Public Finance Case Study

3297 Words14 Pages
Student Number: 109031116
Program Title: MSc Finance
Module Title: Public Finance

What are the likely impacts of an increase in the rate of the personal income tax upon the supply of work effort; personal saving and risk taking? What empirical evidence exists to support your answer?

The main purpose of taxation is to fund public sector activities and affect the economy. The design of an optimal personal income tax system is dependent upon the how well the responses by individuals are known. Tax changes impact government revenue; as a result government is particularly keen on assessing the likely impact of a change. Researchers have heeded the call and come up with theories and undertaken empirical work to discern these impacts.
…show more content…
This makes it difficult to determine what deviations would result from the impact of income tax.

Confronted with increased tax an individual can react in two contradictory ways. Firstly, a higher income tax causes less reward from the same amount of effort and it can be assumed that risk taking may be curtailed. Secondly, that same increase in income tax may also lead the individual take on more risk in order to offset the decrease in after tax income. From theory alone the result is ambiguous as the decision is not solely made on the financial considerations and may include personal matters.

The classic view has been that taxation lowers risk taking behaviour through its lowering of expected return rates. (Domar & Musgrave 1944) were the forerunners in the work on the effect of taxation on risk taking. Their view was that investors shared some of the risk with government which in some cases resulted in an increase in the holding of the risky assets. (Cullen & Gordon 2007) have similar results findings concluding that there is a positive relationship between income tax rates and risk taking. This is a result of an increase in income tax saved from business losses thus encouraging risk
…show more content…
This can be achieved by providing a conducive environment that provides incentives to work, promotes risk taking and inculcates a culture of saving. The path towards an optimal tax system is littered with trade-offs and in cannot therefore be viewed in isolation. The impact of fiscal policy is more potent when it is implemented in conjunction with monetary policy.

Several theories on how income taxes affect work effort, risk taking and saving have been development but the collection of empirical evidence to support these theories has lagged somewhat. Below are some of the reasons why conclusions have been difficult to draw.
• In order to arrive at conclusions of research, certain assumptions are made. These may ignore the realities that individuals face.
• Time series data is good quality time series data has been difficult to come by and when its available it may at times not be reliable
• Analysis of broad data may be prejudiced by individual attributes that affect decision making.
• Much of the evidence has been for the short run and may not give a well-defined response to the effect of incentives especially in the long

More about Public Finance Case Study

Open Document