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Taxation and Government Intervention Chapter 7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Laugher Curve Two economists meet on the street. Q. How’s your wife? A. Relative to what? McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer and Consumer Surplus Consumer surplus – the value the consumer gets from buying a product less its price. It is the area underneath the demand curve and above the price an individual pays. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer and Consumer Surplus Producer surplus – the value the producer sells a product for less the cost of producing it. It is the area above the supply curve but below the price the producer receives. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer and Consumer Surplus The combination of consumer and producer surplus is as large as it can be at market equilibrium. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer and Consumer Surplus $10 9 Consumer Surplus 8 7 6 5 4 Producer 3 Surplus 2 1 0 1 2 3 4 5 6 7 8 Quantity McGraw-Hill/Irwin Supply Demand 9 10 © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer and Consumer Surplus The combined consumer and producer surplus falls when price is above market equilibrium. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Producer and Consumer Surplus $10 9 8 7 6 5 4 3 2 1 0 McGraw-Hill/Irwin Consumer Surplus Lost Surplus Supply Producer Surplus Demand 1 2 3 4 5 6 7 8 Quantity 9 10 © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Taxation and Government For government to operate, it must tax. For the market to work, it needs government. Tax rates depend on what goods and services government provides. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Highest Tax Rates on Wage Income (2001) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. How Much Should Government Tax? To answer this, we must know the costs and benefits of taxation. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation The costs of taxation include: The direct cost of the revenue paid to government The loss of consumer and producer surplus caused by the tax The cost of administering the tax codes. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation A tax paid by the supplier shifts the supply curve up by the amount of the tax. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation When government raises taxes, there is a loss of consumer and producer surplus that is not gained by government. This is known as deadweight loss. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation Graphically the deadweight loss is shown on a supply-demand curve as the welfare loss triangle. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation Price Consumer surplus S1 S0 P1 tax Deadweight loss P0 P1–t Producer surplus Q1 McGraw-Hill/Irwin Demand Q0 Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Costs of Taxation The other costs of taxation are the administrative costs of compliance. Resources are used by the government to administer the tax code and by citizens and businesses to comply with it. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Benefits of Taxation The benefits of taxation are the goods and services that government provides. Provides a stable set of institutions and rules. Promotes effective and workable competition. Corrects for externalities. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Benefits of Taxation The benefits of taxation are the goods and services that government provides. Creates an environment that fosters economic stability and growth. Provides public goods. Adjusts for undesirable market results. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Benefits of Taxation Measuring the benefits of governmentsupplied goods is difficult because they are not provided in a market setting. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Two Principles of Taxation The government follows two general principles of taxation: The benefits principle. The ability-to-pay principle. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Benefit Principle Benefit principle of taxation –the individuals who receive the benefit of the good or service should pay the tax necessary to supply the good. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Ability-to-Pay Principle The ability-to-pay principle –individuals who are most able to bear the burden of the tax should pay the tax. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Difficulty of Applying the Principles of Taxation The principles of taxation are difficult to apply. The two principles often conflict. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Difficulty of Applying the Principles of Taxation The elasticity concept helps us to understand the tradeoffs. If the government seeks to minimize the welfare loss, it should tax goods with inelastic supplies and demands. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Who Bears the Burden of a Tax? The supply and demand framework gives the answer to this question. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Burden Depends on Relative Elasticity The person who physically pays the tax is not necessarily the person who bears the burden of the tax. The burden of the tax is rarely shared equally since elasticities are rarely equal. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Burden Depends on Relative Elasticity The more inelastic one’s relative supply and demand, the larger the tax burden one will bear. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Burden Depends on Relative Elasticity If demand is more inelastic than supply, consumers will pay the higher share. If supply is more inelastic than demand, suppliers will pay the higher share. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Who Bears the Burden of a Tax? Supplier Pays Tax Price of luxury boats S1 $70,000 60,000 50,000 40,000 30,000 20,000 10,000 Supplier pays Demand 510 200 McGraw-Hill/Irwin tax Consumer pays S0 400 600 Quantity of luxury boats © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Who Bears the Burden of a Tax? Demand is inelastic Price of luxury boats S1 $70,000 Consumer pays 60,000 50,000 Supplier pays 40,000 30,000 20,000 10,000 200 McGraw-Hill/Irwin 400 tax S0 Demand 590 600 Quantity of luxury boats © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price of luxury boats Who Bears the Burden of a Tax? Consumer Pays Tax $70,000 60,000 50,000 40,000 30,000 20,000 10,000 S0 Consumer pays Supplier pays tax D0 D1 510 200 McGraw-Hill/Irwin 400 600 Quantity of luxury boats © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Who Pays Versus Who Bears the Burden of a Tax The burden of a tax is independent of who physically pays the tax. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Tax Incidence and Current Policy Debates The analysis of tax incidence is helpful when discussing current policy debates. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Social Security Taxes Both employer and employee contribute the same percentage of before-tax wages to the Social Security fund. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Social Security Taxes The fact that both the employer and employee contribute the same percentage does not mean they share the burden equally. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Social Security Taxes On average, labor supply tends to be less elastic than labor demand, so the Social Security tax burden is primarily on employees. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sales Taxes Sales taxes are those paid by retailers on the basis of their sales revenue. Since sales taxes are broadly defined, consumers find it hard to substitute. Demand is inelastic so consumers bear the greater burden of the tax. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sales Taxes As consumers increase purchases on the internet where sales are not taxed, retail stores will bear a greater burden of the sales tax. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Intervention Taxation is but one way in which government affects our lives. Other forms of government intervention include price controls. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Intervention as Implicit Taxation Government intervention can be seen as a combination tax and subsidy. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Ceilings A price ceiling is a government-set price below market equilibrium price. It is an implicit tax on producers and an implicit subsidy to consumers. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Ceilings Price ceilings cause a loss in producer and consumer surpluses that is identical to the welfare loss from taxation. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Effect of Price Ceiling Price Consumer surplus Welfare loss P0 P1 Price ceiling Producer surplus Transferred to consumers Q1 McGraw-Hill/Irwin Supply Q0 Demand Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Floors A price floor is a government-set price above equilibrium price. It is a tax on consumers and a subsidy to producers. Price floors transfer consumer surplus to producers. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Effect of Price Floor Price Consumer surplus Transferred to producers P2 Welfare loss P0 Producer surplus Demand Q1 McGraw-Hill/Irwin Supply Price Floor Q0 Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Difference Between Taxes and Price Controls Price ceilings create shortages and taxes do not. Shortages also create black markets. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Price Ceiling with Forced Supply The draft is a law that requires some people to serve a set period in the armed forces at whatever pay the government chooses. The draft is an example of a price ceiling with forced supply. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Price Ceiling with Forced Supply A draft must be imposed when the wage offered by the army is below equilibrium. The quantity of soldiers demanded is below the quantity supplied. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Price Ceiling with Forced Supply Those conscripted are forced to accept a lower wage than they would otherwise get. The surplus is transferred from the ones drafted to the government. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Effect of a Draft on Surplus Wage Supply Surplus transferred to the government Deadweight loss caused by draft We W0 Demand QS McGraw-Hill/Irwin QD=Draft Quantity of soldiers © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Rent Seeking, Politics, and Elasticities Price controls reduce total producer and consumer surpluses. Governments institute them because people care more about their own surplus than they do about total surplus. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Rent Seeking, Politics, and Elasticities Individuals lobby government to institute policies that increase their own surplus. Others have the incentive to spend money to counteract that lobbying. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Rent Seeking, Politics, and Elasticities Rent seeking – activities designed to transfer surplus from one group to another. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Rent Seeking, Politics, and Elasticities Public choice economists integrate economic analysis of politics with their analysis of the economy. They argue that when all rent seeking and tax consequences are netted out, there is often no net gain to the public. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Demand and Incentives to Restrict Supply When demand is inelastic, producers have incentives to restrict supply. Farming is an example. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Demand and Incentives to Restrict Supply Advances in farming productivity increases supply but at lower prices. Since food has few substitutes, its demand is inelastic. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Demand and Incentives to Restrict Supply Inelastic demand means that prices fall faster than a rise in quantity sold. Revenues fall, and farmers are worse off. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Demand and Incentives to Restrict Supply Farmers have an incentive to restrict supply when demand is inelastic because that increases total revenue. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Demand and Incentives to Restrict Supply Price S0 P0 S1 Revenue gained P1 Revenue lost Total Revenue Demand Q0 Q 1 McGraw-Hill/Irwin Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Supplies and Incentives to Restrict Prices Consumers are also rent seekers. When supply is inelastic, consumers have incentives to restrict prices. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand goes up, prices jump causing consumers to lobby for price controls. Rent control in New York City is an example. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Floors and Elasticity of Demand and Supply Price floor with elastic supply and demand Price Supply PF PE Demand QD McGraw-Hill/Irwin QS Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Floors and Elasticity of Demand and Supply Price floor with elastic supply and inelastic demand Price Supply PF PE Demand QD McGraw-Hill/Irwin QS Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Floors and Elasticity of Demand and Supply Price floor with inelastic supply and demand Price Demand Supply PF PE Q D QS McGraw-Hill/Irwin Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long-Run/Short-Run Problem of Price Controls The problem of price controls worsen from the short run to the long run. In the long run, supply and demand tend to be much more elastic than in the short run. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long-Run/Short-Run Problem of Price Controls In the short run there will be small effects from the price controls. There will be huge effects in the long run. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Long-Run/Short-Run Problem of Price Controls In the face of price controls, potential new competitors hate to enter the market thereby strangling supply. Vacancy rates drop as potential new renters scramble to find shrinking affordable housing. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run and Short-Run Effects of Price Controls Price Short run supply P1 P2 P0 Long run supply Price ceiling D1 D0 Q0 Q1 McGraw-Hill/Irwin Q2 Q3 Shortage Quantity © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Taxation and Government Intervention End of Chapter 7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
