LESSON 9
Tax efficiency, administrative efficiency and
flexibility
INTRODUCTION
This lesson focuses on the efficiency implications of taxation. At this stage, you should realise
that in economics we are trying to ensure the efficient use of scarce resources. Taxation can
cause inefficiencies and wastage. Did taxes influence your economic behaviour in the past?
For instance, did you ever buy anything that is taxed at a lower rate rather than something that
is taxed at a higher rate? Are you of the opinion that different tax rates should be applied to
different goods and services? Why? Have you experienced the high costs in terms of time taken
to fill-in your income tax returns? Do you realise that inflation causes your nominal income to
increase, which in turn, pushes you into a higher marginal income tax bracket? Does the tax
system adjust to these macroeconomic changes? In the 12th chapter of CSS tax efficiency and
the two remaining criteria for analysing taxes – administrative efficiency and the flexibility of
taxes – are studied.
After you have studied this lesson (and the prescribed sections in chapter 12 in CSS), you will
have a better understanding of
• the excess burden of a selective tax using indifference curve analysis
• the excess burden of a selective tax using the consumer surplus approach
• the importance of administrative efficiency
• the flexibility of the tax system
CONTENTS
9.1 Excess burden of taxation: Indifference curve analysis
As taxpayers, we are all too aware that taxes are a burden. In addition to the normal burden of
a tax, most taxes also cause an excess burden. Taxes cause relative prices to change, which
affect people's choices. For example, you are on your way to the supermarket to purchase a
big-screen high-definition TV and the Minister of Finance announces that the excise duty on
only the big screen HD TVs is to be doubled. The implication is that given your budget
constraint, you can now only afford a smaller TV. Therefore, in addition to the welfare loss
caused by the excise duty payable on the TV, the relative price change has caused an additional
loss in welfare since you cannot satisfy your first choice.
The concept of excess burden is explained in section 12.1. For comparison purposes, a lump-
sum tax is used as a benchmark tax. Two types of taxes are studied: selective taxes, which
distort relative prices, and general taxes, which do not distort relative prices. Budget lines and
indifference curves are used to illustrate that a selective tax causes an excess burden whereas a
general tax does not (see figure 12.1).
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When new taxes are designed or when tax changes are contemplated, policymakers have to
consider the excess burden of taxes. The objective should be the minimisation of the excess
burden of taxes (i.e. taxes should preferably be neutral).
STUDY
• Section 12.1 of CSS
ACTIVITY 1
Note:
Hints on answering the questions marked with an asterisk (*) are provided at the end of this
lesson.
(a) Explain what is meant by tax efficiency.
(b)* Evaluate the efficiency implications of a selective tax on Coca-Cola by using the
indifference curve analysis. [Hint: Measure Coca-Cola on the horisontal axis and all
“Other cold drinksˮ on the vertical axis and compare the selective tax on Coca-Cola
with a general tax on all cold drinks (Coca-Cola included).]
(c) Why are general taxes more efficient than selective taxes? Explain your answer by
using indifference curves.
9.2 Excess burden: Consumer surplus approach
We now know that selective taxes are inefficient from an allocative efficiency point of view
(provided, of course, that the allocation was efficient before the tax). But what is the true cost
of this inefficiency to the economy? The size of the excess burden of a tax can, at least in
principle, be calculated using the consumer surplus approach. When this technique is used to
determine the excess burden, two variables affect the outcome, namely the price elasticity of
demand and supply and the tax rate. (The original amount spent on the good before the tax also
plays a role, but for sake of simplicity we ignore this variable.) In section 12.2 it is shown that
the excess burden of a selective tax
• is greater the more elastic the demand curve is (known as Ramsey's inverse elasticity rule)
• increases by a multiple of the tax rate (i.e. broad-based general taxes are more efficient than
narrow-based selective taxes)
The tax optimisation rules derived above are explained using ordinary demand and supply
curves. These rules can also be explained using simple algebra.
STUDY
• Section 12.2 of CSS
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ACTIVITY 2
(a) Evaluate the efficiency implications of a selective tax by using the consumer surplus
approach.
(b) Define Ramsey’s inverse elasticity rule.
(c) “The excess burden of a tax quadruples when the tax rate doubles.” Explain this
statement using a diagram. What is the significance of this result for tax analysis?
9.3 Administrative efficiency
Taxes cause administrative costs and compliance costs. When taxes are designed, these costs
should be minimised. High compliance costs create incentives for tax evasion (it is illegal) and
tax avoidance (it is legal). Section 12.3 discusses these concepts and lists several ways in which
administrative efficiency can be enhanced. Section 12.3 also includes an analysis of how much
tax rational taxpayers will try to evade and what the tax authorities can do about it. You need
not study figure 12.5. It will suffice to know that tax evasion can be combated by using
• higher penalties (increase the cost of being caught)
• lower marginal tax rates (decrease the benefits from underreporting)
Note the issues that need to be considered when designing taxes to minimise administrative
inefficiencies.
STUDY
• Section 12.3 of CSS (excluding figure 12.5)
ACTIVITY 3
(a) Explain the meaning of administrative efficiency and how it can be achieved.
(b) Define tax avoidance and tax evasion.
(c) How can tax evasion be reduced?
9.4 Flexibility
In section 12.4 the macroeconomic stabilisation characteristic of taxes is discussed briefly.
Note that taxes can influence economic activity from the supply side and demand side. These
types of discretionary interventions must be distinguished from automatic stabilisers, which
have built-in flexibility.
STUDY
• Section 12.4 of CSS
ACTIVITY 4
(a) Define tax flexibility.
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(b) Compare automatic to discretionary stabilisers.
LOOKING BACK
Now that you have worked through this lesson do you still agree with the answers you gave to
the questions in the introduction of this lesson? After studying this lesson you should be able
to explain that selective taxes can cause inefficiencies as reflected in an excess burden. You
must also be able to explain how good taxes minimise administrative inefficiencies and are
flexible from a macroeconomic perspective.
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