THE SINGLE TAX ON BANK TRANSACTIONS
TURNOVER VERSUS VALUE-ADDED TAXES: DISTORTIONS AND ADVANTAGES 35
Productivity and competitiveness
A BNDES paper states that cumulative taxes such as a bank transaction tax “are easier to collect and pay.”, whereas valued added taxes are “more complex to calculate and even to comprehend.” 36
Arguing their opposition to cumulative taxes, the authors list two of their undesirable characteristics, supposedly inexistent in VATs. They say cumulative taxes “are most damaging to the competitiveness of domestic production because of the difficulty in exempting their incidence on exported goods and because of the advantage they grant to imports, which usually are not subjected to the same treatment in the country of origin.”
Concerning this observation, it is interesting to note the reaction of Professor J.
A. Scheinkman when invited to lecture on trade competitiveness and tax harmonization in Brazil. He said, “Competitiveness is a notion that does not make sense for a country as a whole. All countries have greater or lesser competitiveness in different products.” He adds, “The idea that the tax system… affects competitiveness, as I see it, does not make sense.” 37
Professor Scheinkman demonstrates that tax evasion and the informal economy are factors that depress an economy’s productivity. If a tax system induces high rates of tax evasion and avoidance, productivity loses its correlation with investments in technology, or with administrative and managerial efficiency. A company that has low production costs may be less “competitive” when compared to a company that evades taxes, even if the tax evader has significantly higher cost of production. This causes inefficient companies to survive and depresses a country’s economic productivity. Because Brazil’s tax system encourages tax evasion and the flight to the informal economy, it “depresses productivity in a very significant way”. We see, therefore, that “national competitiveness” is not hurt by cumulativeness, but rather by a tax system that induces tax evasion, as usually occurs when conventional declaratory taxes are employed.
He adds, “The need for tax reform has nothing to do with matters of the country’s integration into a trade bloc,” and, “we need a tax reform that is taken seriously, that lowers the high rates prevalent in Brazil which make people simply avoid and evade taxes.”
35 For comprehensive discussions of VAT´s, especially of its advantages and problems in emerging countries that lack strong fiscal tradition, see the following works: [BIRD, 2003], [BIRD and GENDRON, 1998, 2000, 2001(b), and 2005], [PIFFANO, 2003, 2007], [FENOCHIETTO and PESSINO, 2000].
36 [AFFONSO and ARAUJO, 2000].
37 [SCHEINKMAN, 2001], pp.133-152.
In other words, removing cumulative taxes will not increase the economy’s productivity and competitiveness. Their elimination will result in the need for higher rates of conventional taxes in order to keep revenues constant and, therefore will lead to increased tax evasion. The great villain of the current tax system is not cumulativeness per se, but rather tax evasion that results from the complexity and high rates inherent in current declaratory tax models.
It should also be noted that adequate tax policy can fully remove the
“disadvantages” of cumulative taxes pointed out in the BNDES paper mentioned above. In fact, the tax reform the Government announced in July 2001 moved in exactly these two directions; that is, zero-rating for exports and the creation of a bank transaction tax on imported goods and services. The objective of these measures was to guarantee absolute isonomy between domestic and foreign producers, which redresses the two criticisms of the CPMF presented by the authors of the BNDES paper. 38
Allocative Efficiency
Cumulative taxes are often criticized on the basis of comparisons with value-added taxes. In general tax analysts follow the usual text-book conclusions that make extensive use of optimal tax theory in reaching normative conclusions about their respective impacts on allocative efficiency. Such conclusions, however, are fragile to the extent that such theoretical work depends heavily on strong assumptions, which are seldom, or never, found in the real world.
Good economic analysis requires that each type of tax be evaluated not only for its intrinsic characteristics, but must also take account of the empirical circumstances surrounding its application. Failure to consider these circumstances, coupled with a naïve, automatic and uncontested acceptance of the simplifying hypothesis found in the theoretical compendia of public finance, implies running the risk of making gross mistakes. Such is the case when the VAT is discussed in Brazil. 39
One advantage claimed on behalf of VATs is that they cause fewer distortions in relative prices than would be caused by cumulative taxes. However, for this statement to be true, one must accept the premise that perfectly competitive markets
38 A project which I sponsored as a Member of Congress (Chamber of Deputies; Bill for Supplemental Law No. 190/2001), creates an Equalization Contribution with the purpose of guaranteeing equal competitive conditions between imports and local products. Such tax has long been considered necessary as can be seen in various specialized papers. See [FIESP, 2001] and also [VARSANO et alii, 2001]. Strangely, business leaders took an opposing view to such an “equalization tax”, fearing higher import costs.
39 It has been suggested that for federative countries a dual or compensatory VAT is the best alternative, whereby a federal VAT “absorbs” the interstate VAT; see [BIRD AND GENDRON, 1998]. Such solution, however, requires a heavy bureaucratic structure, solid administrative organization, and absence of large scale evasion practices. Unfortunately, such characteristics are totally absent in Brazil. The same authors point out the main difficulties and obstacles to the use of VAT´s and some of its variants in [BIRD and GENDRON, 2000, 2001(b)].
exist, such as assumed in conventional optimal tax theories, based on excess-burden analytics.40
We know, however, that such a hypothesis is essentially heuristic and that, in practice, markets do not meet the criteria needed to be considered perfect. As stated by the Federal Revenue Service “the superiority of value-added taxes in terms of distortionary impacts is readily recognized in the case of easily administered tax systems that are nationally harmonized, with low evasion rates…and with one or two tax rates. However, given the actual restrictions, and considering that the ideal situation cannot be easily reached in the short run, it is wise to adjust the debate and avoid making decisions which can hurt the system”41.
In an interesting paper that seeks to establish normative conclusions on the allocative impact of different taxes, Cláudia and Ibrahim Eris use Leontief’s linear model in seeking tax policy guidelines. They write, “the task of ranking taxes as
‘better’ or ‘worse’ is very complex, even in simple models such as the one adopted above; and the literature on this matter has been reduced to a few scarce studies that are sometimes even erroneous.” 42 The authors conclude by saying, “truthfully, the world of Public Finance is a second-best world, and as such the traditional graphs of utility frontiers are often irrelevant, because the system’s distortions place the economy at a point below such frontiers. The upward movement of the utility frontier says nothing about the point (below the frontier) in which the economy finds itself.”
On the validity of policy prescriptions of optimal tax theory it is worth quoting Frank Hahn, who says “…while these studies have increased our understanding of what is involved, the tax formulas which they contain cannot be taken very seriously…Welfare economics is the grammar of arguments about policy, not the policy.” 43
On this same line of thought Sandmo states that “The theory obviously has its limitations. It is at its best in yielding rules for the optimal structuring of a given tax system and has less to contribute to the discussion of major problems of tax reform, which typically involves the choice between alternative tax systems. A difficulty with the extension of the theory to cover these global problems is that the costs of administration have not been incorporated into the theory; this is one aspect of the neglect of transactions costs in the theory of general equilibrium….This raises the question of whether optimum tax formulae can have any claim to be taken seriously, given that they abstract from such central concerns as administrative costs and incomplete information….it may well be that we shall find the models of optimal taxation to be useful, even though we may have to supplement them with
40 On optimal tax theory see [SANDMO, 1976] pp.37-54. A seminal work on modern optimal tax theory is [DIAMOND and MIRRLEES, 1971(a), 1971(b)], pp. 8-27, 261-278.
41 [SECRETARIA DA RECEITA FEDERAL, 2002(a)], p.21.
42 [ERIS and ERIS, 1983] p.20.
43 [HAHN, 1973], pp.96-106.
considerations which are exogenous to the models themselves.”44
Indeed, welfare theory demonstrates that society will not choose a point which is allocatively efficient if, compared to another situation (even if inefficient), it is capable of reaching a superior point in its social welfare function. In other words, even though ideally the VATs may theoretically introduce fewer distortions in relative prices, it is possible that cumulative taxes would be preferable if, for example, it can be proven that it decreases tax evasion, or that it requires a lower nominal tax rate to collect a given amount of revenue, and as a result the pattern of tax incidence is considered more acceptable to society, as demonstrated below. 45
It is generally assumed that efficiency is the only criterion for choosing a particular allocation of resources. However, even assuming a perfectly competitive economy, one may not state that a Pareto-efficient allocative situation resulting from such market configuration will necessarily maximize social welfare.
The implication of this statement is that one cannot guarantee that the use of a neutral tax, such as the VAT is assumed to be (even though in fact it may not always be so), will necessarily maximize the social utility function. Distributive considerations can make possible the attainment of a higher point in the social welfare function of a society through the use of a cumulative tax. In other words, from the standpoint of maximizing the social welfare function of an economy, the use of a tax that is non-neutral and “inefficient” from an allocative standpoint, and thus configuring a Pareto-inefficient situation, may be preferable to a Pareto-efficient position resulting from the use of a neutral tax. This possibility demonstrates the error contained is statements to the effect that VATs are necessarily better and always preferable to cumulative taxation.
A resource allocation is Pareto-efficient if, in order to improve one person’s position it is necessary to worsen the situation of at least one other individual. A situation is deemed Pareto-superior if, it is possible to improve one person’s initial welfare state without diminishing another’s.
The Fundamental Theorem of Social Welfare Economics says that if producers and consumers act competitively, strictly as price takers, a market in perfect competition will produce a Pareto-efficient situation.
To maximize utility, consumers will equate prices of goods and services to their respective marginal utilities; that is, with two products (X and Y) and two consumers (A and B), the marginal rate of substitution (MRS) between the products will be equal to their relative prices (P(X)/P(Y) If consumers are price takers,
MRS (A) = MRS (B) = P(X)/P(Y). (1)
44 [SANDMO, 1976], pp.37-54.
45 [ERIS and ERIS, 1983] mention that, “it is possible, albeit improbable, that a less efficient fiscal plan may be preferable to a more efficient one. The welfare literature is full of apparent paradoxes, and this seems to be one such paradox: the economy as a whole seems to benefit, but the groups that make up that economy were harmed”, p.31.
This equality is a necessary condition for a Pareto-efficient situation in an exchange market economy.
In an Edgeworth Box (GRAPH 1), the points where the condition expressed by equation (1) is satisfied are found on the Contract Curve that results from the tangential points between the indifference curves for consumers A and B.
GRAPH 1
The Contract Curve: Efficiency in an exchange economy
Assuming perfect competition and that the production of X and Y requires the use of scarce resources, firms will maximize their profits equating product prices with their marginal costs (MgC). Firms are also price takers. Thus, P(X) = MgC(X), and P(Y) = MgC(Y).
From the Transformation Curve (GRAPH 2), we know that a Pareto-efficient situation requires the impossibility of increasing production of one good without reducing production of another, from which results that the marginal rate of transformation (MRT) in production of both goods be equal to their relative prices.
MRT= MgC(X)/MgC(Y) = P(X)/P(Y). (2)
Considering equations (1) and (2), it follows that MRT= MRS (A) = MRS (B).
Thus, producers and consumers, as price takers in competitive markets and acting so as to maximize profits and utilities, will produce a set of Pareto-efficient positions in production and in exchange.
GRAPH 2
The Transformation Curve: Efficiency in a production economy
GRAPH 3 depicts the points of competitive equilibrium in a production and exchange economy. Considering an initial factor endowment distribution between individuals A and B, competitive markets will result in such prices and costs of X and Y as given by the marginal rate of transformation T. It is important to remember that, starting at an initial point O of factor distribution, it will be possible to achieve a Pareto-efficient point located in the Contract Curve. Through exchange and production adjustments, the economy will move from the initial point O and attain a Pareto-efficient point E where competitive equilibrium is reached.
GRAPH 3 Competitive equilibrium:
Efficiency in a production and exchange economy
The question now is to find out whether the Pareto-efficient situation resulting from a given initial factor endowment and from the functioning of a competitive market will always be preferable to any other possible situation. The response is clearly negative.
A Pareto-inefficient point can be socially preferable to the point of competitive equilibrium. GRAPH 4 demonstrates such a situation. Given an initial endowment, competitive equilibrium is found at E1. Can one, however, state that this point is preferable to point M? E1 is a competitive equilibrium, and therefore Pareto-efficient, solution, while M is a point not on the Contract Curve and, therefore, is inefficient.
Point M could be preferred if the Social Welfare Function attributes value to the pattern of wealth and income distribution among individuals A and B. Point E1 determines a strong concentration of wealth in favor of individual B. If society prefers a more equitable pattern of distribution, point M could be preferable, even though it is inefficient from an allocative standpoint. Pareto-efficiency alone is insufficient to assess social preferences of a society. I addition to a mere evaluation of allocative efficiency, it may become necessary to use other criteria for choosing a social optimum.46
46 With alteration of the relative prices of P(X)/P(Y) to P(X)’)/P(Y)’ it is possible to achieve Pareto-efficiency point E2, a Pareto–superior point relative to point M. What can be said, then, is that if there
GRAPH 4
Efficiency and distribution
GRAPH 5 shows the Utility Possibility Frontier (UPC) between individuals A and B resulting from the Contract Curve in GRAPH 4. Given the utility functions of A and B, U(A) = U(X,Y), and U(B) = V(X,Y), each point on the Contract Curve determines a point on the UPC. Assuming a Social Welfare Function W = W(U(A), U(B)) that reflects the preferences of society, it is possible to construct the Social Indifference Curves (IS). The maximization of social welfare occurs at the Pareto-efficiency point W. Pareto-efficient point E1, however, is inferior to Pareto-inefficient point M, from the standpoint of social values of such a society. In this example, it prefers a more equitable income distribution, even though it implies an inefficient solution from the standpoint of competitive equilibrium.
is a Pareto-inefficient point socially preferable to a given Pareto-efficient solution, there will always be another preferable Pareto-efficient point on the Contract Curve. In other words, a point in the Contract Curve is not always Pareto-superior to any other point not situated on it. But there will always be a point on the Contract Curve which is Pareto-superior a point not situated on it.
GRAPH 5
Utility Possibility Curve (UPC) Maximization of social welfare
The Fundamental Theorem of Social Welfare Economics proves that under perfect competition the market searches for an efficient competitive equilibrium at some point on the Utility Possibility Curve. Nothing guarantees, however, that it will be the point of maximum social utility.
It is possible to draw parallels between this situation and choices involving taxation.
Tax systems based on value-added taxes suffer from higher evasion rates than do cumulative tax systems, such as a bank transactions tax. Though we admit that theoretically VATs are neutral, and therefore more efficient from an allocative point of view (although this may not be true from an empirical standpoint), we cannot conclude that they necessarily result in a resource allocation pattern capable of maximizing the Social Utility Function. This stems from the perverse distributive consequences caused by VATs’ patterns of tax incidence, such as higher rates of evasion and higher administrative and operational costs, as compared to cumulative taxes on bank transactions.
In other words, there is a trade-off between tax efficiency and social evaluation of alternative patterns of tax incidence. A non-neutral tax, such as the bank transactions tax, may be preferable from the social standpoint because it drains less real resources from society due to its lower operational and compliance costs, and also because it does not encourage evasion, and therefore has a better pattern of
incidence than is the case with VATs.
GRAPHs 6 and 7 demonstrate a situation in which a tax introduces distortions, but at the same time is preferred by society.
Initially, the economy is at competitive equilibrium E. It is a Pareto-optimal situation, with income distribution favoring individual B. However, the government seeks a fiscal policy that aims to redistribute income in favor of individual A, and therefore wants the economy to be located at a point in the shaded area, where social preferences for greater equity in income distribution are satisfied, preferably at some point along the contract curve within the area of the government’s preference.
GRAPH 6
Tax policy, evasion, and competitive equilibrium
One option is to adopt a conventional tax model, such as a VAT, which is considered to be neutral and efficient from the standpoint of relative-price determination, such as point E1. In order for this new equilibrium to be attained, relative prices would have to be P(X)1/P(Y)1, compatible with the competitive equilibrium E1.
However, if the conventional VAT tax model stimulates evasion, the change to point E1 will be frustrated, re-concentrating income and dislocating the new equilibrium, to E2, outside the government’s area of preference. In this sense, the option of a Pareto-inefficient solution as the point E* can be preferable, even if it is not a competitive equilibrium solution. In this situation the economy will stand at point E*, with relative prices that are incompatible with a Pareto-optimal situation given by the tangency point between the Indifference Curves I(A) and I(B) on the Contract Curve. However, this point (E*), as demonstrated in GRAPH 7, is
preferable to points E and E2, despite the fact that it is Pareto-inferior relative to the solution originally desired by the government, point E1.
GRAPH 7
Tax policy and social welfare
What these examples demonstrate is that one cannot state a priori that the best tax policy must necessary be made up of taxes that are considered allocatively efficient. In principle, neither cumulative nor any other type of tax system should be rejected strictly due to judgments about their allocative efficiency. There may be room for them in configuring a tax system capable of improving the social welfare of an economy. It is an empirical question.
A second reason why one cannot state a priori that a VAT is preferable to a
A second reason why one cannot state a priori that a VAT is preferable to a