Download Taxes

Unit 3: Government and
Microeconomics
Book Chapters 4, 28, 29, and 32
TAXES
• Governments levy taxes to raise revenue for
public projects.
How Taxes on Buyers (and Sellers) Affect Market
Outcomes
• Taxes discourage market activity.
• When a good is taxed, the
quantity sold is smaller.
• Buyers and sellers share
the tax burden.
Elasticity and Tax Incidence
• Tax incidence is the manner in which the
burden of a tax is shared among participants
in a market.
• The economic burden of a tax is independent
of the legal burden.
A Tax on Buyers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
Price
3.00
2.80
without
tax
Price
sellers
receive
Supply, S1
Equilibrium without tax
Tax ($0.50)
A tax on buyers
shifts the demand
curve downward
by the size of
the tax ($0.50).
Equilibrium
with tax
D1
D2
0
90
100
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
A Tax on Sellers
Price of
Ice-Cream
Price
Cone
buyers
pay
$3.30
3.00
Price
2.80
without
tax
S2
Equilibrium
with tax
S1
Tax ($0.50)
A tax on sellers
shifts the supply
curve upward
by the amount of
the tax ($0.50).
Equilibrium without tax
Price
sellers
receive
Demand, D1
0
90
100
Quantity of
Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
ELASTICITY AND TAX INCIDENCE
So, how is the burden of the tax divided?
• The burden of a tax falls more
heavily on the side of the
market that is less elastic.
THE DEADWEIGHT LOSS OF TAXATION
• How do taxes affect the economic well-being
of market participants?
THE DEADWEIGHT LOSS OF TAXATION
• It does not matter whether a tax on a good is
levied on buyers or sellers
of the good . . . the price
paid by buyers rises, and
the price received by
sellers falls.
The Effects of a Tax
Price
Supply
Price buyers
pay
Size of tax
Price
without tax
Price sellers
receive
Demand
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
How a Tax Affects Market Participants
• A tax places a wedge between the price
buyers pay and the price sellers receive.
• Because of this tax wedge, the quantity sold
falls below the level that would be sold
without a tax.
• The size of the market for that good shrinks.
How a Tax Affects Market Participants
• Tax Revenue
– T = the size of the tax
– Q = the quantity of the good sold
T  Q = the government’s tax revenue
Tax Revenue
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
without tax
Quantity
Copyright © 2004 South-Western
How a Tax Effects Welfare
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Q1
Quantity
Copyright © 2004 South-Western
How a Tax Affects Market Participants
• Changes in Welfare
– A deadweight loss is the fall in total surplus that
results from a market distortion, such as a tax.
How a Tax Affects Market Participants
• The change in total welfare includes:
– The change in consumer surplus,
– The change in producer surplus, and
– The change in tax revenue.
– The losses to buyers and sellers exceed the
revenue raised by the government.
– This fall in total surplus is called the deadweight
loss.
DETERMINANTS OF THE DEADWEIGHT
LOSS
• What determines whether the deadweight
loss from a tax is large or small?
– The magnitude of the deadweight loss depends on
how much the quantity supplied and quantity
demanded respond to changes in the price.
– That, in turn, depends on the price elasticities of
supply and demand.
Tax Distortions and Elasticities
(a) Inelastic Supply
Price
Supply
When supply is
relatively inelastic,
the deadweight loss
of a tax is small.
Size of tax
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(b) Elastic Supply
Price
When supply is relatively
elastic, the deadweight
loss of a tax is large.
Size
of
tax
Supply
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(c) Inelastic Demand
Price
Supply
Size of tax
When demand is
relatively inelastic,
the deadweight loss
of a tax is small.
Demand
0
Quantity
Copyright © 2004 South-Western
Tax Distortions and Elasticities
(d) Elastic Demand
Price
Supply
Size
of
tax
Demand
When demand is relatively
elastic, the deadweight
loss of a tax is large.
0
Quantity
Copyright © 2004 South-Western
DETERMINANTS OF THE DEADWEIGHT
LOSS
• The greater the elasticities of demand and
supply:
– the larger will be the decline in equilibrium
quantity and,
– the greater the deadweight loss of a tax.
DEADWEIGHT LOSS AND TAX REVENUE
AS TAXES VARY
• The Deadweight Loss Debate
– Some economists argue that labor taxes are highly
distorting and believe that labor supply is more
elastic.
– Some examples of workers who may respond more to
incentives:
•
•
•
•
Workers who can adjust the number of hours they work
Families with second earners
Elderly who can choose when to retire
Workers in the underground economy (i.e., those engaging
in illegal activity)
A Payroll Tax
Wage
Labor supply
Wage firms pay
Tax wedge
Wage without tax
Wage workers
receive
Labor demand
0
Quantity
of Labor
Copyright©2003 Southwestern/Thomson Learning
DEADWEIGHT LOSS AND TAX REVENUE
AS TAXES VARY
• With each increase in the tax rate, the
deadweight loss of the tax rises even more
rapidly than the size of the tax.
Deadweight Loss and Tax Revenue from Three Taxes of Different
Sizes
(a) Small Tax
Price
Deadweight
loss Supply
PB
Tax revenue
PS
Demand
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
Deadweight Loss and Tax Revenue from Three Taxes of Different
Sizes
(b) Medium Tax
Price
Deadweight
loss
PB
Supply
Tax revenue
PS
0
Demand
Q2
Q1 Quantity
Copyright © 2004 South-Western
Deadweight Loss and Tax Revenue from Three Taxes of Different
Sizes
(c) Large Tax
Price
PB
Tax revenue
Deadweight
loss
Supply
Demand
PS
0
Q2
Q1 Quantity
Copyright © 2004 South-Western
DEADWEIGHT LOSS AND TAX REVENUE
AS TAXES VARY
• As the size of a tax increases, its deadweight
loss quickly gets larger.
• By contrast, tax revenue first rises with the
size of a tax, but then, as the tax gets larger,
the market shrinks so much that tax revenue
starts to fall.
How Deadweight Loss and Tax Revenue Vary with the Size of a
Tax
(a) Deadweight Loss
Deadweight
Loss
0
Tax Size
Copyright © 2004 South-Western
How Deadweight Loss and Tax Revenue Vary with the Size of a
Tax
(b) Revenue (the Laffer curve)
Tax
Revenue
0
Tax Size
Copyright © 2004 South-Western
CASE STUDY: The Laffer Curve and Supply-side
Economics
• The Laffer curve depicts the relationship
between tax rates and tax revenue.
• Supply-side economics refers to the views of
Reagan and Laffer who proposed that a tax cut
would induce more people to work and
thereby have the potential to increase tax
revenues.
“In this world nothing is certain but death and taxes.”
. . . Benjamin Franklin
100
80
60
40
20
0
1789
Taxes paid in Ben
Franklin’s time
accounted for 5
percent of the
average
American’s
income.
“In this world nothing is certain but death and taxes.”
. . . Benjamin Franklin
100
80
Today, taxes
account for up
to a third of
the average
American’s
income.
60
40
20
0
1789
Today
Government Revenue as a Percentage of GDP
Revenue as
Percent of 35
GDP
Total government
30
25
State and local
20
15
Federal
10
5
0
1902
1913
1922 1927 1932
1940
1950
1960
1970
1980
1990
Copyright © 2004 South-Western
2000
The Federal Government
• The U.S. federal government collects about
two-thirds of the taxes in our economy.
– The largest source of revenue for the federal
government is the individual income tax.
• The marginal tax rate is the tax rate applied to each
additional dollar of income.
• Higher-income families pay a larger percentage of their
income in taxes.
The Federal Government
• Other taxes
– Payroll Taxes: tax on the wages that a firm pays its
workers.
• Social Insurance Taxes: taxes on wages that is
earmarked to pay for Social Security and Medicare.
– Excise Taxes: taxes on specific goods like gasoline,
cigarettes, and alcoholic beverages.
The Federal Government
• Federal Government Spending
– Government spending includes transfer payments
and the purchase of public goods and services.
• Transfer payments are government payments not made
in exchange for a good or a service.
• Transfer payments are the largest of the government’s
expenditures.
The Federal Government
• Federal Government Spending
– Expense Category:
•
•
•
•
•
•
•
Social Security
National Defense
Income Security
Net Interest
Medicare
Health
Other
State and Local Governments
• State and local governments collect about 40
percent of taxes paid.
State and Local Government
• Receipts
– Sales Taxes
– Property Taxes
– Individual Income Taxes
– Corporate Income Taxes
– Federal government
– Other
Taxes
$
State and Local Government
• Spending
– Education
– Public Welfare
– Highways
– Other
TAXES AND EFFICIENCY
• Policymakers have two objectives in designing
a tax system...
– Efficiency
– Equity
TAXES AND EFFICIENCY
• One tax system is more efficient than another
if it raises the same amount of revenue at a
smaller cost to taxpayers.
• An efficient tax system is one that imposes
small deadweight losses and small
administrative burdens.
TAXES AND EFFICIENCY
• The Cost of Taxes to Taxpayers
– The tax payment itself
– Deadweight losses
– Administrative burdens
Administrative Burdens
• Complying with tax laws creates additional
deadweight losses.
– Taxpayers lose additional time and money
documenting, computing, and avoiding taxes over
and above the actual taxes they pay.
– The administrative burden of any tax system is
part of the inefficiency it creates.
Marginal Tax Rates versus Average Tax Rates
• The average tax rate is total taxes paid divided
by total income.
• The marginal tax rate is the extra taxes paid
on an additional dollar of income.
Lump-Sum Taxes
• A lump-sum tax is a tax that is the same
amount for every person, regardless of
earnings or any actions that the person might
take.
TAXES AND EQUITY
• How should the burden of taxes be divided
among the population?
• How do we evaluate whether a tax system is
fair?
Benefits Principle
• The benefits principle is the idea that people
should pay taxes based on the benefits they
receive from government services.
• An example is a gasoline tax:
– Tax revenues from a gasoline tax are used to
finance our highway system.
– People who drive the most also pay the most
toward maintaining roads.
Ability-to-Pay Principle
• The ability-to-pay principle is the idea that
taxes should be levied on a person according
to how well that person can shoulder the
burden.
• The ability-to-pay principle leads to two
corollary notions of equity.
– Vertical equity
– Horizontal equity
Ability-to-Pay Principle
• Vertical equity is the idea that taxpayers with a
greater ability to pay taxes should pay larger
amounts.
– For example, people with higher incomes should
pay more than people with lower incomes.
Ability-to-Pay Principle
• Vertical Equity and Alternative Tax Systems
– A proportional tax is one for which high-income
and low-income taxpayers pay the same fraction
of income.
– A regressive tax is one for which high-income
taxpayers pay a smaller fraction of their income
than do low-income taxpayers.
– A progressive tax is one for which high-income
taxpayers pay a larger fraction of their income
than do low-income taxpayers.
Ability-to-Pay Principle
• Horizontal Equity
– Horizontal equity is the idea that taxpayers with
similar abilities to pay taxes should pay the same
amounts.
– For example, two families with the same number
of dependents and the same income living in
different parts of the country should pay the same
federal taxes.
Three Tax Systems
Copyright©2004 South-Western
Tax Incidence and Tax Equity
• The difficulty in formulating tax policy is
balancing the often conflicting goals of
efficiency and equity.
• The study of who bears the burden of taxes is
central to evaluating tax equity.
• This study is called tax incidence.
Goals of Tax Policy and Transfer
Programs
• If the goal is equality, we must be able to
measure income inequality
• Two tools
– Lorenz Curve
– Gini Coefficient
Goals of Tax Policy and Transfer
Programs
• Lorenz Curve
– shows the degree of
inequality that exists in
the distributions of two
variables, and is often
used to illustrate the
extent that income or
wealth are distributed
unequally in a particular
society.
Goals of Tax Policy and Transfer
Programs
Gini Coefficient
area between Lorenz
curve and diagonal___
=
total area below the
diagonal
=A / A+B
Goals of Tax Policy and Transfer
Programs
• Gini Coefficient
– Closer to zero means less inequality
– Closer to one means more inequality
• How do we get closer to zero?
– More progressive tax system?
• Estate and gift taxes
• Graduated income tax
– More redistribution of income?
• Social programs
• Medicare and Medicaid
• Welfare and unemployment assistance
Market Failures and Externalities
• Recall: Adam Smith’s “invisible hand” of the
marketplace leads self-interested buyers and
sellers in a market to maximize the total
benefit that society can derive from a market.
But market failures can still happen.
EXTERNALITIES AND MARKET
INEFFICIENCY
• An externality refers to the uncompensated
impact of one person’s actions on the well-being
of a bystander.
• Externalities cause markets to be inefficient, and
thus fail to maximize total surplus.
• An externality arises...
. . . when a person engages in an activity that
influences the well-being of a bystander and yet
neither pays nor receives any compensation for that
effect.
EXTERNALITIES AND MARKET
INEFFICIENCY
• When the impact on the bystander is adverse,
the externality is called a negative externality.
– Negative externalities lead markets to produce a
larger quantity than is socially desirable.
• When the impact on the bystander is
beneficial, the externality is called a positive
externality.
– Positive externalities lead markets to produce a
smaller quantity than is socially desirable.
EXTERNALITIES AND MARKET
INEFFICIENCY
• Negative Externalities
– Automobile exhaust
– Cigarette smoking
– Barking dogs (loud pets)
– Loud stereos in an apartment building
EXTERNALITIES AND MARKET
INEFFICIENCY
• Positive Externalities
– Immunizations
– Restored historic buildings
– Research into new technologies
The Market for Aluminum
Price of
Aluminum
Supply
(private cost)
Equilibrium
Demand
(private value)
0
QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Welfare Economics: A Recap
• The Market for Aluminum
– The quantity produced and consumed in the
market equilibrium is efficient in the sense that it
maximizes the sum of producer and consumer
surplus.
– If the aluminum factories emit pollution (a
negative externality), then the cost to society of
producing aluminum is larger than the cost to
aluminum producers.
Welfare Economics: A Recap
• The Market for Aluminum
– For each unit of aluminum produced, the social
cost includes the private costs of the producers
plus the cost to those bystanders adversely
affected by the pollution.
Figure 2 Pollution and the Social Optimum
Price of
Aluminum
Social
cost
Cost of
pollution
Supply
(private cost)
Optimum
Equilibrium
Demand
(private value)
0
QOPTIMUM QMARKET
Quantity of
Aluminum
Copyright © 2004 South-Western
Negative Externalities
• The intersection of the demand curve and the
social-cost curve determines the optimal
output level.
– The socially optimal output level is less than the
market equilibrium quantity.
Negative Externalities
• Internalizing an externality involves altering
incentives so that people take account of the
external effects of their actions.
Negative Externalities
• Achieving the Socially Optimal Output
• The government can internalize an externality
by imposing a tax on the producer to reduce
the equilibrium quantity to the socially
desirable quantity.
Positive Externalities
• When an externality benefits the bystanders, a
positive externality exists.
– The social value of the good exceeds the private
value.
Positive Externalities
• A technology spillover is a type of positive
externality that exists when a firm’s
innovation or design not only benefits the
firm, but enters society’s pool of technological
knowledge and benefits society as a whole.
Education and the Social Optimum
Price of
Education
Supply
(private cost)
Social
value
Demand
(private value)
0
QMARKET
QOPTIMUM
Quantity of
Education
Copyright © 2004 South-Western
Positive Externalities
• The intersection of the supply curve and the
social-value curve determines the optimal
output level.
– The optimal output level is more than the
equilibrium quantity.
– The market produces a smaller quantity than is
socially desirable.
– The social value of the good exceeds the private
value of the good.
Positive Externalities
• Internalizing Externalities: Subsidies
– Used as the primary method for attempting to
internalize positive externalities.
• Industrial Policy
– Government intervention in the economy that
aims to promote technology-enhancing industries
• Patent laws are a form of technology policy that give
the individual (or firm) with patent protection a
property right over its invention.
• The patent is then said to internalize the externality.
PRIVATE SOLUTIONS TO
EXTERNALITIES
• Government action is not always needed to
solve the problem of externalities.
PRIVATE SOLUTIONS TO
EXTERNALITIES
•
•
•
•
Moral codes and social sanctions
Charitable organizations
Integrating different types of businesses
Contracting between parties
The Coase Theorem
• The Coase Theorem is a proposition that if private
parties can bargain without cost over the
allocation of resources, they can solve the
problem of externalities on their own.
– 3 Conditions
• Property ownership is clearly defined
• The number of people involved is small
• Bargaining costs (transaction costs) are negligible
• Transactions Costs
– Transaction costs are the costs that parties incur in
the process of agreeing to and following through on a
bargain.
Why Private Solutions Do Not Always Work
• Sometimes the private solution approach fails
because transaction costs can be so high that
private agreement is not possible.
PUBLIC POLICY TOWARD
EXTERNALITIES
• When externalities are significant and private
solutions are not found, government may
attempt to solve the problem through . . .
– command-and-control policies.
– market-based policies.
PUBLIC POLICY TOWARD
EXTERNALITIES
• Command-and-Control Policies
– Usually take the form of regulations:
• Forbid certain behaviors.
• Require certain behaviors.
– Examples:
• Requirements that all students be immunized.
• Stipulations on pollution emission levels set by the
Environmental Protection Agency (EPA).
PUBLIC POLICY TOWARD
EXTERNALITIES
• Market-Based Policies
– Government uses taxes and subsidies to align
private incentives with social efficiency.
– Pigovian taxes are taxes enacted to correct the
effects of a negative externality.
PUBLIC POLICY TOWARD
EXTERNALITIES
• Examples of Regulation versus Pigovian Tax
– If the EPA decides it wants to reduce the amount
of pollution coming from a specific plant. The EPA
could…
– tell the firm to reduce its pollution by a specific
amount (i.e. regulation).
– levy a tax of a given amount for each unit of
pollution the firm emits (i.e. Pigovian tax).
PUBLIC POLICY TOWARD
EXTERNALITIES
• Market-Based Policies
• Tradable pollution permits allow the voluntary
transfer of the right to pollute from one firm
to another.
– A market for these permits will eventually
develop.
– A firm that can reduce pollution at a low cost may
prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
Public Goods
“The best things in life are free. . .”
• Free goods provide a special challenge for
economic analysis.
• Most goods in our economy are allocated in
markets…
“The best things in life are free. . .”
• When goods are available free of charge, the
market forces that normally allocate resources
in our economy are absent.
“The best things in life are free. . .”
• When a good does not have a price attached
to it, private markets cannot ensure that the
good is produced and consumed in the proper
amounts.
“The best things in life are free. . .”
• In such cases, government policy can
potentially remedy the market failure that
results, and raise economic well-being.
THE DIFFERENT
KINDS OF GOODS
• When thinking about the various goods in the
economy, it is useful to group them according
to two characteristics:
– Is the good excludable?
– Is the good rival?
THE DIFFERENT
KINDS OF GOODS
• Excludability
– Excludability refers to the property of a good
whereby a person can be prevented from using it.
• The seller controls who can receive benefits from the
product.
• Rivalry
– Rivalry refers to the property of a good whereby
one person’s use diminishes other people’s use.
• When one buys or consumes the product, it is not
available for someone else.
THE DIFFERENT
KINDS OF GOODS
• Four Types of Goods
– Private Goods
– Public Goods
– Common Resources
– Natural Monopolies
THE DIFFERENT
KINDS OF GOODS
• Private Goods
– Are both excludable and rival.
• Public Goods
– Are neither excludable nor rival.
• Common Resources
– Are rival but not excludable.
• Natural Monopolies
– Are excludable but not rival.
Four Types of Goods
Rival?
Yes
Yes
No
Private Goods
Natural Monopolies
• Ice-cream cones
• Clothing
• Congested toll roads
• Fire protection
• Cable TV
• Uncongested toll roads
Common Resources
Public Goods
• Fish in the ocean
• The environment
• Congested nontoll roads
• Tornado siren
• National defense
• Uncongested nontoll roads
Excludable?
No
Copyright © 2004 South-Western
PUBLIC GOODS
• A free-rider is a person who receives the
benefit of a good but avoids paying for it.
The Free-Rider Problem
• Since people cannot be excluded from
enjoying the benefits of a public good,
individuals may withhold paying for the good
hoping that others will pay for it.
• The free-rider problem prevents private
markets from supplying public goods.
The Free-Rider Problem
• Solving the Free-Rider Problem
– The government can decide to provide the public
good if the total benefits exceed the costs.
– The government can make everyone better off by
providing the public good and paying for it with
tax revenue.
Some Important Public Goods
• National Defense
• Basic Research
• Fighting Poverty
CASE STUDY: Are Lighthouses Public Goods?
The Difficult Job of Cost-Benefit Analysis
• Cost benefit analysis refers to a study that
compares the costs and benefits to society of
providing a public good.
• In order to decide whether to provide a public
good or not, the total benefits of all those
who use the good must be compared to the
costs of providing and maintaining the public
good.
The Difficult Job of Cost-Benefit Analysis
• A cost-benefit analysis would be used to
estimate the total costs and benefits of the
project to society as a whole.
– It is difficult to do because of the absence of
prices needed to estimate social benefits and
resource costs.
– The value of life, the consumer’s time, and
aesthetics are difficult to assess.
COMMON RESOURCES
• Common resources, like public goods, are not
excludable. They are available free of charge
to anyone who wishes to use them.
• Common resources are rival goods because
one person’s use of the common resource
reduces other people’s use.
Tragedy of the Commons
• The Tragedy of the Commons is a parable that
illustrates why common resources get used
more than is desirable from the standpoint of
society as a whole.
– Common resources tend to be used excessively
when individuals are not charged for their usage.
– This is similar to a negative externality.
Some Important Common Resources
• Clean air and water
• Congested roads
• Fish, whales, and other wildlife
CASE STUDY: Why Isn’t the Cow Extinct?
• Will the market protect me?
Private
Ownership and
the Profit
Motive!
Other Market Failures…Inadequate
Information
• Asymmetric Information
– Unequal Knowledge
• Adverse Selection
– When info known by the first party to a contract or agreement
is not known by the second party, causing the second party to
incur major losses
• Moral Hazard
– Tendency for one party in a contract or agreement to alter
behavior in ways that could be costly to the other party
• Principal-Agent Problem
– Interests of the principal does not align with interests of the
agent