Reports 2015/15

The cost of collecting tax revenue

A general equilibrium analysis of the Norwegian economy

This publication is in Norwegian only.

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A significant proportion of public projects are financed by tax revenues. Taxes distort the allocation of resources within and between households and firms. Costs connected to such distortions are incorporated in cost-benefit analysis of public projects in Norway by multiplying cost with a factor of 1,2. This study employs the intertemporal, disaggregated general equilibrium model, MSG6, calibrated to Norwegian national account and tax system in 2009, to calculate the marginal cost of public funds (MCF). The study found that MCF associated with collecting additional tax revenue using a general income tax or a value added tax amounts to approximately 1.05. This estimate is approximately identical to the estimate in Holmøy and Strøm (1997). The main explanation for this relatively low estimate is that higher public consumption reduces consumption possibilities (i.e. income) for private households, who respond to the lower income by wanting less leisure (i.e. working more). In addition to an income effect, however, the tax increase implies a substitution effect towards leisure since consumption of goods and services becomes more expensive relative to leisure. A general equilibrium wage rate increase contributes to reverse some of the substitution effect of the tax rate increase. The wage rate increase combined with the positive labor supply response contributes to expand the tax base. Hence, a more modest increase in the tax rate is required to finance an increase in public consumption. The welfare cost of taxation is consequently reduced even though the alternative value of leisure is lower compared to time spent working. The MCF associated with corporate and capital income taxation is estimated to be higher. The study found that MCF is about 1.2 when tax revenue is collected using corporate and capital income taxation. A higher rate of return on capital lowers investments. The lower capital/ labor ratio contributes to lower the equilibrium wage rate, which lowers the supply of labor. Hence, efficiency losses emerge due to lower investments and due to a lower supply of labor. An increase in tax revenue paid by foreign capital owners contributes to increase the welfare. This result, however, relies on more uncertain assumptions about foreign ownership and capital flight.

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