Table of Contents
Modern Views on the Incidence of Tax:
Professor Musgrave defined the term ‘incidence’ as a change in the distribution of income available for private use; when arises as a result of changes in budget policy, i.e., changes in the policy of taxation and public expenditure. He pointed out that whenever budget policy changes, in other words, when a tax is imposed or a public expenditure is incurred, it may result in three important effects, viz.
- Changes in the transfer of resources from private to public use.
- It may affect the output.
- It may affect income distribution between different sections of the community.
According to Musgrave, the term ‘incidence’ is used to designate the third type of effect. More specifically, resource transfer may occur without taxes, and taxes may be imposed without resource transfer, the resulting change in the distribution of income has been referred to as, incidence by Musgrave.
Obviously, this concept of incidence is entirely different from the traditional concept. Musgrave emphasized the role of public revenue and expenditure both while the role of public expenditure has been completely ignored by the traditional theory of incidence.
Thus, according to Prof. Musgrave, “a change in the distribution of income available for private use which arises as a result of changes in budget policy is called an incidence. Besides, Prof. Musgrave pointed out that such a distributional change may be brought through three different policies.
- Changes in tax policy, holding public expenditure constant in real terms.
- Changes in public expenditure while holding taxes constant.
- Changes in tax and expenditure policies will provide the required changes in yield.
The changes in distribution brought about by the above policies are called tax incidence, expenditure incidence, and balanced budget incidence respectively. However, tax incidence can be analyzed in two ways- specific tax incidence and differential tax incidence. Similarly, expenditure incidence can also be analyzed in two ways- specific expenditure incidence and differential expenditure incidence. Let us now discuss the different concepts of incidence as laid down by Porf. Musgrave.
Specific Tax Incidence:
If the public expenditure is held constant in real terms and the text policy is changed or modified, the resulting change in the distribution of income is called a specific tax incidence. For instance, under conditions of full employment income tax rates are reduced, which means, more income in the hands of people would be left, and this would increase the aggregate demand for goods and services. A rise in price and cost may be expected which in turn will lead to increased public expenditure in money terms to maintain the same level of purchases. This may be possible by printing of notes. Thus, inflationary pressure in the economy is generated. On the other hand, if income tax rates are increased, it will reduce the money income in the hands of the people, and this may lead to a reduction in private expenditure, and hence, deflationary tendencies may be generated. Hence, inflation and deflation both influence the distribution of income and wealth. Inflation, in both instances, tends to transfer income and wealth from the hands of the poor people to the rich. Obviously, there are two types of incidence: the incidence due to a change in a particular tax and the incidence due to inflation and deflation. The effects on the distribution in both situations are called ‘specific incidence’.
Differential Tax Incidence:
Differential tax incidence refers to the distributional effect that results when one tax is substituted for another, assuming that the money income of the two taxes is the same. When one tax is substituted for another, and money income to the Government doesn’t change, it will imply that the amount of public expenditure will remain the same. Hence, it seems that government will be in a position to secure the same transfer of real resources from private to public use and may maintain the same amount of public expenditure. But however, different taxes will affect different demands differently, involving changes in the price level. When the price level changes, the government would require different levels of money expenditure to secure the same transfer of real resources. Hence, Musgrave said it will be well to define differential incidence as the difference in the distribution that results, as a result of two tax policies that provide for equal yield. Substitution of equal yield taxes thus defined refers to a balanced budget operation. This implies that money yields are adequate to finance a given level of real expenditure of the government under different prices caused by the substitution of one tax for another. The concept of differential tax incidence is of great use for framing an alternative tax policy to finance government expenditure and maintain economic stability.
Specific Expenditure Incidence:
When the public expenditure changes and the tax rate structure and assessment formula remain constant, the effects of change in public expenditure upon distribution are called specific expenditure incidence. Again, when public expenditures increased or decreased in money terms, there may be an increase or decrease in the transfer of resources from private use to public use. Hence, changes in the income of the people, due to the changes in public expenditure, are called specific expenditure incidence. For instance, if public expenditure is increased, this implies larger incomes for the people in general. But with the rise in public expenditure price of goods and services tend to rise leading to inflationary conditions. Similarly, a reduction in public expenditure implies a reduction in the income of people. But with the fall in the income of the people, the aggregate demand for goods and services is reduced, and hence, deflationary conditions are generated. Thus the changes in expenditure affect the distribution in two ways:
- changes due to public expenditure.
- changes due to inflation, and deflation, which may arise because of changes in public expenditure.
Hence, the concept of specific expenditure incidence suffers from the same effect as specific tax incidence.
Differential Expenditure Incidence:
When we hold the tax functions constant and consider the changes in expenditure on different items under a balanced budget to avoid the incidence of inflation and deflation, the changes in the distribution of income disposable for private use under such a policy may be referred to as differential expenditure incidence. In other words, under a balanced budget policy, an increase in public expenditure in some direction should be canceled by a decrease in expenditure in some other direction. The distributional effects of such public expenditure may be termed differential expenditure incidence. However, Musgrave was of the view that the concept of specific expenditure incidence and differential expenditure incidence is not so useful as the concept of differential tax incidence to analyze the problems of incidence of taxation and transfer of resources. To put it in the words of Musgrave, “The problem of incidence by its very nature is of great interest in changes in tax or transfer policy than the changes in public expenditures on goods and services. While the benefits, derived from public services may have distributional significance, especially in the case of merit wants, these benefits are not part of the incidence. The term as we use, it is limited to changes in the distribution of income disposable for private use.
Balanced Budget Incidence:
The resulting change in distribution due to the changes in tax expenditure policy under the framework of a balanced budget may be referred to as balanced budget incidence. For instance, if the real expenditure of the government is to be increased and necessary changes are made in the tax function to secure additional income, the resulting changes in the distribution can be referred to as balanced budget incidence. Hence, the concept of balanced budget incidence may be readily applied where certain public services are actually added or dropped, accompanied by specific tax changes. Balanced budget incidence automatically excludes the effects of inflation or deflation or distribution. Therefore, the concept is of great use. However, it has the disadvantage of inextricably mixing up with the incidence of tax and expenditure policy.
According to Musgrave, the most useful formulation of incidence is that of differential tax incidence, and next to it is that of balanced budget incidence.
Measure of Incidence:
Musgrave has also proposed a measure of incidence in terms of the Lorenz curve. Consider the figure given below.
In the above figure, OB is the ‘line of perfect equality’. Let OCB be the Lorenz curve corresponding to the initial distribution. It means OCB points out the initial state of distribution. The coefficient of equality now is given by OCBA/OBA. As a result of a change in tax or expenditure or both, suppose the Lorenz curve becomes ODB. It means ODB points out the state of distribution after the implementation of tax and budget policy. The coefficient of equality now is given by ODBA/OBA. Incidence is then measured by the ratio
|R = (ODBA/OBA) / (OCBA/OBA) = ODBA/OCBA|
If R > 1, the incidence is progressive
If R = 1, the incidence is proportional
If R < 1, the incidence is regressive
The above measure, however, is inadequate. If R equals 1, it only means that the overall state of distribution is unchanged. The distribution may have changed between different sections. For example, the Lorenz Curve may change from OCB to OGB and (OGBA/OCBA = 1) may be. Therefore, one would require more detailed measures in such cases.
There are no definite rules to tell us what effects should be included in the concept of incidence and effects should not be included, ultimately the decision on this issue is a matter of taste. Thus, Prof. Musgrave himself admitted that “whether the element of distributional change should be given the label of incidence is a matter of taste. Some readers may prefer to call it merely the distributions; effect of budget policy.”
Besides, it has also been argued that one’s definition of incidence would also depend on one’s objective in analyzing incidence. Different taxing authorities may have different objectives. For instance, if welfare is objective, then it may include both distribution and output in the concept of incidence. Thus, Hans Juergen Krupp observed that if one has welfare considerations, then one ought to include distribution and output effects in one’s concept of incidence. “Thus income of a household depends on the national income to be distributed and its distribution. One can think of a situation where a high level of national income is combined with an unequal distribution as opposed to a situation where a low level of national income is combined with a more equal distribution. It might be useful to include this type of problem in the concept of incidence.” Since the income of the household depends on output, thus, welfare consideration should include both distribution and output in the concept of incidence.