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Interventions. Lesson 22: Government Taxation. It ain’t Real.

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Lesson 22: Government Taxation

it ain t real
It ain’t Real

Mary and Gary are counterfeiters. One day, they make a perfect copy of a $10 bill.  They use it to pay their gardener.  The gardener uses the $10 to buy pizza.  The pizza maker uses the $10 to rent video tapes.  The $10 bill keeps circulating in the economy, and no one ever discovers that it is counterfeit.  Who was harmed by Mary and Gary counterfeiting a $10 bill?


The government--and its citizens--lose.  The Federal Reserve Board usually increases the money supply by buying government securities--the stuff that the U.S. Treasury issues to finance budget deficits.  This process is called monetizing the deficit.  Most of the new money that's created eventually assumes the form of demand deposits (a.k.a. checking accounts), but some of it is in the form of vault cash and currency in circulation.  By issuing their own $10 bill, the counterfeiters prevented the Fed from taking a piece of paper that only cost the Bureau of Engraving and Printing about 2½¢ to produce and exchanging it for $10 worth of government securities.

laugher curve
Laugher Curve

Two economists meet on the street.

Q. How’s your wife?

A. Relative to what?

deficits debt
Deficits & Debt
  • G Spending > Tax Revenue
  • Run a deficit
  • Borrow (issue bonds)
  • National debt =
  • Deficit FY 2009 $1.8 trillion

Deficits & Debt

Outstanding Public Debt as of 12 Jan 2011 at 04:35:20 AM GMT is:

Debt Clock: Update


Teaser #11:

If the government reduced the budget deficit, would the national debt rise or fall?



It would rise as long as there's a budget deficit.  The federal budget deficit measures how much the government borrows per year.  The national debt is the sum of all the deficits less all the surpluses the government has run since the 1789.  The budget deficit, then, tells us by how much the national debt increased in any given year.   We decrease the national debt only when we run budget surpluses. 

deficits debt1
Deficits & Debt
  • The estimated population of the United States is 309,860,142 so each citizen's share of this debt is $44,249.51.
  • The National Debt has continued to increase an average of 4.17 billion per day since September 28, 2007!
taxation and government
Taxation and Government

For government to operate, it must tax.

For the market to work, it needs freedom.

Tax rates depend on what goods and services government provides and the productive sector.


The Mix of Government Expenditure

Source: Economic Indicators, Council of Economic Advisors

types of taxation
Types of Taxation
  • Regressive
    • % with lower incomes
    • Sales taxes, SS tax, property taxes
  • Progressive taxes
    • % with higher incomes
    • Income taxes, too a point
  • Flat or Proportional tax
    • % the same regardless of incomes
the costs of taxation
The Costs of Taxation
  • To answer this, we must know the costs and benefits of taxation.
  • The costs of taxation include:
  • – The direct cost of the revenue paid to government
  • – The loss of consumer and producer surplus caused by the tax
  • – The cost of administering the tax codes.
  • • A tax paid by the supplier shifts the supply curve up by the amount of the tax.
  • • When government raises taxes, there is a loss of consumer and producer surplus that is not gained.
  • • This is known as deadweight loss.
the costs of taxation1
The Costs of Taxation

• Graphically the deadweight loss is shown on a supply-demand curve as the welfare loss triangle.

• The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.

losses due to taxes
Losses due to Taxes


A per unit tax Tpaid by the suppliers shifts the supply curve from S to S+T and increases price to PB and decreases quantity to Q2.

Consumer surplus is A+B+C before the tax and A after the tax.

Producer surplus is D+E+F before the tax and F after the tax.

Government revenue=B+D Deadweight loss=C+E

the costs of taxation2
The Costs of Taxation

•The other costs of taxation are the administrative costs of compliance.

•Resources are used by the government to administer the tax code and by citizens and businesses to comply with it.

the benefits of taxation
The Benefits of Taxation

The benefits of taxation are the goods and services that government provides.


two principles of taxation
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

Who Bears the Burden of a Tax?

The supply and demand framework gives the answer to this question.

burden depends on relative elasticity
Burden Depends on RelativeElasticity
  • •The person who physically pays the tax is not necessarily the person who bears the burden of the tax.
  • •The burden of the tax is rarely shared
  • The more inelastic one’s relative supply and demand, 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.
who bears the burden
Who Bears the Burden?

S: without Tax

S+T: after tax, supply shifts

Consumer Pays

Seller Pays

who bears the burden1
Who Bears the Burden?

What’s the difference?


who pays versus who bears the burden of a tax
Who Pays Versus Who Bears theBurden of a Tax?
  • The burden of a tax is independent of who physically pays the tax!
  • There are only tax payers or tax looters.
tax incidence and current policy debates
Tax Incidence and Current Policy Debates

The analysis of tax incidence is helpful when discussing current policy debates.


Social Security Taxes

  • •Both employer and employee contribute the same percentage of before-tax wages to the Social Security Fund.
  • The fact that both the employer and employee contribute the same percentage does not mean they 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.
sales taxes
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.


Mimi:  "From 1977 to 1992, Americans in the top 1% income group had their federal tax rates cut by more than 17%."  Kimmy:  "In 1992, Americans in the top 1% income group paid a larger share of federal taxes than they did in 1977.” Mimi and Kimmyseem to be contradicting each other, but both of their claims are correct.  Can you explain why these statements aren't contradictory?


Solution:  From 1977 to 1992, the federal effective tax rate for families in the top 1% income group fell from 35.5% to 29.3% -- a decrease of more than 17%.  Over this same period, the share of total federal taxes paid by that group rose from 13.6% to 18.3%.  This happened because the share of U.S. pretax income received by the top 1% grew substantially over this period (from 8.7% in 1977 to 14.6% in 1992).  With this higher income, the richest 1% paid more taxes even though its tax rates had fallen.


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