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Chapter 7
TAXATION AND
GOVERNMENT
INTERVENTION
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-2
Today’s lecture will:
• Show how equilibrium maximizes
consumer and producer surplus.
• Demonstrate the cost of taxation to
consumers and producers.
• Distinguish between the benefit
principle and the ability-to-pay
principle.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-3
Today’s lecture will:
• Explain why the person who physically
pays the tax is not necessarily the person
who bears the burden of the tax.
• Demonstrate how an effective price
ceiling is the equivalent of a tax on
producers and a subsidy to consumers.
• Define rent seeking and show how it is
related to elasticity.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-4
Producer and Consumer Surplus
• Consumer surplus - the value the consumer
gets from buying a product, less its price.
 It is the area below the demand curve and above
the price.
• 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
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-5
Producer and Consumer Surplus
$10
9
8
7
6
5
4
3
2
1
0
Consumer
Surplus
Producer
Surplus
S
CS = ½(5x5) = 12.5 =
Area of blue triangle
PS = ½(5x5) = 12.5 =
Area of red triangle
D
The combination of
producer and consumer
surplus is maximized at
market equilibrium.
1 2 3 4 5 6 7 8 9 10
Quantity
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-6
Producer and Consumer Surplus
$10
9
8
7
6
5
4
3
2
1
0
Combined consumer and
producer surplus decreases
when price is above
equilibrium.
If price is $6,
Consumer Surplus:
CS = 1/2 ($4x4) = $8
S
Lost surplus = ½($2x1) = $1
Producer Surplus gains 2x4 = 8
units of lost consumer surplus
D
1 2 3 4 5 6 7 8 9 10
Quantity
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-7
Taxation and Government
• For government to operate, it must
tax.
• For the market to work, it needs the
government.
• Tax rates depend on what goods and
services government provides.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-8
Percent of Income
Highest Tax Rates on Wage
Income (2003)
80
70
60
50
40
30
20
10
0
68.4
64.2 62.3
59.3 57.4 56.2
55.3
48.5 48.2 48.1 48
47.8 46.4 46.1
42.9 40.5
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McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-9
The Costs of Taxation
• To determine how much to tax, the
•
government must determine the costs and
benefits of taxation.
The costs of taxation include:
 Direct cost of revenue paid to the government
 Deadweight loss - loss of consumer and producer
surplus that is not gained by the government
 Administrative costs of compliance – resources
used by the government to administer the tax and
individuals and businesses to comply with it
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-10
Costs of Taxation
Price
Consumer
surplus
S1
A
P1
tax
B
P0
C
E
D
P1–t
F
Producer
surplus
Q1
McGraw-Hill/Irwin
A per unit tax t paid by the
suppliers shifts the supply
curve from S0 to S1 and increases price to P1 and
S0 decreases quantity to Q1.
Consumer surplus is
A+B+C before the tax
Deadweight
and A after the tax.
loss
Producer surplus is
D+E+F before the tax
and F after the tax.
D
Q0
Quantity
Government revenue=B+D
Deadweight loss=C+E
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-11
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
Creates an environment that fosters stability and
growth
 Provides public goods
 Adjusts for undesirable market results
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-12
Two Principles of Taxation
• The benefits principle – the
individuals who receive the benefit of
the good or service should pay the
tax necessary to supply the good.
• The ability-to-pay principle –
individuals who are most able to bear
the burden of the tax should pay.
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-13
Tax Burden
• The person who physically pays the tax is not
•
necessarily the person who bears the burden
of the tax.
The more inelastic one’s relative demand and
supply, the larger the tax burden one will bear.
 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
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-14
Who Bears the Tax Burden?
Demand is elastic
Equal burden
Demand is inelastic
Larger consumer burden
S1
$70
tax S
0
60
50
40
0
Quantity of luxury boats
McGraw-Hill/Irwin
$70
S0
60
50
40
590
0
510 600
S1
D
Price of luxury boats
Price of luxury boats
D
500 600
Quantity of luxury boats
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-15
Who Bears the Tax Burden?
Tax burden is independent of who pays the tax.
Supplier pays the taxSupply shifts
S1
Price of luxury boats
D
$70
tax S
0
60
50
40
Price of luxury boats
Consumer pays the taxDemand shifts
$70
60
510 600
Quantity of luxury boats
McGraw-Hill/Irwin
D0
50
40
0
0
S
tax
D1
510 600
Quantity of luxury boats
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-16
Social Security Taxes
• Both employer and employee contribute the
•
•
same percentage of before-tax wages to the
Social Security fund.
Although the employer and employee
contribute the same percentage, they do not
share the burden equally.
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
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-17
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.
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
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-18
Government Intervention as
Implicit Taxation
• Government intervention in the form of price
•
•
controls can be viewed as a combination tax
and subsidy.
A price ceiling is an implicit tax on producers
and an implicit subsidy to producers that
causes a welfare loss identical to the loss from
taxation.
A price floor is a tax on consumers and a
subsidy for producers that transfers consumer
surplus to producers.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-19
Effect of a Price Ceiling
Price
Consumer
surplus
A
P0
P1
Welfare loss
B
D
C
E
F
Transferred to
consumers
Producer
surplus
Q1
McGraw-Hill/Irwin
S
Price ceiling
Q0
D
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-20
Effect of a Price Floor
Price
Consumer
surplus
Price floor
A
S
P1
P0
B
D
C
E
F
Transferred to
producers
Producer
surplus
Q1
McGraw-Hill/Irwin
Welfare loss
Q0
D
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-21
The Difference Between Taxes
and Price Controls
• Price ceilings create shortages and
taxes do not unless people try to
evade them.
• Taxes leave people free to choose
how much to supply and consume as
long as they pay the tax.
• Shortages also create black markets.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-22
A Price Ceiling with
Forced Supply
• The draft is an example of a price ceiling
with forced supply.
• A draft must be imposed when the wage
offered by the army is below equilibrium
and the quantity of soldiers supplied is
below the quantity demanded.
• The surplus is transferred from the ones
drafted to the government.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-23
Effect of a Draft on Surplus
Wage
S
Deadweight loss
caused by draft
We
Surplus transferred to
the government
W0
D
QS
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QD=Draft
Quantity of soldiers
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-24
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 about total surplus.
• Individuals spend money to lobby
governments to institute policies that
increase their own surplus.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-25
Rent Seeking, Politics,
and Elasticities
• Rent seeking – activities designed to
transfer surplus from one group to
another.
• 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 not a net gain to the public.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-26
Inelastic Demand and
Incentives to Restrict Supply
• When demand is inelastic, such as the
•
•
•
demand for food, producers have
incentives to restrict supply.
Advances in farming productivity increase
supply, but decrease price.
Since demand is inelastic, lower prices
decrease total revenue.
Farmers have an incentive to restrict
supply in order to raise price and increase
total revenue.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-27
Inelastic Demand and
Incentives to Restrict Supply
Price
S0
P0
Revenue lost
S1
P1
Revenue gained
Total Revenue
D
Q0 Q1
McGraw-Hill/Irwin
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-28
Inelastic Supplies and
Incentives to Restrict Prices
• When supply is inelastic, consumers
have incentives to restrict prices.
• When supply is inelastic and demand
increases, prices increase causing
consumers to lobby for price
controls.
• Rent control in New York City is an
example.
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-29
Price Floors and Elasticity of
Demand and Supply
• The surplus created by a price floor is
larger if demand and supply are elastic.
P
P
surplus
S
surplus
D
PF
PE
PF
PE
S
D
QD
McGraw-Hill/Irwin
QS
Q
QD QS
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-30
The Long-Run/Short-Run
Problems of Price Controls
• In the long-run, supply and demand tend
•
•
to be much more elastic than in the short
run.
In the short run, when demand and supply
are more inelastic, the effects of price
controls are small.
In the long run, with more elastic demand
and supply, the shortages or surpluses
are larger.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-31
Long-Run and Short-Run
Elasticities
Short run
supply
P
Long run
supply
P1
P2
Larger long-run
elasticities result
in smaller price
increases when
demand increases.
P0
D1
D0
Q0
McGraw-Hill/Irwin
Q1
Q2
Q3
Q
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-32
Summary
• Consumer surplus is the net benefit a consumer
•
•
•
gets from purchasing a good.
Producer surplus is the net benefit a producer
gets from selling a good.
Equilibrium maximizes the combination of
consumer and producer surplus.
Taxes create a loss of consumer and producer
surplus known as deadweight loss, which is
graphically represented by the welfare loss
triangle.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-33
Summary
• The cost of taxation to consumers and
•
•
producers includes the actual tax paid, the
deadweight loss, and the costs of
administering the tax.
Government follows both the benefit principle
and the ability-to-pay principle when deciding
on whom to levy taxes.
Relative elasticities determine who bears the
burden of the tax. The more inelastic one’s
demand or supply, the larger the burden of the
tax.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-34
Summary
• Price ceilings and floors, like taxes, result in
•
•
•
loss of consumer and producer surplus.
Price ceilings transfer producer surplus to
consumers; they are a tax on producers and a
subsidy to consumers.
Price floors transfer consumer surplus to
producers; they are a tax on consumers and a
subsidy to producers.
The more elastic supply and/or demand is, the
greater the surplus with an effective price floor
and the greater the shortage is with an effective
price ceiling.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7-35
Review Question 7-1 Given the following demand and
supply of pizza, find consumer and producer surplus.
$10
$9
Consumer surplus:
½ x ($10-6) x 100 = $200
S
$8
$7
Producer surplus:
½ x ($6-4) x 100 = $100
$6
$5
D
$4
50
McGraw-Hill/Irwin
100
150
200
250
300
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7-36
Review Question 7-2 Given the following demand and
supply of pizza, show the effects of a price floor at $8.
$10
S
Consumer surplus
$9
Price floor
$8
$7
Deadweight loss
$6
$5
Producer surplus
$4
D
50
McGraw-Hill/Irwin
100
150
200
250
300
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.