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CHAPTER 17: PUBLIC CHOICE THEORY AND THE ECONOMICS OF TAXATION
Introduction
As we have seen, government plays an important role in addressing market failures. But it also
plays a significant role in taxation and redistribution of income, and sometimes policy can create
inefficiency. Chapter 17 introduces the types, effects, and efficiency loss of taxation. This
begins a series of chapters dealing with specific government policy issues. Material from Chapter
17 consistently appears in a few multiple-choice questions and infrequently in a free-response
question on the AP microeconomics exam.
Public Choice Theory and Government Failure
Government has an important responsibility to provide public goods when the market fails, but
the dynamics of a democratic system can complicate that effort. Because voters cannot indicate
the strength of their desires for public goods, it is difficult for policymakers to determine the
appropriate provision of public goods.
Government failure occurs when a government policy creates inefficiency in the market. Special
interest effects allow a small, vocal group to obtain policy for their own benefit at the expense of
the wider society. Interest groups with an incentive to promote a particular policy outcome lobby
strongly, leaving policymakers with a distorted understanding of public positions. Logrolling, or
vote trading, can lead to inefficient outcomes, including spending for pork barrel projects, or
earmarks-special projects that may benefit a small group or a candidate's reelection but not
society in general. And to promote reelection, policymakers prefer programs that bring
immediate, clear benefits but that defer or hide costs. Inefficiency within bureaucratic institutions
also contributes to government failure.
Bear in Mind
Public choice theory and government failure have not been directly tested on the AP economics
exams and are only briefly discussed here.
Apportioning the Tax Burden
Once government determines which public goods will be provided, it must determine who will
pay for those public goods through taxes. The benefits-received principle holds thatthose who
receive the most public goods should pay the most in taxes. Gasoline taxes, which are used to
fund highway building and maintenance, use this system. However, this principle is clearly
ineffective in the case of imposing higher taxes on those who receive food stamps, housing
subsidies, and unemployment checks; the low income or unemployment status that qualifies them
for the benefits also indicates they are the least able to afford a higher tax rate. Further, how can
indirect benefits of public goods be calculated? The ability-to-pay principle instead holds that
taxpayers should be charged according to their income; those with higher incomes should pay
higher tax rates. Federal income taxes are based on this principle, under the argument that those
with higher incomes are more financially able to pay taxes than those with lower incomes. The
problem with this principle is the difficulty in determining the relative ability of any particular
household to pay a certain tax rate.
Progressive, Regressive, and Proportional Taxes
Under a progressive tax, such as the federal income tax, as income rises, the percentage of
income paid in taxes rises. Proportional tax has each taxpayer pay the same percentage of income
in taxes, regardless of income. With a regressive tax, those with lower incomes pay a higher
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Chapter 17: Public Choice Theory and the Economics of Taxation
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percentage of their income in taxes than those with higher incomes. Sales taxes are regressive
taxes, though they may seem to be proportional. Those with lower incomes spend a greater
portion of their income on taxable items, while those with higher incomes save and invest part of
their income-which is not subject to the sales tax. The lower-income taxpayer may pay 5
percent of his income in sales tax, while the higher-income taxpayer pays only 3 percent of his
income in sales tax. Social Security payroll taxes are also regressive, in that only the first
$100,000 of income is subject to the payroll tax. Workers earning less than $100,000 pay the
payroll tax on their entire income, while those earning higher incomes pay no more payroll tax,
and other significant earnings in interest, dividends, and other benefits are not subject to the
Social Security payroll tax at all.
Tax Incidence
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Efficiency loss (or deadweight loss) of a tax
Policymakers must also consider the tax incidence, or who pays the final burden of the tax.
Sometimes taxes can be shifted to other people. When graphing a tax increase, the supply curve
shifts directly upward by the amount of the tax. Market equilibrium shifts to a lower quantity and
a higher price. We then need to determine how the burden of the tax is divided. Is it paid by the
firm or by the consumers? In this case, the price to consumers rose from $8 to $9, so consumers
paid $1 of the tax. But because the tax is $2, the firm must pay the oth~ $1 of the tax. The
firm's revenue at the new equilibrium is $87.5 million ($7 x $12.5 million), while the
government's revenue is $25 million ($2 x $12.5 million). A deadweight loss again appears in
the triangle abc, representing the loss of producer and consumer surplus resulting from the tax.
Production and consumption have fallen from the point where marginal benefit equals marginal
cost of production (supply equals demand), so we no longer achieve allocative efficiency.
Bear in Mind
It is important to be able to identify producer and consumer surplus, after-tax deadweight loss, the
firm's revenue, the tax revenue, and the relative burdens of the tax to consumers and the firm.
Previous AP microeconomics free-response questions have asked students to identify such
information from a graph presented in the question or from graphs the student has been asked to
draw. It is also important to recognize the differences in the tax burden on consumers and the
firm based on the elasticity of demand for the product.
Chapter 17: Public Choice Theory and the Economics of Taxation
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Elasticities and the Tax Burden
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Tax incidence and elastic
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Tax incidence and inelastic
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Demand elasticity and the incidence of an excise tax
With elastic demand, consumers are sensitive to price changes. An increase in the price results in
a much lower quantity demanded. If we apply the $2 tax increase with elastic demand, quantity
shifts significantly to the left. From points above the new output, you can see that the difference
between the original price and the new price (a), the tax burden passed on to consumers, is very
small. At that output, the difference between the original price and the old supply curve (c)
indicates the burden on the firm. The area abc indicates the deadweight loss. When demand is
elastic, consumers pay little of the tax burden, while the firm pays most of the burden, and the
area of deadweight loss is large. In the extreme, if demand were perfectly elastic (horizontal),
any attempt to raise the price of the product through a tax would reduce demand to zero. So if the
firm wanted to remain in operation, it would be forced to absorb the entire cost of the tax. The .
more elastic the demand for the product, the more the firm must absorb the burden of the tax.
When demand is inelastic, consumers are less sensitive to price change, so they only slightly
reduce the quantity demanded after the tax. As a result, most of the tax burden is shifted to
consumers, while firms pay little of the burden, and the deadweight loss is small. This is why
governments tend to place excise taxes on gasoline, cigarettes, alcohol, and other products for
which consumer demand is inelastic; consumers will continue to buy the product, generating
more government revenue and leaving little burden of the tax on firms. In the extreme situation
of a perfectly inelastic (vertical) demand curve, firms would pass the entire tax on to consumers
and there would be no deadweight loss because quantity did not change. The more inelastic the
demand for the product, the more the tax burden is passed on to consumers.
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Chapter 17: Public Choice Theory and the Economics of Taxation
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Tax incidence and elastic
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Tax incidence and inelastic
supply
Supply elasticity and the incidence of an excise tax
Similarly, when supply is more elastic, firms are able to pass more of the tax burden on to
consumers. When supply is inelastic, the 'tax burden primarily falls on the firms.
Bear in Mind
Previous AP microeconomics exam questions have focused on differences in the elasticity of
demand for the product, rather than elasticity of supply.
Benefits of Taxes
Because of the free-rider problem, taxes are necessary to raise the funds to pay for public goods.
The government also uses taxes to redistribute income. By using progressive income taxes and
redistributing those funds to those with lower incomes through safety net programs like TANF,
food stamps, and rent subsidies, the government has equalized incomes somewhat. In addition,
we have seen that taxes can actually improve efficiency in the case of negative externalities.
Government can impose taxes in a way that forces firms to absorb all of their costs and return the
market to allocative efficiency.
Multiple-Choice Questions
1.
Public policy regarding economic issues can be difficult to develop for all of the
following reasons EXCEPT
(A)
special interest effects.
(B)
logrolling.
(C)
pressure in support of pork barrel projects.
(D)
budget surpluses cannot be equally divided among programs.
(E)
policymakers have an incentive to support programs that help their reelection
efforts.
2.
Which of the following taxes illustrates the benefit principle of taxation?
(A)
regressive payroll taxes used to pay for national defense
(B)
gasoline taxes used to pay for highway building and maintenance
(C)
cigarette taxes used to pay for NASA
(D)
progressive income taxes used to pay for the local police force
(E)
property taxes used to pay for local economic development
Chapter 17: Public Choice Theory and the Economics of Taxation
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3.
A tax which charges those with higher incomes a higher tax rate is
progressive.
(A)
regressive.
(B)
proportional.
(C)
excise.
(D)
efficient.
(E)
4.
The federal government primarily redistributes income through
(A)
regressive Social Security taxes and highway programs.
(B)
proportional property taxes and education programs.
(C)
progressive excise taxes and law enforcement programs.
(D)
regressive sales taxes and national defense programs.
(E)
progressive income taxes and safety net programs.
5.
If the state places an excise tax on a product with relatively elastic demand, supply,
equilibrium output, and equilibrium price will change in what ways?
(A)
(B)
(C)
(D)
(E)
Supply
Output
Price
Increase
Decrease
Decrease
Increase
Increase
Increase
Decrease
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
6.
If an excise tax is placed on a product with relatively inelastic demand and elastic supply,
who will pay most of the burden of the tax?
(A)
the firm
(B)
consumers
(C)
the firm and consumers equally
(D)
the government
(E)
foreign consumers who purchase those products as exports
7.
The deadweight loss associated with a tax increase is largest when
(A)
demand is perfectly inelastic.
(B)
demand is relatively inelastic.
(C)
demand is unit elastic.
demand is relatively elastic.
(D)
consumers will buy the same quantity, regardless of price.
(E)
8.
For what purposes do governments institute taxes?
I.
To provide public goods
II.
To redistribute incomes
III.
To resolve positive externalities
I only
(A)
III only
(B)
I and II only
(C)
II and III only
(D)
I, II, and III
(E)
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Chapter 17: Public Choice Theory and the Economics of Taxation
Free-Response Questions
Assume the government imposes a per-unit sales tax in each of the three markets below, all of
which have identical upward-sloping supply curves.
(a)
In the pharmaceuticals industry, consumers buy exactly the same amount of heart
medicine, regardless of the price.
(i)
Using a correctly labeled graph, identify each of the following:
(a)
the equilibrium price and quantity before the tax
(b)
the equilibrium price and quantity after the tax
(ii)
Explain how the burden of the tax will be distributed between the consumers and
the producers.
(b)
In the food industry, consumer demand for fish sandwiches is relatively elastic.
(i)
Using a correctly labeled graph, identify each of the following:
(a)
the equilibrium price and quantity before the tax
(b)
the equilibrium price and quantity after the tax
(ii)
Explain how the burden of the tax will be distributed between the consumers and
the producers.
(c)
In the fruit industry, consumer demand for apples is perfectly elastic.
(i)
Using a correctly labeled graph, identify each of the following:
(a)
the equilibrium price and quantity before the tax
(b)
the equilibrium price and quantity after the tax
(ii)
Explain how the burden of the tax will be distributed between the consumers and
the producers.
(d)
Is a deadweight loss more likely to develop in the pharmaceuticals industry or in the food
industry as a result of the tax? Explain.
(e)
Assume that the quantity of heart medicine and the quantity of fish sandwiches sold per
day are equal. If the government imposed a $1 per unit tax on heart medicine and fish
sandwiches, which would bring the government more revenue? Explain.
Multiple-Choice Explanations
1.
(D)
The federal government generally runs budget deficits, not surpluses. Decisions
on policy often hinge on the interests of those promoting the policy, not an objective
consideration of effects and efficiencies involved.
2.
(B)
The benefit principle calls for those who benefit most from a program to pay the
most taxes to support it. Those who use highways the most are most likely to buy the
gasoline and, therefore, support the highways.
3.
(A)
A progressive tax is based on the ability-to-pay principle, stating that those with
the highest incomes are best able to afford the tax.
4.
(E)
The federal government taxes those with the highest incomes at higher tax rates
and then redistributes that money to those with lower incomes through TANF, food
stamps, rent subsidies, and other income programs.
5.
(C)
The supply curve shifts upward (essentially to the left), decreasing the
equilibrium output and increasing the equilibrium price.
6.
(B)
Consumers of the product pay the majority of the tax burden, because with their
inelastic demand, the quantity purchased falls very little when the price rises; therefore,
the firm can pass the tax increase on to consumers.
7.
(D)
When consumers are sensitive to the change in price due to the tax, the quantity
sold drops significantly, causing a greater deadweight loss.
8.
(C)
Taxes are used in the case of negative (not positive) externalities to force firms to
absorb all of their costs of production, in order to try to move the market back to
allocative efficiency.
Chapter 17: Public Choice Theory and the Economics of Taxation
149
Free-Response Explanations
16 points (4 + 4 + 4 + 2 + 2)
(a)
4 points:
• 1 point is earned for correctly identifying price and quantity before the tax.
• 1 point is earned for correctly identifying a higher price and no change in quantity.
• 1 point is earned for stating that consumers will pay the entire tax.
• 1 point is earned for explaining that because demand is perfectly inelastic, the firm can
pass the entire tax on to the consumers.
(b)
4 points:
• 1 point is earned for correctly identifying price and quantity before the tax.
• 1 point is earned for correctly identifying a higher price and a lower quantity.
• 1 point is earned for stating that firms will pay a larger burden of the tax than consumers
will.
• 1 point is earned for explaining that because consumers are so sensitive to the price
change, the firm must absorb more of the tax in order to avoid losing sales.
(c)
4 points:
• 1 point is earned for correctly identifying price and quantity before the tax.
• 1 point is earned for correctly identifying a lower quantity and no change in price.
• 1 point is earned for stating that firms will pay the entire tax.
• 1 point is earned for explaining that because demand is perfectly elastic, the firm must
absorb the entire tax or the quantity demanded will fall to zero.
(d)
2 points:
• 1 point is earned for stating that the deadweight loss will develop in the food industry.
• 1 point is earned for explaining that the quantity of fish sandwiches demanded fell as a
result of the tax, while the quantity of heart medicine demanded did not change.
(e)
2 points:
• 1 point is earned for stating that the government would earn more revenue from a tax on
heart medicine.
• 1 point is earned for explaining that, with the tax, the same quantity of heart medicine but
a lower quantity of fish sandwiches would be sold, which would lower the revenue.
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Chapter 17: Public Choice Theory and the Economics of Taxation