metadata: authors: 0: author: Yitzhaki, Shlomo
1: author: Thirsk, Wayne
count: Cote d'Ivoire
docna: 0: docna: Welfare dominance and the design of excise
            taxation in Cote d'Ivoire
docty: Policy Research Working Paper
subtopic: Tax Administration,Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Tax Law,Disability,Public Sector Economics,Tax Policy,Transport in Urban Areas,Services & Transfers to Poor,Urban Transport,Energy Policies & Economics,Economic Assistance,Access of Poor to Social Services,Public Finance Decentralization and
            Poverty Reduction
teratopic: Poverty Reduction
abstracts: cdata!: Governments in developing countries are
            continuously searching for new and improved tax bases.
            Existing methods of taxation in these countries frequently
            fall short of meeting acceptable criteria of efficiency,
            equity and administrative ease.  This paper argues that
            there is a compelling fiscal rationale for encouraging
            greater reliance on taxing the consumption of electrical and
            telephone (ET) services. Greater emphasis on this selective
            commodity tax base would contribute to the achievement of
            taxpayer equity and would be administratively easy to
            impose. In addition, the efficiency characteristics of this
            form of taxation may also add to the attractiveness of the
            ET base.
geo_reg_key: 1927320,517191
repnme: repnme: Welfare dominance and the design of excise
            taxation in Cote d'Ivoire
display_title: Welfare dominance and the design of
            excise taxation in Cote d'Ivoire
listing_relative_url: /research/1988/08/700677/welfare-dominance-design-excise-taxation-cote-divoire
topicv3: Power and Electricity Sector m1327094 515,Social Assistance m1327201 1466,Mass Transit m1327372 1726,Taxation m1327615 1121,Tax Policy m1327616 983
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Policy Plan & Prog Review Dept
no_of_pages: 42
model_extractions: **Polay nning, and Rd"c**

# **Public Economba**

There is a compelling fiscal rationale for encouraging greater reliance on taxing the consumption of electricity and telephone (ET) services.

ET taxes are easy to administer. Enforcement and collection of the tax is relatively inexpensive, since the tax can be added to comrnercial charges, and the services quickly turned off for nonpayment. It is not difficult to distinguish in most cases between business and personal use of these services. ET taxes avoid the problems of smuggling and evasion commonly associated with taxing the production or use of commodities that can be imported.

On equity grounds, in COte d'lvoire at least, ET taxes are clearly the most desirable excise taxes. Ranking alternative commodity taxes with high income elasticity, telephone services - clearly dominate and electricity consumption nearly dominates - the taxation of alcoholic beverages and public transportation.

These conclusions on the distributive impact of altemative indirect tax measures are reached through the application of the relatively new concept of marginal conditional welfare dominance. A commodity tax dominates others on social welfare grounds when a marginal shift in the balance of commodity taxation toward that particular comnodity enhances social welfare.

Using household budget data, such dominance can be established statistically and shown graphically without resort to normative considerations. T'is approach suggeats that ET services may be an underexploited tax base in many developing countries.

ET taxes may also meet the test of relatively high efficiency if they can be implemented thomugh a two-part pricing schedule that charges a flat fee for access to service and an additional escalating fee for marginal use.

This paper is a product of the Public Economics Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Ann Bhalla, room N10077, extension 60359.

The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and Research Complex. An objective of the series is to get these fmdings out quickly, even if presentations are less than filly polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.

Copyright i 1988 by the International Bank for Reconstruction and Developmnent/lhe World Bank
# Welfare Dominance and the Design of Excise Taxation in C6te d'Ivoire

by Shlomo Yitzhaki and Wayne Thirsk

# Table of Contents

A. The General Case for an ET Tax ..................... 2 B. The Concept of Welfare Dominance ................... 4 C. Welfare Dominance and ET Taxes in the C6te d'Ivoire 17 D. Sunming Up ............ 27 Endnotes ................. ,.31 Appendix ......................... 33 References ........... 37
Governments in developing countries are continuously searching for new and improved tax bases. Existing methods of taxation in these countries frequently fall short of meeting acceptable criteria of efficiency, equity and administrative ease. This paper argues that there is a compelling fiscal rationale for encouraging greater reliance on taxing the consumption of electrical and telephone (ET) services. Greater emphasis on this selective commodity tax base would contribute to the achievement of taxpayer equity and would be administratively easy to impose. In addition, as argued later on, the efficiency characteristics of this form of taxation may also add to the attractiveness of the ET base. These advantages are described below.

This paper makes further use of the notion of marginal conditional welfare dominance in exploring the equity implications of adopting the ET tax base in the Cote d'Ivoire. In an earlier set of papers Yitzhaki and Olkin (1987) and Yitzhaki and Slemrod (1987) have developed this concept and applied it to an investigation of the redistributive impact of commodity taxation in Israel. In this paper, we develop an extension of this methodology by introducing dead-weight loss considerations into the analysis. We also consider some other excise tax bases besides electricity and telephones.

If a commodity tax dominates others on welfare grounds it means that, for a wide class of secial welfare functions, social welfare will be

**Massllfu/Wolfare** Dominance & the Design of Excise Taxation in the Cote D'Ivoire/WThirsk:ab/5/18/88
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enhanced by a marginal shift in the balance of commodity taxation towards that particular commodity. There is nothing in the methodology that guarantees a complete ranking of alternative commodity tax structures can be obtained but, in the countries examined so far, a partial ranking is feasible and serves to identify some tax bases that are promising on distributional grounds. In the C6te d'Ivoire, and possibly other developing countries as well, the ET base is one of these.

The remainder of this paper is organized as follows. The overall merits of adopting an ET ttz are discussed in the section below. After that the concept of marginal conditional welfare dominanc 'teria is more fully explained, and its application leads to utilizing u - 1-known tool for analyzing tax incidence, the concentration curve. (See Pfahler, (1987) and the literature cited there). The application of this approach to the ranking oL alternative taxes in the C6te d'Ivoire is discussed in the next section. The final part of the paper summarizes the main arguments and examines some of the ways in which they may be extended in future work.

# A. The General Case for an ET Tax

Although commonly deployed in developing countries, commodity taxes are felt to have limited appeal and to be tolerated only until superior methods of taxation, usually related to incomes, can be cultivated. - Objections to commodity taxes come from several directions. Broad-based commodity taxes on consumption such as a value-added tax (VAT), are viewed as efficient revenue instruments but are frequently objected to MeasllW4/Welfere Dominance & the **Design** of Excise Taxation in the Cote D'Ivoire/WThirek:ab/5/18/88
- 3 -

on distribution grounds, i.e. "making the poor even poorer". Efforts to narrow the VAT base and make it more distributionally acceptable normally give rise to problems of administrative complexity and, to the extent exemptions are used to grant relief, create numerous economic distortions that detract from economic efficiency. Moreover, in many developing countries more narrowly based commodity taxes are inappropriately levied on production rather than consumption.3! Production taxes may be easier to collect but they also lead to tax cascading which seriously distorts economic behavior and generates a haphazard pattern of tax incidence.

In a number of developing countries the challenge facing commodity taxation is to get taxes off of production and onto consumption that is linked to ability to pay and to do so in a way that is administratively feasible. The ET tax base offers one response to this challenge. First, as shown below, a wide range of social welfare functions would approve of its adoption in the C6te d'Ivoire for income distribution reasons and we suspect that the same result would hold in many other developing countries. Secondly, it is relatively easy to distinguish business from residential use of electricity and telephones; the only major difficulty occurs whenever households operate a business from out of their home. Mainly for this reason Cnossen (1978) argues that it is better to tax all usage of telephones. Thirdly, enforcement and collection of the tax is relatively inexpensive since the tax can be easily added on to commercial charges and services can be quickly turned off in the case of noncompliance. Fourth, because it applies to a nontradeable service, the ET tax does not have to grapple with the issue of taxing imports and domestic production in a fair 4assll#4/Welfare Dominance & the Design of Excise Taxation **in** the Coto D'Ivoire/WThirsk:ab/5/18/88
and consistent manner. Smuggling and evasion, common problems with excise taxes on commodities, will not emerge under an ET tax.

Finally, although there is much less certainty on this score, the ET tax may be a relatively efficient tax instrument because it can effectively burden infra-marginal units of consumption. Significant installation or hook-up charges may be able to capture a sizeable fraction of the consumers' surplus from using these services and allow lower rates to be charged for marginal usage witn correspondingly smaller distortions of consumer choice. Charging a fee for access to the service effectively introduces an element of poll taxation into the tax system and this feature of the tax may render it a relatively efficient instrument of taxation.

Of all of the merits add-:essed in support of the ET tax base, the one that is examiined in greater detail below is the claim made for its distributive superiority. As will be seen, the ET tax base dominates other commodity tax bases on income distribution grounds tn the C6te d'Ivoire.

# B. The Concept of Welfare Do".inance

As explained more fu.ly in Yitzhaki and Slemrod (1987), the notion of marginal conditional welfare dominance (hereafter welfare dominance) has its origins in the theory of finance. In the fin nce literature asset A is said to stochastically dominate asset B in the investor's portfolio if, given the composition of other assets in the ptrtfolio, the investor's expected utility is always enhanced whenever a small amount of asset A is substituted for asset B. The only restriction imposed on the investor's Massll#4/Welfare Dominance & the Design of Excise Taxation in the Cote D'Ivoire/WThirsk:ab/5/S8/88
. 5 utility function is that the marginal utility of income be a non-' creasing function of income.

In a certain world .. . commodity taxation the analogous question is whether substituting one coituodity tax for another in a revenue-neutral fashion will improve social welfare. Frequently the answer to this type of question has depended on the exact shape of the social welfare function. In the optimum tax literature, for instance, the analysis of desirable commodity tax structures often has been bedevilled by sensitivity to the exact specification of the social welfare function.

The concept of welfare dominance does not suffer from the same defect. It adopts a Utilitarian formulation of the social welfare function which is distributively neutral since each household or income class receives the same ethical weight. The only assumption required is that the marginal utility of income be a non-increasing function of real income. If a particular tax substitution is shown to be welfare dominant under this assumption it will be true a fortiori for all other social welfare functions which exhibit some greater degree of aversion to income inequality.

Formally, the argument can be constructed along the following lines with the aid of the notation below: W - level of social welfare vh - level of utility attained by the h'th household, Massll#4/Welfare Dominance & the Design of Excise Taxation in the Cote D'Ivoire/WThirsk:ab/5/18/88
-6

where vh _ (P1, .. Pn, Yh) is the indirect utility function Yh - money income received by the n'th household xh- amount of the J'th commodity consumed by the h'th household

- Pj consumer price for the jth commodity

h Xi - total consumption of commodity j (Xi - Zh **xj** For a distribution of H households the Utilitarian social welfare function can be expressed as: and it is assumed that Vy > 0 Vyy S 0. For simplicity of presentation we assume that initial producer prices are all equal to one.

Consider next the following hypothetical experiment. For a revenue neutral commodity tax substitution a small increment in the tax rate levied on the i'th commodity must be accompanied by a small decrement in the tax rate on the jth commodity. The first-order approximation to the change in social welfare is

**Massll#AlWelfare** Dawinance & the Design of **Excise** Taxation in **the** Cots D'Ivoir*/WThirsk:ab/5/18/88
-7-

where h is the derivative of the h'th household's utility with respect to the i'th price. Using Roy's identity we can write (2) as where Ah is the marginal utility of income of the h'th household.

Let us turn now to the revenue constraint of the government. Total commodity tax revenue, R, can be expressed as: (4) R { , tk Xk

-where Xk **Eh** 1 Xk and tk is the ad valorem tax rate applied to the k'th

commodity. Revenue neutrality requires that and by simple algebraic manipulation we can write equation (5) as where a The parameter a determine the rate of substitution between the changes in the two prices and captures the efficiency dimension of the tax substitution. It can be interpreted as the differential welfare cost of raising public funds by taxing the i'th commodity more heavily and using the proceeds to subsidize the J'th commodity. To see this interpretation

**Massllf4/W*lsr* Dominanoe** & **the** Design of **holeO** Tasztion In **the** Coto D'ZvoIre/WThirak:Ab/5/18/88
more clearly, conslder a commodLty tax substitution where the iniclal tax bases, XL and Xj, are of equal size. In this case, if a er,ceds one it requires more than a dollar of extra taxes from the i'th commodity in order to redutce the consumer price of the j'th commodity by one dollar. Of course, careful inspection of the expression for a reveals that it may be just as easily less than ona since it measures tne interaction of the commodity tax substitution with the initial tax distortions tk. In the absence of pre-existing commodity taxes, the value of the a parameter would simi Afy to one.3/ If income were fixed, implying that nontaxable leisure consumption was independent of the design of commodity taxation, it is easy to see that uniform, across-the-board indirect taxes (a general sales tax for example) would be superior on efficiency grounds. With no change in relative prices all of the derivatives in the expression for a would have a value of zer, and thei value of a would be simply one. Of course the optimal tax literature allows for interactions between the consumption of leisure and commodities or treats leisure as an untaxed commodity and, under these circumstances, non-uniform commodity taxes generally will have the highest efficiency rating. Here, our task is to suppress the efficiency issue and seek to discover instead which excise tax bases are preferable on distribution grounds.

In the special case whe!t All cross-price-elasticities are zero, a reduces to the simpler expression

**Masall#A/Welfaxe D-inaee & the** Dealsn of **Exies** Taxation in **the** Cote D'IvoirlWbThirsk:ab/5/18/88
-9

where v~. and 'i are uncompensated price elasticities. Note that a **-** oij; that is, the value of a may be different for each particular commodity tax substitution. As we show later, it i8 important to know whether a is more or less than unitv. In the special case under consideration, since a will be smaller than one it ti is negative and tj is positive; that is, if the reform reduces an initial subsidy attached to thn i'th commodity. In this situation a lower level of both subsidization and taxation produces a gain in economic efficiency. Conversely, if tj is negative (an initial sui.aidy) and ti is positive, a must be greater than one as the overall _1trel_ of fiscal distortion is increased. Other alternative reforms are morc difficult to sign. Note, however, that aij can be estimated from a modes. with a representative consumer which ignores distributional considerations.

Substituting (6) into (3) and rearranging terms we obtain the principal result: If this expression is positive, then social welfare is enhanced by the tax reform. Note that, if the households are ordered according to their income, Ah is a decreasing function of income and h, the rank in the Massel/Welfare Dominance & the Design of Excise Taxation in **the** Coat D'1voir*/WThIr:k:ebI5118/88
10 income distribution. Also, note once again that dPj is negative for the experiment that is described.

# If household h benefits from the reform, it follows that

while if the inequality is raversed that household's welfare is diminished. If households are ordered according to their income, a necessary condition for expression (7) to hold fo- all admissible social welfare functions is that, for the poorest household consuming x1 and xi, Otherwise, a maxi-min social welfare function that cares only for the welfare of the poorest hous3hold would show a decline in social welfare.

In a similar fashiom. the next poorest household, whose 2 2 consumption pattern is denoted by xi and xj. experiences an increase in welfare if However, aggregate welfare could increase even if the second household were harmed by the reform. With declining marginal utility of income the sum of both welfare changes is positive if <!-- Start of picture text --> x1 +x2 x1 + 2<br>Xi i a X i 2- 0<br>j i<br><!-- End of picture text --> Massll#4/W.lfare Dominance & the Design of Excite Taxation in **the** Cote D'Zvoire*tVhrsk:ab/5/18S88
- 11 -

Generalizing from the preceding argument, the requirement for welfare dominance can be stated as follows. For a revenue neutral commodity tax substitution which shifts tax burdens from the j'th to the i'th commodity, social welfare will increase if the following condition is satisfied: The expression contained in brackets in equation (8) can be interpreted as the vertical difference between the concentration curve of the jt'th commodity minus a times the concentration curve of the i'th commodity. A concentration curve is similar to the more familiar Lorenz curve but instead of total income it compares the fraction of total expenditure on a commodity that is attributable to different income groups when they are arranged, starting with the poorest group, according to the size of their income. If the value of a is unity, welfare dominance occurs whenever one concentration cure lies wholly above another throughout the entire range of the cumulative distribution of income. Alternatively, the vertical difference between two concentratior. curves, hereafter referred to as DCC, must b- positive for welfare dominance to occur. If, on the other hand, two concentration curves intersect, taxation of one commodity cannot be said to dominate the other. That is, one can always find two plausible welfare functions which rank the commodities in contradicting orders. For a thorough discussion of the properties of concentration curves see Kakwani (1160), Pfahler (1987), Nygard and Sandstrom (1981) and Yitzhaki and Olkin (1987).

**Masa11I/WeLfare** Daminmnce **& the** Design ot lExcis Taxation in the Coto D'Ivoire/WThirak:ab/5/18/88
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The left hand panel of Figure I portrays a situation in which a revenue neutral tax *ubstitution from commodity A to commodity B is welfare dominant. The absence of welfare dominance is indicated in the right hand panel of Figure I where the two concentration curves cross. Welfare dominance is also impossible to achieve whenever a exceeds unity. To see this note that whenever a is unity the graph for the concentration curve starts at coordinates (0,0) and ends up at (1,1). If a exceeds unity, however, at least for the richest household, the difference between the concentration curve of commodity A minus a times the concentration curve for commodity B must be negative. The reason for this outcome is simple. With an increase in deadweight loss, any welfare function with constant marginal utility which does not care for redistribution will indicate a deterioration in social welfare.

In Panel C of Figure I a is assumed to ae larger than one and, - since the DCC curve ends up at the coordinates [1 a, 1], the DCC curve either crosses the horizontal axis at least once or never rises above it. Welfare dominance is ruled out when this happens. If, however, a is less than one, the DCC will end up in the positive orthant as shown in Panel D of Figure I. In this case an overall efficiency gain is indicated but welfare dominance still requires that the DCC curve remain above the horizontal axis.

In a separate appendix we explore some additional features of the DCC curve. Assuming that a has a value of unity, we show that the curvature of the DCC curve has an interesting welfare interpretation. Specifically, the slope of the DCC curve at a particular income level

**MOSa11#Iwsfetre Damnuice C the Desin** of **Exciseo** Taxtion in the Cots DIvoir5/WThiruk:^b/5118/88
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**_,ll prs_** IS TR 3UIU of XWU uaiacz

<!-- Start of picture text --> A. Velfare domluance of co@odity l. o welfe drodamee<br>S over A<br>450<br>Cs IL~~I<br>° ?ramt of com s 1c 0 potenlt of colu_n 1<br>Q ~~p e swe of eons_rc pe1rent of<br>Masl141elav Dinno te Desig of EcisemTaxa1o inth Ct Dgvie a*aka fs 68<br>ILLx<br>0 0<br><!-- End of picture text -->
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representing the poorest F families in the cumulative distribution measures the gain in real income experienced by the family at that income level. Similarly, the size of the DCC curve itself indicates the cumulative gain of the poorest F families over the range of incomes when the DCC curve is increasing. Losses, on the other hand, occur whenever the DCC curve is decreasing and, over the entire range of the DCC curve, there is no net gain or loss as long as a is one.

Since the value of a is unknown and difficult to determine empirically, we concentrate in the rest of the paper on the special case where a is one. For simplicity of exposition belov we will also assume that the income distribution is a continuous distribution.

Since household surveys of consumer expenditure normally include thousands of obeservations it would be extremely cumbersome to calculate the DCC for more than a few commodities. Clearly, some sort of screening mechanism would be desirable to distinguish promising candidates for welfare dominance. However, Yitzhaki (1987) has provided a fairly straightforward procedure for reducing the number of possibilities to a manageable total. In an earlier paper that author has established the following result: where F is the cumulative distribution of income, Gy is the Gini coefficient of income, Si is the share of the expenditure on Xi and (9) bi - cov (Xi, F(y))/cov (y,F (y)) Dominance **& the** Design of Excise Taxation in **the** Cots D'Ivoire/Wrhirsk:ab/I/18/8S Massll#4/Welfare
- 15 -

is Siever's (1983) non-parametric estimator of the slope of the regression line of Xi on Y. In our context bi can be interpreted in two ways. On one hand bi is equal to the area between the **450** line and the concentration curve if the ith coi.modity divided by the area between the **450** line and the Lorenz curve (see Yitzhaki and Olkin, 1987). Alternatively, bi is a weighted mean of the marginal propensity to spend on commodity i. As argued in Yitzhaki (1987), bi/Si can be interpreted as the weighted average income elasticity of commodity i. Hence equation (9) indicates that the sign of the area below che DCCji curve is determined by the difference between the weighted average income elasticities of the commodities. Since, if commodity i is to dominate commodity J, DCCii must be positive, it is clear that a necessary (but, of course, not sufficient) condition for welfare dominance is that the weighted income elasticity of commodity j be lower than that for commodity i.

The isame argument can be repeated using the extended Gini. The extended Gini is a weighted integral of the area between the forty-five degree line and the Lorenz curve (see Yitzhaki 1983). The formula for the extended Gini is: (10) Gy (v) - - v cov (y, [l-F(y)]V-l) / y ; v > 1. Here v is an inequality-aversion parameter chosen by the investigator and py is the mean value of the distribution. The extended Gini is similar to the Gini coefficient except that it uses a different weighting scheme. The standard Gini is a special case of the extended Gini where v is 2. The

**MHasllW/Welfare Doinance** A **the Design** of **Zxcise** Taxation in the Cote D'IvoirIWNThLrek:b/5/18188
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higher **is** v, the greater is the importance attached to the bottom of the income distribution. / The preceding analysis based on the Gini can be replicated in terms of the extended Gini.

- (11) (v-l) f [DCCji (F) (l.F)v-2 df -

- -

- [bj (v) / Sj bi (v) / _Si))_ Gy (v)

wherg

- cov (Xi, [1 - F(y)] 1)

- (12) b **i** (v) -Cv(.1 ()v1 coy (y, [1 - F(y)] -)

is the estimator of the (extended) Gini marginal propensity to spend on commodity i. The difference in the bi (v) is attributable to the choice of weighting schemes. Each weighting scheme is increasing with income up to a certain quantile and then it declines. Table 1 presents the quantile with the highest weight for various values of v.

Equation (11) provides additional necessary conditions for welfare dominance. If commodity i dominates commidity J, a shift from taxing commodity j to commodity i would decrease the extended Gini inequality index for all v, including the standard Gini case where v - 2. These necessary conditions are useful in empirical investigation of welfare dominance because they are fairly easy to calculate and can be used to identify the pair of commodities for which welfare dominance is possible.

Not surprisingly, the notion of welfare dominance is linked to the conventional wisdom of imposing luxury excises on items of consumption

**Hse11#4/wilte Domiuiee** a **the** Desin **_of_ zxocis Tatlon** **_in_ the Cote** _D'Zvoire/WThrsk:&b/5118/68_
- 17 -

having a relatively high income elasticity of demand. However, important differences between the two approaches still exist. Conventional measurements of income elasticity use the mean of the income distribution as a reference point and are indifferent to income inequality. The partial test for welfare dominance, on the other hand, measures the income elasticity at each point along the concentration curve and is sensitive to the income position of the spender.6/ Moreover, the usual argument for luxury excises cannot easily distinguish on welfare grounds which of two income-elastic commodities would be the most suitable target for excise taxation.

In the analysis of the expenditure data for the C6te d'Ivoire that follows, weighted income elasticities are compared for different pairs of commodities. The weights employed are those associated with the calculation of the extended Gini coefficient. Values for these weights are permitted to vary between 1.5 and 5 and some of the welfare implications of this range of values are depicted in Table 1. Higher values for these weights attach more importance to the lower end of the income distribution. A weight of unity implies complete indifference to inequality while an infinitely large value would assign zero weights to everyone except the household with the lowest income. Thus a range of values between 1.5 and 5 encompasses a reasonable diversity of views about the importance of income inequality.

# C. Welfare Dominance and ET taxes in the C6te dl'voire

Data for the C6te d'Ivoire originate from a random sample of 1,600 households who were surveyed over a period of a year starting in Hess114j/We1faro Dominanco & **the** Dmsi&n of **Excise** Taxation **in the** Coto **_D'!voir/lWTir h:aIb/5/18/I_**
- 18 -

# Table 1: 'WELFARE WEIGHTS (v) AND THE DISTRIBUTIVE PERCENTILE (Pi) WITH THE LARGEST WEIGHT

<!-- Start of picture text --> V 1.5 2 3 6<br>Pi .56 .5 .42 .3<br><!-- End of picture text -->

**xosle. Taxatton in the Cote DIlvolze/Nlz.:ab/3/lSS/S**

MHasllO/Welfcre **Dominance** & the Design of
- 19 -

1985. The design of that *urvey and its implementation is thoroughly described in Ains%orth and Munoz (1986). The survey attempted to collect information on household income sources, consumption patterns, employment activities, housing conditions and several other subjects. On the expenditure side data were collected on regularly purchased nonfood items (fuel, cigarettes for example), on irregularly purchased clothing, household goods and maintenance, food expenditures, durable goods ownership, housing rents and the value of home produced and consumed food.

In Table 2 one can see the expenditure shares of different consumption categories and the range of values for the weighted income elasticities. Most food items and, as well, tobacco products, are incomeinelastic but as the welfare weights attach more importance to low-income consumption the income elasticity approaches unity for rice, millet, bread, casava and a casava derivative called attieke. Income elasticities for public transportation, education expenses and alcoholic beverages hover slightly above unity. Consumption of gasoline, telephone-telegraph and electricity, on the other hand, all exhibit income elasticities substantially larger than one.

On the basis of the income elasticity information contained in Table 2 numerous pairwise tax comparisons can be made to identify instances of welfare dominance. It would appear, for example, that, as alternative commodity tax bases, telephones dominate electricity and gasoline, electricity dominates public transportation and gasoline dominates alcoholic beverages. Figures 2-5, which exhibit the form of the empirical DCC curve for each comparison, confirm these suspicions.

HMuellA/Welfare Dominanco **& tho** Design of **excise Taxation** in **the** Coto **D'** voLre/WThirsk eb/5S/18/8
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Tale.2: INCOME ELASTICITIES OF CONSUMPTION FOR C6TE D'IVOIRE A/

|Consumption category|Expenditure<br>share|Weighte|d inco|me elas|ticity:|v-|
|---|---|---|---|---|---|---|
|||1.5|2|3|4|5|
|Total expenditure (Gini|)<br>1|.32|.45|<br>.57|<br>.64|<br>.67|
|Casava|.036|.46|.54|<br>.64|<br>.7|.74|
|Rice|.04|.78|.87|<br>.95|<br>.98|<br>.99|
|Maize|.05|.42|.58|<br>.69|<br>.75|<br>.77|
|Millet|.001|.88|1.0|1.1|1.12|1.12|
|Bread|.016|.82|.88|<br>.95|<br>.98|1.0|
|Attieke|.018|.93|.99|1.05|1.07|1.09|
|Sugar<br>|.007|.59|.68|<br>.77|<br>.82|<br>.85|
|Cigarettes, tobacco,|||||||
|cola nuts|.011|.63|.65|<br>.68|<br>.70|<br>.72|
|Gasoline<br>|.04|1.71|1.58|<br>1.41|1.33|1.29|
|Public<br>transportation<br>|.03|1.13|1.12|<br>1.11|1.10|1.10|
|Telegraph-telephone|.003|2.25|1.96|<br>1.67|1.54|1.47|
|Alcoholic beverages|.017|1.17|1.14|<br>1.11|1.10|1.09|
|Electricity|.02|1.64|1.52|<br>1.41|1.36|1.32|
|Education expenses|.042|1.24|1.20|<br>1.16|1.14|1.13|
|Rent and dividends|.05|1.61|1.54|<br>1.45|1.39|1.35|
|Wages|.30|1.54|1.52|<br>1.42|1.37|1.34|

s' Income is defined as total expenditure plus consumption of home produced goods per capita.

Source: C6te d'Ivoire Living Standards Survey, World Bank, 1986.

Mass11#4/Welfare Dominance **_&_** the Design of Excise Taxation in the Cote D'1voire/Wlhirsk:ab/5/18/88
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Rather than present a large, and potentially confusing, array of DCC curves for the C6te d'Ivoire, Table 3 summarises our efforts to establish a welfare ordering of alternative commodity taxes using the criterion of marginal welfare dominance. Of the five promising excise tax candidates consisting of telephones, electricity, gasoline, alcoholic beverages and public transportation, we concluded that the taxation of telephone services dominates all of the other items in this group. Taxing electricity consumption, on the other hand, dominates the taxation of alcoho'lic beverages and public transportation but does not quite manage to dominate the taxation of gasoline. Gasoline taxation, by the same token, dominates a tax on either alcoholic beverages or public transportation. Finally, a tax on alcoholic beverages fails to dominate a tax on public transportation. It would be possible to extend this welfare ordering to include other items shown in Table 2 but tbs ranking shown in Table 3 are perhaps the most interesting ones for policy purposes and it is clear from Table 2 that taxes on food and cigarettes would be dominated by taxes on any of the five candidates already examined.

An interesting extension of the analysis is to consider the welfare implications of adjusting the mix of direct and indirect taxes in the C6te d'Ivoire. This welfare comparison can be achieved by viewing a tax on wages or rents and dividends as a tax on all of the expenditure made by workers or capitalists respectively. From Table 2 it appears that the weighted income elasticities for capital and labor incomes are relatively large and extremely close to one another in size. Moreover, while telephone consumption dominates either income component as a tax base, it is also apparent that neither electricity nor gasoline consumption does the

**MHas11*/Welfsre** Dominance & **the** Design of Excise Taxation in **the** Coto D'Ivoir/WThirsk:ab/5/18/88
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# Table: THE WELFARE ORDERING OF COMMODITY TAXES IN THE COTE D'IVOIRE

# Commodity/Tax Base

<!-- Start of picture text -->
1. Telephone  dominates  A/  dominates  &/  dominates dominates<br>2. Electricity  does not  dominates dominatej<br>dominate<br>3. Gasoline  dominates  dominates<br>4. Alcoholic  does not<br>beverages  dominate<br>5. Public<br>transportation<br><!-- End of picture text -->

- A/ A close examination of the individual observations for bread and water reveals that the curve intersects the X-axis for the very last observation. If this sample exactly portrayed the population, a social welfare function that is linear over the whole range of the distribution and concave between the second richest family and the richest one would show that subsidizing bread at the expense of water would be welfare decreasing. However, we suspect that this is a result of the sampling error. Where we take the average of two consecutive observations this anomaly disappears.

Tuuatios **In the** Cote **DlvorL/Uhirkzuk:b1510188** Kssall*/Welfare **Dminano.** A **the** Design **of toles**
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Figure 3 <!-- Start of picture text --> I- PUEBUC TRANSPORTATIO ELECTR!CITY<br>i4H* 0.19<br>0.17<br>0.16<br>-<br>1s 0.15<br>0.14-<br>0.13<br>0.12<br>0.11<br>S* ~0.1<br>0.09<br>(9<br>o 02460.08 8<br>0.07-<br>0.06<br>ft * ~0.05-<br>0.04-<br>* ~0.03<br>0.02<br>i ~0.01I<br>0~~<br>la* 0 0.2 0.4 0.6 0.8<br><!-- End of picture text -->
<!-- Start of picture text --> Figure 4<br>ALCOHOL GASOUNE<br>0.24-<br>002<br>0.%<br>* 0.22<br>'. 0. -~l, /<br>0.12 i ,<br>0.18<br>0.04<br>0~~ X 0.01|5<br>002.<br>b ~ ~0 0.2 0.4 0.6 0.^ s<br><!-- End of picture text -->
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same. On balance, income taxes and ET taxes have surprisingly similar consequences for income distribution.

Currently, the C6te d'Ivoire functions with a value-added tax on manufacturing activity and a cascaded tax on most services provided in urban areas. Both taxes are described in Heian and Monson (1987). There are also traditional excise tax levies on tobacco products, alcoholic beverages and fuel. Our results suggest that it would be worthwhile to extend the excise tax network to include electricity and telephones.

# D. Summing Mg

This paper has had two major goals. Introducing a relatively new technique for evaluating alternative excise tax bases has been one of them. Examining differences in the concentration curves between various pairs of commodities can be used as a tool for identifying desirable excise tax options. Concentration curves have been used previously to illuminate the distributive impact of alternative direct tax measures. In this paper the concept has been adapted to study the structure of indirect taxes and to explore the welfare consequences of a variety of indirect tax reforms.

In particular, concentration curves have been used to obtain conditions under which a wide range of social welfare functions would approve of a particular commodity tax substitution. Where imposing a tax on one commodity and using the proceeds to reduce taxes on another receives the approval of nearly all plausible social welfare functions, the first commoditv is said to dominate the other. More precisely, the requirements

**sscil4/Welfare Dominance** & **the** Doeign of Exciso Tazation in **the Cote** D1Ivoire/WThirk:ab/5/18/88
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for marginal conditional welfare dominance are satisfied. Part of the attraction of the concept of welfare dominance is that it allows at least some excise tax policies to rest on weak and reasonably nonrestrictive normative considerations. Using household budget data at least a partial welfare ordering of alternative excise taxes can be achieved. Besides being virtually value-free, the approach of searching for welfare dominance is to a large extent model free in that in its simpliest form no knowledge of consumer price behavior is required. More sophisticated application of the methodology would, however, have to consider the efficiency as well as the equity implications of changes in excise taxes and to take into account the reactions of consumers to tax reforms.

The welfare framework utilized in this paper is closely related to that found in the literature on optimum taxation. Ahmad and Stern (1984), for example, measure the marginal social cost of raising extra indirect tax revenue from different sources using explicit welfare weights and empirical estimates of consumer price elasticities. However, their objective is to describe the optimum commodity structure that would emerge from equalizing the marginal social cost of revenue from different sources. Our task of identifying welfare-improving tax reforms is less ambitious and requires significantly le!is information about the economy.

The other goal of this paper has been to apply the dominance approach to the C6te d'Ivoire and to extract some policy conclusions about the design of excise taxation in that country. What emerged from that effort was the clear dominance of telephones as a tax base and the near dominance of electricity consumption.. Further reflection on ET (electricity-telephone)

**Massml4I/Welfare Dominance** & **the** Design of Excise Taxation **in the** Cote D'Ivoire/WThirsk:dbI5/18/88
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taxation suggests that it may be a relatively under-exploited tax base in a number of developing countries.

Greater reliance on the ET tax base has much to recommend it. In addition to their appeal on income distribution grounds, ET taxes may be relatively efficient revenue sources if they can be implemented through twopart pricing schemes. Moreover, they are relatively easy to administer, they lend themselves readily to the destination principle of commodity taxation and they can distinguish between business and household use without great difficulty.

Despite these advantages, the basic argument favoring higher ET taxes in the C6te d'Ivoire, and perhaps elsewhere, relies on acceptable income distribution effects. In an earlier paper, McLure and Thirsk (1978) proposed the removal of excise taxes on beer and cigarettes for essentially the same reasons, that they were income and price inelastic in consumption and therefore had a harmful impact on welfare. Here, we make the opposite claim, that the imposition of ET taxes would enhance economic welfare. Many countries appear to act perversely by taxing beer consumption heavily and subsidizing the consumption of electricity. Another way of looking at this eqjuity claim is to note that in most developing countries the consumption of a wide range of consumer durables such as TVs, VCRs and fridges is income elastic. However, in most cases it is difficult to tax either the services provided by these durables or their initial purchase. It may be much easier instead to tax a close complement, electricity consumption, in this situation.

Massll4A/Welfcrc **Dominance** & **the** Design of Excise **Taxation** in **the Cote** D'Ivoire/WThirck:ab/5118/88
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Our enthusiasm for ET taxes may have to be tempered by a consideration of external effects in consumption. At least in the case of telephones consumers' enjoyment from phoning may depend on who else has access to a phone. Up to a point, the utility of owning a telephone may be a function of the number of subscribers, in which case an efficiency argument can be made for subsidizing rather than taxing telephone use. Once more, efficiency and equity concerns clash in the design of an appropriate tax policy.

Future work in this area can profitably proceed in several areas. First, it would be useful to disaggregate large expenditure aggregates such as public transportation, alcoholic be-erages and telephones in order to see if some components have different distributive characteristics and are not close substitutes in consumption. For example, differential excise taxes on beer versus fine wine, or long distance versus local phone calls, may be used to fine-tune the system of excise taxes. Secondly, more work on the efficiency dimensions of excise taxation would be desirable. Finally, a useful extension to the analysis would incorporate the horizontal equity aspects of excise taxation.

**MasI*A4JWelf&rc Dominanca** & **the** Design of **ExciLe** Tezatiom in **the** Cott D'Zvoire/W2hiz.k:eb/5/18688
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# ENDNOTES

1. This unhappy situation, and the recommendation to shift more towards consumption taxation, is discussed in an African context by Z. Shalizi and L. Squire, "Tax Policy for Sub-Saharan Africa", World Bank, June 2986.

2. More generally, the change in a Bergson-Samuelson social welfare function, W - W (U1 ..UH) can be written as dW - M18W/8Ui . aUi/ayi . yi where aW/aU1 is the ethical weight attached to the i'th household's change in utility and the product aw/au1 . aui/ly, can be interpreted as the marginal social utility of income. In the utilitarian framework the ethical weights are all normalized around unity and the marginal social utility of income declines with higher incomes.

3. It is worth emphasizing that the value of a is unique to each particular commodity tax substitution and that it is the single part of our methodology that compels resort to some kind of modelling exercise. The purpose of our analysis is to see what welfare implications can be extracted from the limited household survey information on consumer behavior that is typically available in developing countries. If more information on consumer behavior were available it woulC also be possible to incorporate secord-order excess burden effects into the analysis.

**HaMc1ll4/Welfar, Dominance** & **the** Design of Excise Taxation in tho Cote D'Ivoire/WThirsk:ab/5/18/88
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4. Nonetheless, the welfare rankings are transitive so that<sup>if a taxon</sup> commodity B dominates one on commodity C, a tax on commodity<sup>A also</sup> dominates one levied on C.

5. See Yitzhaki (1983) for a complete discussion of the properties of<sup>the</sup> extended Gini.

# 6. Formally we can write

bi (v) - _f_ w (F (y), v) xi (y) dy

- where w (F (y), v) is the weight attached to the marginal propensity of spending on the ith commodity, xi(y). In the case of the Gini v - 2 then

-

- v (F (), 2) F (y) [1 F(y)]

- -- (F tY), 2) -J F (z) [1 - F (z) dz

which means that the highest weight is given to the marginal propensity of the median individual. The higher v, the higher the weight attached to low income groups. See Yitzhaki (1987).

7. The results for the C6te dl'voire also indicate the desirability of taxing gasoline. We have resisted the temptation to recommend ETG (electricity-telephone-gasolin **e** xcises because gasoline taxes in most) countries serve as crude user fees for the consumption of road services and therefore have an efficiency rationale that is quite different from the equity considerations which distinguish ET taxes.

**_Massll4/Wlfoar_** Dominance & **the** Design of Exciso Taxation in **the** Coto D Ivoire/WThiLrk:ab/5/18/88