TRADE OFF BETWEEN EQUITY AND EFFICIENCY IN TAXATION

                  TRADE OFF BETWEEN EQUITY AND EFFICIENCY IN TAXATION

A big issue in economics is the trade off between efficiency and equity.

Definition:

        An economic situation in which there is a perceived tradeoff between the equity and efficiency of a given economy. This tradeoff is commonly viewed within the context of the production possibility frontier, where any additional gains in production efficiency must be offset by a reduction in the economy's equity.

Equity:

       Equity is concerned with how resources are distributed throughout society.

1. Vertical equity is concerned with the relative income and welfare of the whole population e.g. Relative poverty when people have less than 50% of average income. Vertical equity is concerned with how fairly resources are distributed and may imply higher tax rates for high income earners.
2. Horizontal equity is treating everyone in same situation the same. e.g. everyone earning £15,000 should pay same tax rates.

Efficiency:

            Efficiency is concerned with the optimal production and allocation of resources given existing factors of production.  There are different types of efficiency

1. Productive efficiency.

       This occurs when the maximum number of goods and services are produced with a given amount of inputs. This will occur on the production possibility frontier. On the curve it is impossible to produce more goods without producing less services.Productive efficiency will also occur at the lowest point on the firms average costs curve

2. Allocative efficiency

           This occurs when goods and services are distributed according to consumer preferences. An economy could be productively efficient but produce goods people don’t need this would be allocative inefficient. Allocative efficiency occurs when the price of the good = the MC of production

3. X inefficiency:

      This occurs when firms do not have incentives to cut costs, for example a monopoly which makes supernormal profits may have little incentive to get rid of surplus labour.

Therefore a firms average cost may be higher than necessary.

4. Efficiency of scale

             This occurs when the firms produces on the lowest point of its Long run average cost and therefore benefits fully from economies of scale

5. Dynamic efficiency:

            This refers to efficiency over time for example a Ford factory in 1920 would be very efficient for the time period, but by comparison would now be inefficient.. Dynamic efficiency involves the introduction of new technology and working practises to reduce costs over time.

6. Social efficiency

         This occurs when externalities are taken into consideration and occurs at an output where the social cost of production (SMC) = the social benefit (SMB)

7. Technical Efficiency:

        Optimum combination of factor inputs to produce a good: related to productive efficiency.

8. Pareto Efficiency

             A situation where resources are distributed in the most efficient way. It is defined as a situation where it is not possible to make one party better off without making another party worse off.

9. Distributive Efficiency

           Concerned with allocating goods and services according to who needs them most. Therefore, requires an equitable distribution.

Increased Inequality and Increased Growth:

    Sometimes, economic policies create a situation where everyone becomes better off (rising real incomes across population). However, those on high incomes gain a bigger % rise in real incomes. The result is that everyone becomes better off, but, there is also greater income inequality. Therefore, some people may feel that relatively they appear worse off compared to others in society.

This is a pareto improvement in economic welfare but also an increase in inequality.The final point is that there doesn’t have to be a trade off between equality and efficiency. An improvement in efficiency, should generally make the economy better off. There is no reason why improved efficiency has to lead to inequality. It is compatible to improve both efficiency and equity within society.

         Within this equity and efficiency tradeoff, equity refers to the economy's financial capital, while efficiency refers to the future efficiency in the production of goods and services. This theory asserts that, in order for a nation to become wealthier, it must save its equity. However, these additional savings will hurt the development of more efficient production in the future.