Download ECN 112 Chapter 8 Lecture Notes

ECN 112 Chapter 8 Lecture Notes
8.1 Taxes
A. Tax Incidence
Tax incidence is the division of the burden of a tax between the buyer and the seller.
1. When a good is taxed, it has two prices: a price that includes the tax and a price that
excludes the tax. We make the price measured on the vertical axis in a demandsupply graph the price that includes the tax, that is, it is the price paid by buyers.
2. Imposing a tax on a good or service decreases the supply. The tax shifts the supply
curve leftward and the vertical distance between the supply curve with the tax and the
supply curve without the tax equals the amount of the tax.
3. Generally, the quantity decreases and the price rises, but by less than the amount of
the tax.
B. Tax Incidence and Elasticities of Demand and Supply
1. For a given elasticity of supply, the buyer pays a larger share of the tax the more
inelastic is the demand for the good.
2. For a given elasticity of demand, the seller pays a larger share of the tax the more
inelastic is the supply of the good.
C. Tax Incidence and Elasticity of Demand
1. Perfectly Inelastic Demand: Buyer Pays Entire Tax
2. Perfectly Elastic Demand: Seller Pays Entire Tax
D. Tax Incidence and Elasticity of Supply
1. Perfectly Inelastic Supply: Seller Pays Entire Tax
2. Perfectly Elastic Supply: Buyer Pays Entire Tax
E. Taxes and Efficiency
1. Taxes decrease consumer surplus and producer surplus and the government collects
tax revenue.
2. Taxes create an excess burden, which is the amount by which the burden of a tax
exceeds the tax revenue received by the government—the deadweight loss from a tax.
8.2 Income Tax and Social Security Tax
A. The Personal Income Tax
1. The amount of income tax a person pays depends on the person’s taxable income,
which is total income minus a personal exemption and a standard exemption (or other
allowable deductions).
a. The marginal tax rate is the percentage of an additional dollar of income that is paid
in tax.
b. The average tax rate is the percentage of income that is paid in tax.
c. A progressive tax is a tax whose average tax rate increases as income increases.
The U.S. personal income tax is a progressive tax.
d. A proportional tax is a tax whose average tax rate is constant at all income levels.
e. A regressive tax is a tax whose average tax rate decreases as income increases.
B. The Effects of the Income Tax
1. Taxes on Labor Income
a. An income tax decreases the supply of labor and the supply of labor curve shifts
leftward.
b. The wage received by workers falls and the wage paid by firms rises. The quantity
of employment decreases and a deadweight loss is created.
2. Taxes on Capital Income
a. The supply of capital is perfectly elastic. An income tax decreases the supply of
capital and shifts the supply curve upward by the amount of the tax.
b. The interest rate paid by firms rises by the full amount of the tax. Firms pay the
entire capital income tax. The quantity of capital decreases and a deadweight loss
is created.
3. Taxes on the Income from Land and Other Unique Resources
a. The supply of land and other unique resources is perfectly inelastic.
b. The suppliers pay the entire income tax and demanders pay none of the tax. The
quantity does not change and no deadweight loss is created.
C. The Social Security Tax
The law states that social security taxes fall equally on workers and employers. But in
actuality the tax incidence depends on the elasticities of the demand for labor and the
supply of labor.
1. A Tax on Workers
a. If the government taxes only workers, the supply of labor decreases.
b. The wage rate employers pay increases and the wage rate workers receive
decreases.
2. A Social Security Payroll Tax
A payroll tax is a tax on employers based on the wages they pay their workers.
a. If the government taxes only firms with a payroll tax, the demand for labor
decreases.
b. The wage rate employers pay increases and the wage rate workers receive
decreases.
c. The effect of a tax on workers is identical to that of a similarly sized payroll tax:
workers receive the same take-home wage and firms pay the same total wage.
8.3 Fairness and the Big Tradeoff
Two principles of fairness for a tax system have been proposed.
A. The Benefits Principle
The benefits principle is the proposition that people should pay taxes equal to the
benefits they receive from public services.
B. The Ability-to-Pay Principle
The ability-to-pay principle is the proposition that people should pay taxes according to
how easily they can bear the burden. The ability-to-pay principle compares people along
two dimensions: vertically and horizontally.
1. Horizontal equity is the requirement that taxpayers with the same ability to pay
should pay the same taxes.
2. Vertical equity is the requirement that taxpayers with a greater ability to pay bear a
greater share of the taxes.
3. The Marriage Tax Problem is the issue that in the United States a married couple can
pay a greater income tax than they would if they remained single.
C. The Big Tradeoff
The fairness of taxes can conflict with efficiency questions. For instance, income taxes
imposed on capital have a large deadweight loss but tax a small number of generally very
wealthy people.