An Analysis of Income and Consumption-Based Taxation (2002)

ABSTRACT An issue in state finance is always how to raise sufficient revenues to cover all the expenditures government is called on to make. This article utilizes a few simple analytical tools of economic analysis to aid in the choice of taxes to impose on citizens. INTRODUCTION Several states have recently raised their income tax rate while some have increased their taxes on such goods as alcoholic beverages and tobacco. It is almost certain that taxes will not go away. An issue in state finance is always how to raise sufficient revenues to cover all the expenditures government is called upon to make. It is hoped that the use of a few simple analytical tools of economic analysis can aid in an objective assessment of the question as to which taxes should be used to collect the revenue from the people. It is the contention of this paper that indifference analysis can be used in a simple understandable way to show on very objective grounds that the income tax is preferable to excise taxes for collecting any given amount of revenue from a citizen of state. Indifference analysis involves taking different combinations of any two products which would provide the same level of satisfaction or utility. This is illustrated in Exhibit 1 in which a consumer's taste for cigarettes is displayed relative to personal disposable income. What is shown on any particular indifference curve are combinations of physical amount of one product and amounts of income that will be spent on all other alternative products (or saved), with every point along the curve showing one level of utility. Any combinations on a higher difference curve is preferable to any of those on a lower curve. Indifference means sliding back and fourth on any curve, and preference means moving northeast to higher levels of utility. While the indifference curve shows the taste or choice preference of a person, a budget line shows the range of choice which a given budget permits a person to afford, given a market price for the products purchased. This is also illustrated in Exhibit 1. If a person has $36,000 in personal disposable income, the choice of spending can range from spending the entire amount on a product to spending nothing on it. In reality it will be something like point A where 1,000 units are purchased at a per unit price of $2.80 for a total expenditure of $2,800, leaving $33,200 to be spent on other things or saved. Point A is, in effect, a consumer equilibrium for the product given income, price of product, and tastes. With the above as background regarding our tool of analysis, this paper is now ready to come to grips with the question as to the effect of different types of taxes on a person's choice of products and level of want satisfaction that can be achieved with a given income level. The following assumptions are made: The pattern of indifference curves reflects the preferences of some typical person; this person has an annual personal disposable income of $36,000; the price of the product, cigarettes, is $2.80 cents per package; and just to avoid confusion, the assumption is made that there are no taxes initially on either income or cigarettes. Our typical person can purchase anywhere along budget line X; and since his preferences are reflected by the indifference curve, he chooses point A where $2,800 is spent on cigarettes and $33,200 is spent on alternative things. Point A is the highest level of utility he can achieve given this income and price for cigarettes. If the government now imposes a 50 cents per package excise tax on cigarettes, this will shift the budget line to Y and the now $3.30 price will permit maximum possible purchase of 10,909 packages. The person is lowered in his consumer equilibrium to B where 900 packages are purchased at $3.30 each for a total expenditure of $2,970. This leaves $33,030 for other spending. Out of this $2,970, the tax portion is $450 (900 x 50 cents). …