CHAPTER 1 - Tax Rates, Factor Employment, Market Production, and Welfare

Abstract

An increasing amount of attention has recently been devoted to the effects of alternative tax structures on the pattern of economic activity, on the level of taxable economic activity, and on the aggregate amount of revenue generated by the tax system. This chapter presents a static, one-sector, two-factor model to analyze the effects of taxes imposed purely for the purpose of generating revenues. The analysis presented in the chapter shows that increases in tax rates on factor incomes reduce the after-tax returns to factors, factor employment, and market output. The analysis also indicates that increases in tax rates could also reduce as well as increase government tax revenue. There exists a tax rate structure, which maximizes government tax receipts. This tax structure depends on the supply and output elasticities of the factors of production. The set of tax rates for which increases in the rates are accompanied by increases in government revenue is referred to as the normal range. Tax rates for which increases in the rates are accompanied by decreases in tax revenue are said to be in the prohibitive range. In general, a reduction in tax rates does not reduce total revenue in the same proportion. The more the elastic factor supplies are, the more likely it is that any given tax rates will fall into the prohibitive range. Also, the higher the level of tax rates, the more likely tax rates are to be in the prohibitive range.