates that fiscal deficit to GDP should be less than 3% while public debt to GDP should be less than 60%. THE CONCEPT OF TAXATION Taxes are general purpose, compulsory contributions by the people to the public treasury (or national exchequer) to meet the expenditure needs of the government. Without taxes, the government would not be able to deliver services like law and order, public administration, national defense, free or subsidized health and education etc. Since taxes interfere with the market mechanism, they are considered distortionary, and as such there is a long-standing debate over the desirability of taxes. In a way, the stance over taxation defines the economic “right” and “left” in HICs. The market-friendly right (like the Republicans in the U.S. or the Conservatives in the U.K.) believe in reducing the size of the government and its spending so that most of the services in the economy are provided by the private sector. As such they can argue for lowering taxes (since government spending is also less) which according to them distort private sector incentives (remember the Monetarist argument for removing income taxes in the context of unemployment). By contrast, the interventionist left (like the Democrats in the U.S. or the Labour in the U.K.) consider that a big and active government essential for the delivery of better public services and therefore are often against cutting taxes and transferring the responsibility of providing these services to the private sector. THE DEBATE OVER TAXATION There are two dimensions to the debate over taxation: equity and efficiency. The Concept of Equity: Equity represents that principle of taxation which emphasizes fairness or just sacrifice, i.e. everyone should pay tax according to his/her ability. So if a person earns higher income, s/he should be subjected to a higher tax rate. Thus, for e.g., a person earning Rs. 2,000 a month should sacrifice 10% of his/her income as taxes (i.e. Rs.200), whereas a person earning Rs. 200,000 should sacrifice 60% of his/her income as taxes (i.e. Rs. 120,000). In the absence of such progressive taxation, the rich person would have also paid a 10% income tax rate (i.e. Rs. 20,000). Progressive taxation, in which the tax rate increases as income increases, is an application of the vertical equity principle which espouses the Robinhood approach of taking money from the rich and distributing it to the poor. While controversial, the vertical equity principle in taxation is applied in one way or another in most countries across the world. Horizontal Equity: A less controversial principle relates to horizontal equity which says: identically well-off people should be taxed identically, i.e. no discrimination due to race, gender, caste, religion etc. There are many examples, however, of violation of this principle and often one comes across an individual belonging to a certain community or grouping enjoying certain economic privileges not enjoyed by a similarly endowed individual of another community or grouping. We now turn to the efficiency dimension, which concerns the distortionary effects of taxation, esp. the possible negative effects on private sector behavior and incentives. The more distortionary a tax, the higher the efficiency concerns surrounding it. The Concept of Efficiency: To illustrate the concept of efficiency, it is useful to develop an understanding of what is meant by a Pareto-efficient allocation of economic resources. This is a situation in which it is impossible to move to another allocation which would make some people better off and nobody worse off. In the context of the production possibilities frontier, therefore, points on the frontier are all Pareto-efficient, as it is not possible to move to another point (i.e. produce more of one good) without incurring some opportunity cost (i.e. sacrificing the production of some other good). © Copyright Virtual University of Pakistan
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