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Lesson Overview. Chapter 7 Taxes Taxes and their Effects Tax Incidence Tax Revenue Tax Rates and Revenue The Deadweight Loss of a Tax Deadweight Loss and Elasticities The Tax System Controversy: Welfare Summary Review Questions. Taxes and their Effects. Excise taxes

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Lesson Overview

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Lesson Overview

Chapter 7 Taxes

Taxes and their Effects

Tax Incidence

Tax Revenue

Tax Rates and Revenue

The Deadweight Loss of a Tax

The Tax System

Controversy: Welfare

Summary

Review Questions

BA 210 Lesson I.8 Taxes

Taxes and their Effects

Excise taxes

• An excise tax is a tax on sales of a good.
• Excise taxes:
• reduce the price received by sellers, called the sellers’ price

BA 210 Lesson I.8 Taxes

Taxes and their Effects

The Supply and Demand for Hotel Rooms in Los Angeles

Equilibrium price

Price of hotel room

\$140

120

S

100

E

80

B

60

D

40

20

0

5,000

10,000

15,000

Quantity of hotel rooms

Equilibrium quantity

BA 210 Lesson I.8 Taxes

Taxes and their Effects

An Excise Tax on Hotel Rooms can be analyzed by the Buyers’ price …

S

Supply curve shifts upward by the amount of the tax

2

\$140

120

A

S

100

1

E

Excise tax = \$40 per room

80

60

D

B

40

20

0

5,000

10,000

15,000

Quantity of hotel rooms

BA 210 Lesson I.8 Taxes

Taxes and their Effects

… or can be analyzed by the Sellers’ price

\$140

Sellers’ Price of hotel room

Demand curve shifts downward by the amount of the tax

120

A

S

100

E

Excise tax = \$40 per room

80

60

D

1

B

40

20

D

2

0

5,000

10,000

15,000

Quantity of hotel rooms

BA 210 Lesson I.8 Taxes

Tax Incidence

Tax Incidence

• The incidence of a tax measures who really bears the tax burden.
• Who really bears the tax burden (in the form of higher prices to consumers and lower prices to sellers) does not depend on who officially pays the tax. For example, the hotel or the hotel guest.
• Depending on the shapes of supply and demand curves, the incidence of an excise tax may be divided differently.
• The wedge between the demand price and supply price becomes the government’s tax revenue.

BA 210 Lesson I.8 Taxes

Tax Incidence

An Excise Tax Paid Mainly By Consumers

When the price elasticity of demand is much lower than the price elasticity of supply is high, the burden of an excise tax falls mainly on consumers.

Price of gasoline (per gallon)

\$2.95

Tax burden falls mainly on consumers

Excise tax = \$1 per gallon

S

2.00

1.95

D

0

Quantity of gasoline (gallons)

BA 210 Lesson I.8 Taxes

Tax Incidence

An Excise Tax Paid Mainly By Producers

When the price elasticity of demand is high and the price elasticity of supply is low, the burden of an excise tax falls mainly on producers.

S

Price of parking space

\$6.50

6.00

D

Excise tax = \$5 per parking space

Tax burden falls mainly on producers

1.50

0

Quantity of parking spaces

BA 210 Lesson I.8 Taxes

Tax Incidence

Tax Incidence Summary

• When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers. That makes sense because consumers have more substitutes in demand.
• When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers. That makes sense because producers have more substitutes in supply.
• So elasticity determines the incidence of an excise tax.

BA 210 Lesson I.8 Taxes

Tax Revenue

The area of the shaded rectangle is:

Area = Height × Width

= \$40 per room × 5,000 rooms = \$200,000

The tax revenue collected is:

Tax revenue = \$40 per room × 5,000 rooms

= \$200,000

Price of hotel room

\$140

120

A

S

100

E

Excise tax = \$40 per room

Area = tax revenue

80

60

D

B

40

20

0

6

5,000

10,000

15,000

Quantity of hotel rooms

BA 210 Lesson I.8 Taxes

Tax Revenue

Tax revenue summary

• The revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity transacted under the tax.

BA 210 Lesson I.8 Taxes

Tax Rates and Revenue

Tax Rates and Revenue

• A tax rate is the amount of tax people are required to pay per unit of whatever is being taxed.
• In general, doubling the excise tax rate on a good or service won’t double the amount of revenue collected, because the tax increase will reduce the quantity of the good or service transacted.
• In some cases, raising the tax rate may actually reduce the amount of revenue the government collects.

BA 210 Lesson I.8 Taxes

Tax Rates and Revenue

Area = tax revenue

Area = tax revenue

• An excise tax of \$20.
• Revenue = \$20 x 7,500 = \$150,000

(b) An excise tax of \$60.

Revenue = \$60 x 2,500 = \$150,000

Price of hotel room

Price of hotel room

\$140

\$140

120

120

110

S

S

90

Excise tax = \$20 per room

E

E

Excise tax = \$60 per room

80

80

70

D

D

50

40

40

20

20

0

6

,000

7,500

10,000

15,000

0

2,500

5,000

10,000

15,000

Quantity of hotel rooms

Quantity of hotel rooms

BA 210 Lesson I.8 Taxes

The Deadweight Loss of a Tax

A Tax Reduces Consumer and Producer Surplus

• A fall in the price of a good causes a gain in consumer surplus. Similarly, a price increase causes a loss in consumer surplus. So, in the case of an excise tax, the rise in the price paid by consumers causes a loss in consumer surplus.
• Likewise, the fall in the price received by producers causes a loss in producer surplus.
• Therefore, an excise tax reduces both consumer surplus and producer surplus.

BA 210 Lesson I.8 Taxes

The Deadweight Loss of a Tax

Fall in consumer surplus due to tax

Fall in producer surplus due to tax

A Tax Reduces Consumer and Producer Surplus

S

P

r

i

c

e

P

C

A

B

P

E

Excise tax = T

E

F

C

P

P

D

Q

Q

Quantity

T

E

BA 210 Lesson I.8 Taxes

The Deadweight Loss of a Tax

The Deadweight Loss of a Tax

• Although consumers and producers are hurt by the tax, the government gains revenue. The revenue the government collects is equal to the tax per unit sold, T, multiplied by the quantity sold, QT.
• But a portion of the loss to producers and consumers from the tax is not offset by a gain to the government.
• The deadweight loss caused by the tax represents the total surplus lost to society because of the tax — that is, the amount of surplus that would have been generated by transactions that now do not take place because of the tax.
• The deadweight loss is the change in total surplus if the tax revenue were simply given back to members of society --- for example, as a type of welfare payment.

BA 210 Lesson I.8 Taxes

The Deadweight Loss of a Tax

Price

S

P

C

P

E

Excise tax = T

E

P

P

D

Q

Q

Quantity

T

E

BA 210 Lesson I.8 Taxes

The Deadweight Loss of a Tax

• The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it.
• The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. The general rule for economic policy is that, other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society.

BA 210 Lesson I.8 Taxes

(a) Elastic Demand

(b)

Inelastic Demand

S

S

Price

Price

Deadweight loss is larger when demand is elastic

P

C

Excise tax = T

P

C

Deadweight loss is smaller when demand is inelastic

E

P

P

E

E

E

Excise tax = T

P

P

D

P

P

D

Q

Q

Q

Q

Quantity

Quantity

T

E

T

E

BA 210 Lesson I.8 Taxes

(c) Elastic Supply

(d)

Inelastic Supply

S

Price

Price

Deadweight loss is larger when supply is elastic

P

C

S

P

Excise tax = T

C

Deadweight loss is smaller when supply is inelastic

E

P

P

E

E

E

Excise tax = T

P

P

P

P

D

D

Q

Q

Q

Q

Quantity

Quantity

T

E

T

E

BA 210 Lesson I.8 Taxes

• To minimize the efficiency costs of taxation, one should choose to tax only those goods for which demand or supply, or both, is relatively inelastic.
• For such goods, a tax has little effect on behavior because behavior is relatively unresponsive to changes in the price.

BA 210 Lesson I.8 Taxes

• In the extreme case in which demand were perfectly inelastic (a vertical demand curve), the quantity demanded is unchanged by the imposition of the tax. As a result, the tax imposes no deadweight loss.
• Similarly, if supply were perfectly inelastic (a vertical supply curve), the quantity supplied is unchanged by the tax and there is also no deadweight loss.

BA 210 Lesson I.8 Taxes

• If the goal in choosing whom to tax is to minimize deadweight loss, then taxes should be imposed on goods that have the most inelastic response—that is, goods and services for which consumers or producers will change their behavior the least in response to the tax.

BA 210 Lesson I.8 Taxes

The Tax System

The Tax System

• The tax base is the measure or value, such as income or property value, that determines how much tax an individual or firm pays.
• The tax structure specifies how the tax depends on the tax base.
• Once the tax base has been defined, the next question is how the tax depends on the base. The simplest tax structure is a proportional tax, also sometimes called a flat tax, which is the same percentage of the base regardless of the taxpayer’s income or wealth.

BA 210 Lesson I.8 Taxes

The Tax System

BA 210 Lesson I.8 Taxes

The Tax System

Some important taxes and their tax bases are as follows:

• Income tax: a tax that depends on the income of an individual or a family from wages and investments
• Payroll tax: a tax that depends on the earnings an employer pays to an employee
• Sales tax: a tax that depends on the value of goods sold (also known as an excise tax)
• Profits tax: a tax that depends on a firm’s profits
• Property tax: a tax that depends on the value of property, such as the value of a home
• Wealth tax: a tax that depends on an individual’s wealth

BA 210 Lesson I.8 Taxes

The Tax System

BA 210 Lesson I.8 Taxes

The Tax System

• Once the tax base has been defined, the next question is how the tax depends on the base. The simplest tax structure is a proportional tax, also sometimes called a flat tax, which is the same percentage of the base regardless of the taxpayer’s income or wealth.
• State and, especially, local governments generally do not make much effort to increase the tax on high income or wealth . This is largely because they are subject to tax competition: a state or local government that imposes high taxes on people with high incomes faces the prospect that those people may move to other locations where taxes are lower.

BA 210 Lesson I.8 Taxes

Controversy: Welfare

Welfare consists of actions or procedures — especially on the part of governments and institutions — striving to promote the basic well-being of individuals in need. These efforts usually strive to improve the financial situation of people in need but may also strive to improve their employment chances and many other aspects of their lives including sometimes their mental health. In many countries, most such aid is provided by family members, relatives, and the local community.

Welfare in most countries is provided to those who are unemployed, those with illness or disability, those of old age, those with dependent children.

BA 210 Lesson I.8 Taxes

Controversy: Welfare

Microeconomics lessons on Revealed Preference and on Taxes reveal that the controversy over the level of welfare and who deserves welfare is caused by the controversy over the rationality of those in need.

If everyone were rational, then Revealed Preference shows someone that is unemployed has high consumption of leisure time and, so, may be happier than someone that is employed. Likewise, Revealed Preference shows someone with dependent children has high consumption of children as a commodity and, so, may be happier than someone without children. And Revealed Preference shows people may be happier if they received tax break when young rather than welfare in old age.

BA 210 Lesson I.8 Taxes

Controversy: Welfare

Finally, even if welfare cash is not a subsidy for the consumption of children and is not delayed until old age, welfare is still controversial because of the deadweight loss of the tax that is needed to pay for welfare.

BA 210 Lesson I.8 Taxes

Controversy: Welfare

Question: Consider the market for labor in the US, illustrated in the accompanying table.

Suppose the US decides to

impose a \$4 tax on wages and

to give the revenue back as

welfare.

a. What is the quantity of labor

bought and sold after the

imposition of the tax? What is

wage paid by employers? What

is the wage received by workers?

b. Calculate the consumer surplus and the producer surplus after the imposition of the tax. By how much has the imposition of the tax reduced total surplus?

c. How much revenue does the US earn from this tax?

BA 210 Lesson I.8 Taxes

Controversy: Welfare

Answer: a. The tax drives a wedge between the price paid by consumers and the wage received

by workers. Consumers now pay

\$7, and workers receive \$3. So

after the imposition of the tax,

the quantity bought and sold will

be 1 unit of labor.

b. Consumer surplus before the

tax was \$3 (at wage = \$5) and

is now \$0 (at wage = \$7).

Producer (worker) surplus before

the tax was \$3 (at wage = \$5) and is now \$0 (at wage = \$3). So, the imposition of the tax reduced total surplus by \$6.

c. The US earns a tax of \$4 per unit sold, which is a total tax revenue of \$4.

BA 210 Lesson I.8 Taxes

Controversy: Welfare

Comment: The total tax revenue of \$4 allows \$4 of welfare to be dispersed. But consumers and

producers of labor are hurt \$6,

which is more than the welfare

recipients are helped. In this

sense, welfare decreased total

prosperity in the US and, so,

is objectionable to a Utilitarian,

who measures society’s

well-being by total happiness.

BA 210 Lesson I.8 Taxes

Summary

Summary

• Excise taxes — taxes on the purchase or sale of a good—raise the price paid by consumers and reduce the price received by producers, driving a wedge between the two.The incidence of the tax—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax.
• The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers.

BA 210 Lesson I.8 Taxes

Summary

• The tax revenue generated by a tax depends on the tax rate and on the number of units transacted with the tax. Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs —resources used to collect the tax.
• An excise tax generates revenue for the government, but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society. This deadweight loss is represented by a triangle, the area of which equals the value of the transactions discouraged by the tax. The greater the elasticity of demand or supply, or both, the larger the deadweight loss from a tax. If either demand or supply is perfectly inelastic, there is no deadweight loss from a tax.

BA 210 Lesson I.8 Taxes

Summary

• An efficient tax minimizes both the sum of the deadweight loss due to distorted incentives and the administrative costs of the tax. However, tax fairness, or tax equity, is also a goal of tax policy.
• There are two major principles of tax fairness, the benefits principle and the ability-to-pay principle. The most efficient tax, a lump-sum tax, does not distort incentives but performs badly in terms of fairness. The fairest taxes in terms of the ability-to-pay principle, however, distort incentives the most and perform badly on efficiency grounds. So in a well-designed tax system, there is a trade-off between equity and efficiency.

BA 210 Lesson I.8 Taxes

Summary

• Every tax consists of a tax base, which defines what is taxed, and a tax structure, which specifies how the tax depends on the tax base. Different tax bases give rise to different taxes—the income tax, payroll tax , sales tax, profits tax , property tax, and wealth tax.
• A tax is progressive if higher-income people pay a higher percentage of their income in taxes than lower-income people and regressive if they pay a lower percentage. Progressive taxes are often justified by the ability-to-pay principle. However, a highly progressive tax system significantly distorts incentives because it leads to a high marginal tax rate, the percentage of an increase in income that is taxed away, on high earners. The U.S. tax system is progressive overall, although it contains a mixture of progressive and regressive taxes.

BA 210 Lesson I.8 Taxes

Review Questions

• Review Questions
• You should try to answer some of the following questions before the next class.
• You will not turn in your answers, but students may request to discuss their answers to begin the next class.
• Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams.

BA 210 Lesson I.8 Taxes

Review Questions