Written by George R. Zodrow

Taxation has always been a controversial topic, with many segments of American society having often very strongly held opinions on how the purchase of public goods and services should be financed. Politicians and their supporters, business owners and their employees, policymakers and academics, and liberals, conservatives, and moderates all have their views about the characteristics of a desirable tax system, based in large part on their perceptions of the ways that taxes affect the economy and the well-being of its citizens. In my Advanced Introduction to Taxation, I provide an overview of how public finance economists think about taxation, with the hope that such an exposition will shed light on the ongoing – some might say never-ending – debates regarding the economic effects of taxes and the features of an effective and equitable tax system. The book is designed to be a supplement for courses in Public Finance or Taxation at the advanced undergraduate or graduate levels, or for anyone with an interest in the effects of taxation and tax policy.

Public Economics is very much an applied micro topic, and the book is organized to reflect that. The introductory chapter provides an overview of the topic of taxation from a public economics perspective, and introduces some of the key concepts that are used throughout the book. Within the construct of the standard life-cycle model of individual economic behavior, it describes the two most commonly used tax bases – income and consumption – as well as other potential alternatives. It concludes with a discussion of the key aspects, both theoretical and practical, of the three criteria that are commonly used to evaluate tax systems – efficiency, equity, and simplicity.

I then discuss some of the many ways that taxation affects individual behavior. Chapter 2 examines the critical issue of taxation and labor supply, focusing on the basic theoretical models and a wide range of empirical results. I also discuss wage subsidies, in particular the very popular and much-studied Earned Income Tax Credit in the United States. Other topics include the dynamic modeling of labor supply decisions and attempts to reconcile the differences in the estimates of the responsiveness of labor supply to taxes found in the macroeconomic and microeconomic empirical literatures. Finally, I explore the concept of taxable income elasticity, which captures in a single comprehensive measure all of the many potential inefficiencies attributable to labor income taxation.

Chapter 3 examines the effect of taxation on saving behavior, arguably an even more important topic, in light of the crucial effects of changes in saving on investment, the capital stock, labor productivity, and wages.  The analysis again begins with an overview of standard theoretical models and some empirical results. But I also consider alternatives to the standard approaches, including models of precautionary savings and those based on the behavioral economics literature. Special topics examined include tax incentives for retirement saving, the effects of taxes on risk-taking, and the always controversial topic of income taxation of capital gains. This chapter concludes with an investigation of the critical question of the effects of different forms of taxation on the accumulation of human capital.

The analysis then turns to the taxation of businesses. Chapter 4 begins with the cost of capital model and marginal effective tax rates, illustrating a methodology that can be used to capture in an intuitive measure all of the effects of the complex tax systems that are typically applied to the returns to investment. I also analyze the empirical evidence on the effects on investment of both marginal and average effective tax rates. The analysis is then extended to what is often described as the most complex problem in taxation – the tax treatment of multinational enterprises. Chapter 5 explores this issue in depth, including not only investment incentive effects, but also such thorny topics as the nature and extent of income shifting and international tax competition, as well as the relatively new phenomenon of taxes on digital services. Chapter 6 examines the taxation of investment in housing, especially the still controversial role played by the property tax. It also considers several other issues related to taxation and investment, includingthe “new view” of dividend taxation, corporate minimum taxes, taxes on share repurchases, and the much-discussed issue of the taxation of the so-called “carried interest” earned by the managers of private investment funds.

A thorough understanding the effects of taxation on individual and business behavior is essential to the next step in the analysis, which is the construction of general equilibrium models of the U.S. and world economies. These models incorporate such responses and are often utilized to analyze and simulate the macroeconomic effects of tax reforms. Chapter 7 provides a thorough discussion of both analytical and computable general equilibrium models; it also includes two key applications – the controversial and still unresolved issue of the incidence of the corporate income tax, and the effects of what is often referred to as “fundamental tax reform,” that is, the replacement of the existing income tax with a consumption-based tax system.

The final chapter of the book explores the topic that has received the most attention in the public economics literature over the past fifty years – optimal taxation, which is the design of tax systems to maximize some measure of social welfare, taking into account the constraints imposed by revenue requirements and the behavioral responses to taxation of individuals and firms. I begin with the subject of optimal commodity taxation, the design of sales or value-added taxes to maximize a social welfare function designed to capture society’s efficiency and equity goals. I next examine the burgeoning field of optimal labor income taxation which, among other things, examines the optimal progressivity of the income tax system in light of society’s willingness to trade off its goals regarding equity and efficiency – a topic that has dominated the optimal taxation literature since the seminal papers of the early 1970s. Finally, the chapter investigates the optimal taxation of capital income, including analyses calling for tax exemption of capital income and qualifications to those results.

A discussion of optimal taxation is an excellent place to conclude the book. It illustrates the importance of understanding and accurately modeling the behavioral responses of individuals and businesses and all of their interactions, while also highlighting the extent of disagreement about the nature of optimal tax systems and the areas in which additional research will hopefully be successful in narrowing these disagreements.

That is my advanced introduction to taxation in a nutshell. I encourage you to take a look, and I hope that you find the book a useful interpretation of the huge and fascinating literature on the many and varied aspects of the economics of taxation and tax policy.

Advanced Introduction to Taxation

By George R. Zodrow, Allyn R. and Gladys M. Cline Chair of Economics, Economics Department and Rice Faculty Scholar, Center for Public Finance, Baker Institute for Public Policy, Rice University, USA

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