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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 y l ia d ce nd an da aly .S. lic ry n y ark um nd en a n a a It U ub g ma m lg i n la ed rw str rla ran el a Jap ana n o r n e u F Ir Fi Sw N Au itze ep C B H G e De R w h S c ze C 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 McGraw-Hill/Irwin 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. McGraw-Hill/Irwin 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 McGraw-Hill/Irwin 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. McGraw-Hill/Irwin 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 Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 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.