Download Taxes

Taxes
CHAPTER
8
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Explain how taxes change prices and quantities, are
shared by buyers and sellers, and create
inefficiency.
2
Explain how income taxes and Social Security taxes
change wage rates and employment, are shared by
employers and workers, and create inefficiency.
3
Review ideas about the fairness of the tax system.
8.1 TAXES ON BUYERS AND SELLERS
Tax Incidence
Tax incidence
The division of the burden of a tax between the buyer
and the seller.
When a good is taxed, it has two prices:
• A price that includes the tax
• A price that excludes the tax
Buyers respond to the price that includes the tax.
Sellers respond to the price that excludes the tax.
8.1 TAXES ON BUYERS AND SELLERS
The tax is like a wedge between the two prices.
Suppose that the government puts a $10 tax on MP3
players.
How does the price that buyers pay change?
How does the price sellers receive change?
How is the burden of a tax shared between the buyer
and the seller?
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.1(a) shows what
happens when the
government taxes buyers
of the MP3 players.
1. With no tax, the price is
$100 and 5,000 players a
week are bought.
2. A $10 tax on buyers of
MP3 players shifts the
demand curve to D – tax.
8.1 TAXES ON BUYERS AND SELLERS
3. The price paid by buyers
rises to $105—an
increase of $5 a player.
4. The price received by
sellers falls to $95—a
decrease of $5 a player.
5. The quantity decreases
to 2,000 players a week.
6. The government’s tax
revenue is $20,000 a
week.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.1(b) shows what
happens when the
government taxes sellers
of the MP3 players.
1. With no tax, the price is
$100 and 5,000 players a
week are bought.
2. A $10 tax on sellers of
MP3 players shifts the
supply curve to S + tax.
8.1 TAXES ON BUYERS AND SELLERS
3. The price paid by buyers
rises to $105—an
increase of $5 a player.
4. The price received by
sellers falls to $95—a
decrease of $5 a player.
5. The quantity decreases
to 2,000 players a week.
6. The government’s tax
revenue is $20,000 a
week.
8.1 TAXES ON BUYERS AND SELLERS
Taxes and Efficiency
A tax places a wedge between the buyers’ price
(marginal benefit) and the sellers’ price (marginal cost).
The equilibrium quantity is less than the efficient
quantity and a deadweight loss arises.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.2 shows the
inefficiency of taxes.
In Figure 8.2(a), the market
is efficient with marginal
benefit equal to marginal
cost.
Total surplus—the sum of
2. Consumer surplus and
3. Producer surplus—is
maximized.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.2(b) shows how
taxes create inefficiency.
A $10 tax shifts the supply
curve to S + tax.
1. Marginal benefit exceeds
2. Marginal cost.
3. Consumer surplus and
4. Producer surplus shrink.
5. The government collects
its tax revenue.
6. A deadweight loss arises.
8.1 TAXES ON BUYERS AND SELLERS
The loss of consumer
surplus and producer
surplus is the burden of
the tax.
The burden of the tax
equals the tax revenue
plus the deadweight
loss.
8.1 TAXES ON BUYERS AND SELLERS
Excess burden
The deadweight loss
from a tax—the
amount by which the
burden of a tax
exceeds the tax
revenue received by
the government.
The excess burden is
$15,000.
(3,000  $10  2)
8.1 TAXES ON BUYERS AND SELLERS
Incidence, Inefficiency, and Elasticity
The incidence of a tax and its excess burden depend on
the elasticites of demand and supply:
• For a given elasticity of supply, the buyer pays a
larger share of the tax the more inelastic is the
demand for the good.
• For a given elasticity of demand, the seller pays a
larger share of the tax the more inelastic is the
supply of the good.
8.1 TAXES ON BUYERS AND SELLERS
Tax Incidence and Elasticity of Demand
Perfectly Inelastic Demand: Buyer Pays and Efficient
Perfectly Elastic Demand: Seller Pays and Inefficient
Figures 8.3(a) and 8.3(b) illustrate these two extreme
cases.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.3(a) shows tax
incidence in a market with
perfectly inelastic demand—
the market for insulin.
A tax of 20¢ a dose raises
the price by 20¢, and the
buyer pays all the tax.
Marginal benefit equals
marginal cost, so the
outcome is efficient.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.3(b) shows tax
incidence in a market with
perfectly elastic demand—
the market for pink pens.
A tax of 10¢ a pink pen
lowers the price received
by the seller by 10¢, and
the seller pays all the tax.
A deadweight loss arises, so
the outcome is inefficient.
8.1 TAXES ON BUYERS AND SELLERS
Tax Incidence, Inefficiency, and Elasticity of
Supply
Perfectly Inelastic Supply: Seller Pays and Efficient
Perfectly Elastic Supply: Buyer Pays and Inefficient
Figures 8.4(a) and 8.4(b) illustrate these two extreme
cases.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.4(a) shows tax
incidence in a market with
perfectly inelastic supply—
the market for spring water.
A tax of 5¢ a bottle does not
change the price paid by the
buyer but lowers the price
received by the seller by 5¢.
Marginal benefit equals
marginal cost, so the
outcome is efficient.
The seller pays the entire tax.
8.1 TAXES ON BUYERS AND SELLERS
Figure 8.4(b) shows tax
incidence in a market with
perfectly elastic supply—
the market for sand.
A tax of 1¢ a pound
increases the price by 1¢ a
pound, and the buyer pays
all the tax.
A deadweight loss arises, so
the outcome is inefficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
The Personal Income Tax
In 2004, the personal income tax raised:
•More than $1 trillion for the federal government
•About $300 billion for state and local governments
The amount of income tax that a person pays depends
on her or his taxable income and on the tax rates.
Taxable income
Total income minus a personal exemption and a
standard deduction (or other allowable deductions).
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Marginal tax rate
The percentage of an additional dollar of income that
is paid in tax.
Average tax rate
The percentage of income that is paid in tax.
8.2 THE
INCOME
TAX AND
SYSTEM
SOCIAL SECURITY TAX
A tax can be progressive, proportional, or regressive.
Progressive tax
A tax whose average rate increases as income
increases.
Proportional tax
A tax whose average rate is constant at all income
levels.
Regressive tax
A tax whose average rate decreases as income
increases.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.5 shows U.S.
tax rates in 2001.
1. Marginal tax
rate increases
with income.
2. Average tax rate
increases with
income
The personal income
tax is a progressive
tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
The Effects of the Income Tax
Tax on Labor Income
Firms can substitute machines for labor, so the demand
for labor is elastic.
Most people must work for their income, so the supply
of labor is inelastic.
With elastic demand and inelastic supply, the worker
bears the greater burden of the income tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.6 shows the effects of
a tax on labor income.
With a 20% income tax:
1. The supply of labor
decreases, the wage rate
rises, and the after-tax wage
rate falls.
2. The employer pays some of
the tax.
3. The worker pays most of the
tax.
4. A deadweight loss arises.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Taxes on Capital Income
Taxing the income from capital works like taxing the
income from labor.
One crucial difference: capital is internationally mobile
and so the supply of capital is highly elastic—perhaps
perfectly elastic.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.7 shows the effect of
a tax on capital income.
1. The supply of capital is
perfectly elastic.
2. With a 40 percent tax on
capital income, the interest
rate rises.
3. The firm pays the entire tax.
4. A large deadweight loss
arises.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Taxes on Income from Land and Unique Resources
Works in the same way as taxing the income from other
sources except for one crucial difference.
The supply of land is highly inelastic.
The tax on land income is fully borne by the landowners
and the quantity of land is unaffected by the tax.
With no change in the quantity of land, the tax on land
income creates no deadweight loss or excess burden
and is efficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.8(a) shows a tax
on income from land.
1. Supply is perfectly inelastic.
2. With a 40 percent tax, the
supply of land is
unchanged and the market
rent is unchanged.
3. The landowner pays the
entire tax.
No deadweight loss
arises—the tax is efficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
Figure 8.7 (b) shows a high tax
rate on Barbara Walter’s income.
1. Supply is perfectly inelastic.
2. With a 40 percent tax, the
supply curve is unchanged and
the market price is unchanged.
3. Barbara Walters pays the entire
tax.
No deadweight loss arises and
the tax is efficient.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
The Social Security Tax
The Social Security tax law says that the tax is to be
shared equally by workers and employers.
But the principles that determine the incidence of other
taxes you’ve studied in this chapter also apply to the
Social Security tax.
We look at two extreme Social Security taxes: one on
workers only and one on employers only.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security Tax
on Workers
With no taxes, the wage
rate is $6.00 an hour
and 4,000 people are
employed.
1. A 20 percent Social
Security tax on workers
shifts the supply curve
to LS + tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
2. The wage rate paid
by employers rises to
$6.25 an hour—an
increase of 25 cents
an hour.
3. The number of people
employed decreases
to 3,000.
4 Workers receive $5
an hour—a decrease
of $1 an hour.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
5. The government
collects tax revenue
shown by the purple
rectangle.
Workers pay most of
the tax because the
supply of labor is more
inelastic than the
demand for labor.
8.2 INCOME AND SOCIAL SECURITY TAX
A Social Security Tax on
Employers
Payroll tax
A tax on employers based on the wages they pay
their workers.
Figure 7.4 on the next slide shows the effects of a
payroll tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security
Tax on Employers
With no tax, the wage
rate is $6.00 an hour
and 4,000 people are
employed.
1. A tax on employers of
$1.25 an hour shifts
the demand curve to
LD – tax.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
2. The wage rate falls
to $5.00 an hour—a
decrease of $1.00 an
hour.
3. The number of
workers employed
decreases to 3,000.
8.2 INCOME TAX AND SOCIAL SECURITY TAX
4. Employers’ total cost
of labor rises to $6.25
an hour—the $5.00
wage rate plus the
$1.25 payroll tax.
5. The government
collects tax revenue
shown by the purple
rectangle.
8.3 FAIRNESS AND THE BIG TRADEOFF
Whenever political leaders debate tax issues, it is
fairness, not efficiency, that looms above all other
considerations.
There are two conflicting principles of fairness of taxes:
• The benefits principle
• The ability-to-pay principle
8.3 FAIRNESS AND THE BIG TRADEOFF
The Benefits Principle
Benefits principle
The proposition that people should pay taxes equal to
the benefits they receive from public goods and services.
This arrangement is fair because it means that those
who benefit most pay the most.
But to implement it, we would need an objective way of
measuring each person’s marginal benefit from public
goods and services.
8.3 FAIRNESS AND THE BIG TRADEOFF
The Ability-to-Pay Principle
Ability-to-pay principle
The proposition that people should pay taxes according
to how easily they can bear the burden.
A rich person can more easily bear the burden of
providing public goods than a poor person can, so the
rich should pay higher taxes than the poor.
This principle compares people according to
• Horizontal equity
• Vertical equity
8.3 FAIRNESS AND THE BIG TRADEOFF
Horizontal equity
The requirement that taxpayers with the same ability
to pay the same taxes.
Vertical equity
The requirement that taxpayers with a greater ability
to pay bear a greater share of the taxes.
8.3 FAIRNESS AND THE BIG TRADEOFF
The Marriage Tax Problem
• In the U.S. tax code, a married couple is
considered a single taxpayer.
• This arrangement means that if they each earn the
same income as before a marriage, the married
couple might pay more tax than they did before
marriage.
8.3 FAIRNESS AND THE BIG TRADEOFF
The Big Tradeoff
Questions about the fairness of taxes conflict with
efficiency questions and create the big tradeoff.
Taxes on capital incomes create the greatest
deadweight loss—are the most inefficient.
But most of the capital is owned by a small number of
rich people, so (most people believe) taxes on capital
are the fairest.
Our tax system is an evolving attempt to juggle to two
goals of efficiency and fairness.
Taxes in YOUR Life
The Tax Foundation has calculated “Tax Freedom Day”—
the day by when the average U.S. citizen has worked long
enough to pay a year’s tax bill.
In 2004, Tax Freedom Day was 17 April—107 days:
• 38 days to pay personal income taxes
• 30 days to pay Social Security taxes
• 16 days to sales and excise taxes
• 11 days to pay property taxes
• 9 days to pay corporate income taxes
• 3 days to pay all other taxes
Work out your own “Tax Freedom Day.”