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Case Study When taxes induce people to change
their behavior—such as inducing Jane to buy less pizza—the taxes cause
deadweight losses and make the allocation of resources less efficient.
As we have already seen, much government revenue comes from the
individual income tax in many countries. In a case study in Chapter 8,
we discussed how this tax discourages people from working as hard as
they otherwise might. Another inefficiency caused by this tax is that it
discourages people from saving.
Consider a person 25 years’ old
who is considering saving $1,000. If he puts this money in a savings
account that earns 8 percent and leaves it there, he would have $21,720
when he retires at age 65. Yet if the government taxes one-fourth of his
interest income each year, the effective interest rate is only 6
percent. After 40 years of earning 6 percent, the $1,000 grows to only
$10,290, less than half of what it would have been without taxation.
Thus, because interest income is taxed, saving is much less attractive.
Some
economists advocate eliminating the current tax system’s disincentive
toward saving by changing the basis of taxation. Rather than taxing the
amount of income that people earn, the government could tax the amount
that people spend.
Under this proposal, all income that is saved
would not be taxed until the saving is later spent. This alternative
system, called a consumption tax, would not distort people’s saving decisions.
Various
provisions of the current tax code already make the tax system a bit
like a consumption tax. Taxpayers can put a limited amount of their
saving into special accounts—such as Individual Retirement Accounts and
401(k) plans—that escape taxation until the money is withdrawn at
retirement. For people who do most of their saving through these
retirement accounts, their tax bill is, in effect, based on their
consumption rather than their income.
European countries tend to
rely more on consumption taxes than does the United States. Most of them
raise a significant amount of government revenue through a value-added
tax, or a VAT. A VAT is like the retail sales tax that many U.S. states
use, but rather than collecting all of the tax at the retail level when
the consumer buys the final good, the government collects the tax in
stages as the good is being produced (that is, as value is added by
firms along the chain of production). Various U.S. policymakers have
proposed that the tax code move further in direction of taxing
consumption rather than income. In 2005, economist Alan Greenspan, then
Chairman of the Federal Reserve, offered this advice to a presidential
commission on tax reform: “As you know, many economists believe that a
consumption tax would be best from the perspective of promoting economic
growth—particularly if one were designing a tax system from
scratch—because a consumption tax is likely to encourage saving and
capital formation. However, getting from the current tax system to a
consumption tax raises a challenging set of transition issues.”
Q1:
What should be taxed – Personal Income or Personal Consumption and why?
Provide your opinion based on the case given above. (Minimum 200
words). [5 Marks]
Q2: How may it affect Saudi Economy if an income tax is imposed in KSA? (Min 200 words)? [5 Marks]
Q3: In each of the following cases, determine how much GDP and each of its components is affected? [5 Marks]
Ahmad spends $300 to buy his dinner at the finest restaurant in Boston.
Abdul spends $1500 on a new laptop to use it in his software company in KSA. The laptop was built in China. Jane
spends $1200 on a computer to use in her editing business. She got last
year’s model on sale for a great price from a local manufacturer.
General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them.
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