Tax Equivalences and Their Implications

In economic analyses of the effects of tax policies, one commonly encounters discussions of the equivalence of apparently different policies, where “equivalence” is defined as the policies having the same impact on fundamental economic outcomes. These related tax policies may differ in many respects, including (1) the side of a market on which they are applied, (2) the form in which they are imposed (e.g., as a unit or ad valorem tax, on a tax-inclusive or tax-exclusive basis, etc.), (3) whether they are imposed on households or firms, (4) the market in which they are directly imposed, (5) their timing, and (6) whether behavioral adjustments are involved in the equivalence. These differences give rise to conditions under which the equivalences may break down, because of several factors, including (1) differences in salience; (2) market imperfections, such as liquidity constraints, price rigidity or imperfect competition; (3) differences in information requirements and the costs of tax administration and enforcement; and (4) government accounting rules. This paper draws out the key issues that relate to tax equivalences, using several illustrations from important instances of such equivalences that span different areas of taxation, with many of these illustrations relating to the taxation of capital income. Recognition of equivalences and the ways in which they may fail to hold is important both for positive analysis (e.g., the political reasons for choosing one approach over another) and for normative analysis (to determine which approach may be a more effective way of implementing a policy).