TAX ANALYSIS AND REVENUE FORECASTING -- Issues and ...

[Pages:191]TAX ANALYSIS AND

REVENUE FORECASTING

-- Issues and Techniques ?

By Glenn P. Jenkins Chun-Yan Kuo Gangadhar P. Shukla Harvard Institute for International Development Harvard University

June 2000

Acknowledgement This book is the result of the effort of many people. Daniel Alvarez-Estrada was the first one to attempt to organize a set of teaching notes into a meaningful manuscript on tax analysis and revenue forecasting. He has assisted in each phase of this endeavor over a period of four years. Roy Kelly, Jonathan Haughton, Graham Glenday, George Plesco and Anil Gupta made major contributions, at an early stage, of their teaching notes and, subsequently, made comments and suggestions. Rubi Sugana and Le Minh Tuan have been veterans of this effort to develop a coherent curriculum in tax modeling and revenue forecasting. Their contribution has been enormous and greatly appreciated. Alberto Barreix has been the source of numerous good ideas and our valued colleague in the Tax Analysis and Revenue Forecasting Program at Harvard University since its inception. Finally, it was Roshan Bajrachaya who worked with us to make the revisions to the manuscript that has produced this current edition. His assistance is greatly appreciated.

_______________ Glenn P. Jenkins is an Institute Fellow at the Harvard Institute for International Development, Chun-Yan Kuo is a Senior Fellow of the International Institute for Advanced Studies, Inc., and Gangadhar P. Shukla is a Development Associate at the Harvard Institute for International Development, Harvard University.

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Table of Contents

Chapter

Pages

1. Functions of the Tax Policy Unit

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1.1 Monitoring of Revenue Collection 1.2 Evaluation of Economic, Structural and Revenue Aspects of Tax Policy 1.3 Tax Expenditure Analysis 1.4 Evaluation of the Impact of Non-Tax Economic Policies 1.5 Forecasting of Future Tax Revenues 1.6 Summary

2. Macro Foundations of Revenue Forecasting

16

2.1 Points of Tax Impact 2.2 National Accounting 2.3 An Example: from GDP to Personal Income 2.4 Savings and Investment 2.5 Summary Appendix: Nominal versus Real Prices

3. Tax Elasticity and Buoyancy

35

3.1 Tax Buoyancy 3.2 Tax Elasticity 3.3 Examples 3.4 Summary Appendix: Computation of Buoyancy

4. GDP Based Estimating Models

48

4.1 Dynamic versus Static Models 4.2 Alternative Approaches 4.3 Details of the Proportional Adjustment Approach 4.4 Summary Appendix: Steps in Calculating Tax Elasticity

5. Statistical Analysis and Micro-Simulation Techniques for

Revenue Forecasting

64

5.1 Introduction 5.2 Data Sources 5.3 Data Validation 5.4 Statistical Analysis

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6. Personal Income Tax Models

77

6.1 Introduction 6.2 Development of the Database 6.3 A Typical Taxpayer Model 6.4 An Aggregate Tax Model 6.5 Concluding Remarks

7. Corporate Income Tax Models

94

7.1 Introduction 7.2 Data Development 7.3 Micro-Simulation Models 7.4 Macroeconomic Forecasting Models Appendix: Stacking Order

8. Value-Added Tax Models

117

8.1 Introduction 8.2 A Credit Invoice System 8.3 Alternative Approaches to Estimate the VAT Base 8.4 Input-Output Model Simulations 8.5 Summary Appendix: A Revenue Forecasting Model for the Mexican VAT

9. Excise Tax Models

147

9.1 Introduction 9.2 Impact of the Excise in the Single Market 9.3 Impact of Excises in Multiple Markets 9.4 Effect on Revenue when Income Rises 9.5 Summary Appendix: Calculation of Elasticity

10. Trade Tax Models

169

10.1 Application of Import Tariffs: Geometry 10.2 Application of Import Tariffs: Formula 10.3 Imposition of Export Duties 10.4 Revenue Forecasting 10.5 Effect of a Change in Tariff Rates on Revenue 10.6 Effect of a Devaluation in Domestic Currency on Revenue 10.7 Summary Appendix: Steps in Calculating Tax Revenue from Imports

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Chapter 1 Functions of the Tax Policy Unit

Tax analysis and forecasting of revenues are of critical importance to governments in ensuring stability in tax and expenditure policies. To augment timely and effective analysis of the revenue aspects of the fiscal policy, governments have increasingly turned toward in-house tax policy units rather than relying on tax experts from outside.

These tax policy units have been increasingly called upon to analyze the impact of tax policies on the economy and to estimate the revenue implications of tax measures, with the ultimate objective of ensuring a healthy fiscal situation within the economy. Tax policy units also help ensure that tax systems are efficient, fair, and simple to understand and comply with. Such systems help to create an economic environment that is conducive to greater social justice.

The tax policy unit of any government has the following broad functions:

(a) Monitoring of Revenue Collection; (b) Evaluation of the Economic, Structural and Revenue Aspects of the Tax Policy; (c) Tax Expenditure Analysis; (d) Evaluation of the Impact of Non-Tax Economic Policies; (e) Forecasting of Future Tax Revenues.

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1.1 Monitoring of Revenue Collections

To ensure a balanced budget and/or to curtail deficit financing, it is of the utmost importance for the Ministry of Finance to be able to effectively monitor not only the expenditure side but also the collections of tax revenues on a regular basis. Depending upon the level of sophistication of the monitoring system, it is possible to track major sources of revenue collection on a weekly or daily basis.

In order to perform this task, it is necessary to establish an effective information system within the government. A proper measurement of actual revenue collection vis a vis expected revenues is possible only if there is a well-developed database. This database should provide the main input for analysis of tax functions, including behavioral responses to new tax measures, revenue forecasting and tax expenditure analysis. Hence, the collection of data for the database and its computerization are pre-requisite conditions for the establishment of an efficient revenue collection and monitoring system.

1.2 Evaluation of the Economic, Structural and Revenue Aspects of the Tax Policy

A country's tax system reflects its evolutionary response to various social, economic, and political influences.1 The form of a tax system, therefore, has wide economic, political, and social implications. In the process of policy formulation, each tax policy unit has to weigh tax policies in terms of the following basic criteria.2

1 Richard A. Musgrave and Peggy B. Musgrave, Public Finance in Theory and Practice, (McGraw-Hill Inc., 1989), Chapter 12, pp. 216.

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A. Economic Efficiency

First of all, any tax on goods and services increases the price of a good by adding a percentage of the price (ad valorem tax) or a fixed amount of money (specific or unit tax) to the original price. This creates a gap between the value that the consumer pays for the good (demand price) and the economic resource cost of production (supply price). If the tax is not designed to offset another market externality, it will create a distortion in the market that will affect the behavior of consumers and/or producers. Such a distortion will have a cost attached to it that the economy has to bear, known as the deadweight loss. If, however, we start with a tax distortion in one market (i.e., there are some constraints that prevent a first-best optimum), then adding yet another distortionary tax can be beneficial.3

Market distortions of any kind, as a result of a tax, create a loss of economic efficiency (e.g., a loss of consumer and producer surpluses). The size of this loss depends primarily on the price elasticities of demand and supply of the items whose markets are distorted, as well as on the rate of the tax imposed. The higher the price elasticity of demand/supply, the higher the inefficiency introduced into the market by the tax. Also, high tax rates lead to larger economic efficiency costs. A tax is said to be efficient if the deadweight, or efficiency loss, is small. These efficiency losses can be substantial. Empirical studies of efficiency loss for the US have found it to be in the range of 17 to 56 cents per dollar of tax revenue.4

Taxes, such as an income tax or a tax on goods and services with an inelastic demand/supply, tend to have a smaller impact on producer or consumer behavior and, therefore, cause less of a distortion in the economy. At present, the economic efficiency

2 See, e.g., Department of Finance Canada, Guidelines for Tax Reform in Canada, (October 1986).

3 For a simple presentation, see Lipsey and Lancaster, Review of Economics and Statistics, v. 24, no. 1, (1956-57), pp. 11-32.

4 There have been a number of empirical studies on this issue. See C.L. Ballard, J.B. Shoven and J.

Whalley, "General Equilibrium Computations of the Marginal Welfare Costs of Taxes in the United States", American Economic Review, (March 1985).

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of a tax is an important issue, although not the sole consideration, when designing an efficient tax system, reflecting a significant departure from the approach of the 1970s/80s, which was based primarily on the tenets of "Optimal Taxation."5

Efficiency criteria for any tax system require that the tax be neutral. That is, the tax should create neither major distortions in consumption and production behavior nor change private investment decisions by favoring one set of investments over the others.

B. Economic Growth

Every good tax system should foster economic growth in its country. This can be achieved primarily through the expansion of savings and the direction of investment into high return activities. An efficient tax system should also be a deterrent to the disincentive to work, which occurs in countries where there is a very high payroll tax.6

In order to stimulate higher economic growth, well-designed tax systems should encourage competitive growth across various sectors of the economy. Even more importantly, the distortion and/or opportunities created by a tax system should not be the cause for tax planning, but provide direction towards more productive endeavors through lowering the tax rates, eliminating tax on tax and widening the base.

C. Revenue Adequacy

Budget expenditures and revenue estimates are usually done within a specified framework of economic assumptions reflecting the level of the expected GNP growth rate, the rate of inflation, and other macroeconomic variables. Revenue estimates are undertaken with respect to these underlying macro variables. Besides the influence of

5 J. Slemrod, "Optimal Taxation and Optimal Tax Systems," J.Ec. Perspectives, (Winter 1990).

6 In countries like Ukraine and Vietnam, the higher tax rate ranges between 52% and 72%.

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