General Equilibrium Effects of Taxes (6 minute read)
Learning Objective:
At the end of this lesson, you will understand how a change in one tax can have general equilibrium effects on the revenues from other taxes.
Tax Codes can be Complex
Most national tax codes are complicated, with varied tax rates on different commodities or activities. For example, taxes on cigarettes and liquor are often very high, while taxes on groceries and clothing are usually low.
The first applications of CGE models were explorations of tax policy codes. The models proved to be especially well-suited for this task. They could show how changing a single tax reverberates through the economy because it can result in shifts in what is produced and consumed. In turn, differences in the tax rates on those activities can result in changes in total tax revenues that are difficult to predict.
An Example of a General Equilibrium Effect of a Tax Change
As an example, consider the tax code shown in Figure 1. In this simple demonstration, there are three production activities - AGR, MFG and SER. The country imposes output taxes on the three activities - and these rates differ. The output tax is lowest for agriculture, at 10% percent, and highest for services, at 20%. Output is identical in the three sectors, at 100 units. But because the activities have different output tax rates, the tax revenues generated from each activity also differ. Total output tax revenue in this example is $45.
Imagine that the country increases its output tax on AGR from 10% to 50% of the value of production. Producers are likely to produce less AGR, and the labor and capital previously employed in AGR will move into other employment in the MFG and SER sectors. As output falls to $50 worth of AGR, output increases in MFG and SER to a value of $125 each.
| Base tax rate (%) | Base output value ($) | Base tax revenue ($) | Updated tax rate (%) | Updated output value ($) | Updated tax revenue ($) | |
|---|---|---|---|---|---|---|
| AGR | 10 | 100 | 10 | 50 | 50 | 25 |
| MFG | 15 | 100 | 15 | 15 | 125 | 18.75 |
| SER | 20 | 100 | 20 | 20 | 125 | 25 |
| TOTAL | - | - | 45 | - | - | 68.75 |
Only one output tax rate has changed, but it has led to a resource reallocation that changes the country's output mix, and results in a change in total output tax revenue. Tax revenue falls in AGR, but increases in MFG and SER. Total tax revenue increases from $45 to $68.75.
Any change in a single tax is likely to have economywide effects. General equilibrium models can be used to comprehensively analyze the general equilibrium effects of changes in tax policy.
Copyright: Cornerstone CGE CC 4.0 BY-NC-SA
Image by Wall Street Journal, 21 May 2021