Unit IV

1. Unit IV Tax Incidence (Chapter7)

2. In this chapter, look for the answers to these questions: • How do taxes affect market outcomes? How does the outcome depend on whether the tax is imposed on buyers or sellers? • What is the incidence of a tax? What determines the incidence? • How does a tax affect consumer surplus, producer surplus, and total surplus? • What is the deadweight loss of a tax?

3. In this chapter, look for the answers to these questions: • What factors determine the size of this deadweight loss? • How does tax revenue depend on the size of the tax? • What are the efficiency costs of taxes? • How can we evaluate the equity of a tax system?

4. Government Policies That Alter the Private Market Outcome • Price controls • Price ceiling: a legal maximum on the price of a good or service. Example: rent control. • Price floor: a legal minimum on the price of a good or service. Example: minimum wage. • Taxes • The govt can make buyers or sellers pay a specific amount on each unit bought/sold. We will use the supply/demand model to see how tax policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity).

5. Taxes • The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. • The govt can make buyers or sellers pay the tax. • The tax can be a percentage of the good’s price, or a specific amount for each unit sold. • For simplicity, we analyze per-unit taxes only.

6. P S1 $10.00 D1 Q 500 EXAMPLE 1: The Market for Pizza Eq’m w/o tax

7. P S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 D2 Q 500 430 A Tax on Buyers Effects of a $1.50 per unit tax on buyers A tax on buyers shifts the D curve down by the amount of the tax. The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

8. P S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 D2 Q 500 430 TheIncidenceof a Tax: how the burden of a tax is shared among market participants Because of the tax, buyers pay $1.00 more, sellers get $0.50 less.

9. P S2 S1 $11.00 PB = $10.00 Tax $9.50 PS = D1 Q 500 430 A Tax on Sellers Effects of a $1.50 per unit tax on sellers A tax on sellers shifts the S curve up by the amount of the tax. The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

10. P S1 $11.00 Tax $10.00 $9.50 D1 Q 500 The Outcome Is the Same in Both Cases! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. PB = PS = 430

11. The market for hotel rooms P S D 0 Q ACTIVE LEARNING 1: Effects of a tax Suppose govt imposes a tax on buyers of $30 per room. Find new Q, PB, PS, and incidence of tax.

12. The market for hotel rooms P S PB = Tax PS = D 0 Q ACTIVE LEARNING 1: Answers PB = $110 Q = 80 PS = $80 Incidence • buyers: $10 • sellers: $20

13. P PB S Buyers’ share of tax burden Tax Price if no tax PS Sellers’ share of tax burden D Q Elasticity and Tax Incidence In this case, buyers bear most of the burden of the tax. CASE 1: Supply is more elastic than demand

14. P S PB Buyers’ share of tax burden Tax Price if no tax Sellers’ share of tax burden PS D Q Elasticity and Tax Incidence In this case, sellers bear most of the burden of the tax. CASE 2: Demand is more elastic than supply

15. Elasticity and Tax Incidence • If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily leave the market when the tax is imposed, so buyers will bear a smaller share of the burden of the tax than sellers. • If sellers’ price elasticity > buyers’ price elasticity, the reverse is true.

16. CASE STUDY: Who Pays the Luxury Tax? • 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. • Goal of the tax: to raise revenue from those who could most easily afford to pay – wealthy consumers. • But who really pays this tax?

17. P S PB Buyers’ share of tax burden Tax Sellers’ share of tax burden PS D Q CASE STUDY: Who Pays the Luxury Tax? Demand is price-elastic. The market for yachts In the short run, supply is inelastic. Hence, companies that build yachts pay most of the tax.

18. So, what do we know so far? • A tax is a wedge between the price buyers pay and the price sellers receive. • A tax raises the price buyers pay and lowers the price sellers receive. • A tax reduces the quantity bought & sold.

19. P Size of tax = $T S PB PE PS D Q QT QE The Effects of a Tax With no tax, eq’m price is PE and quantity is QE . Govt imposes a tax of $T per unit. The price buyers pay is PB , the price sellers receive is PS , and quantity is QT .

20. P Size of tax = $T PB PS Q The Effects of a Tax The tax generates revenue equal to $T x QT . S PE D QT QE

21. The Effects of a Tax • Next, we use the tools of welfare economics to measure the gains and losses from a tax. • We will determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax. • Tax revenue is included in total surplus, because tax revenue can be used to provide services such as roads, police, public education, etc.

22. P S PE D Q QE The Effects of a Tax Without a tax, CS = A + B + C PS = D + E + F A Tax revenue = 0 B C Total surplus= CS + PS = A + B + C + D + E + F E D F QT

23. P PB PS Q The Effects of a Tax With the tax, CS = A PS = F A Tax revenue = B + D S B C Total surplus= A + B + D + F E D D F The tax causes total surplus to fall by C + E QT QE

24. P PB PS Q The Effects of a Tax C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. A S B C E D D F QT QE

25. P PB PS Q About the Deadweight Loss Because of the tax, the units between QT and QE are not sold. So, the tax has prevented some mutually beneficial trades. S D QT QE

26. P $ S D Q The market for airplane tickets A C T I V E L E A R N I N G 2:Analysis of tax A.Compute CS, PS, and total surplus without a tax. B.If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL.

27. P $ S P = D Q The market for airplane tickets A C T I V E L E A R N I N G 2: Answers to A CS = ½ x $200 x 100 = $10,000 PS = ½ x $200 x 100 = $10,000 total surplus = $10,000 + $10,000 = $20,000

28. P $ S PB = PS = D Q A $100 tax on airplane tickets A C T I V E L E A R N I N G 2: Answers to B CS = ½ x $150 x 75 = $5,625 PS = $5,625 tax revenue = $100 x 75 = $7,500 total surplus = $18,750 DWL = $1,250

29. What Determines the Size of the DWL? • The govt needs tax revenue to finance roads, schools, police, etc., so it must tax some goods and services. • Which ones? One answer is that govt should tax the goods or services with the smallest DWL. • So when is the DWL small vs. large? Turns out it depends on the elasticities of supply and demand. • Recall: The price elasticity of demand (or supply) measures how much quantity demanded (or supplied) changes when the price changes.

30. P S Size of tax D Q DWL and the Elasticity of Supply When supply is inelastic, the DWL of a tax is small.

31. P S Size of tax D Q DWL and the Elasticity of Supply The more elastic supply, the larger the DWL.

32. P S Size of tax D Q DWL and the Elasticity of Supply When demand is inelastic, the DWL of a tax is small.

33. P S Size of tax D Q DWL and the Elasticity of Supply The more elastic the demand, the larger the DWL.

34. Why Elasticity Affects the Size of DWL • A tax distorts the market outcome: consumers buy less and producers sell less, so eq’m Q is below the surplus-maximizing quantity. • Elasticity measures how much buyers and sellers respond to changes in price, and therefore determines how much the tax distorts the market outcome.

35. ACTIVE LEARNING 3: Elasticity and DWL of a tax Would the DWL of a tax be larger if the tax were on A. Rice Krispies or sunscreen? B. Gasoline in the Short Run vs. Gasoline in the Long Run C. Insulin vs. Caribbean Cruises

36. ACTIVE LEARNING 3: Answers A. Rice Krispies or sunscreen From Chapter 6: Rice Krispies has many more close substitutes than sunscreen, so demand for Rice Krispies is more price-elastic than demand for sunscreen. So, a tax on Rice Krispies would cause a larger DWL than a tax on sunscreen.

37. ACTIVE LEARNING 3: Answers B. Gasoline in the short run or long run From Chapter 6: The price elasticities of demand and supply for gasolline are larger in the long run than in the short run. So, a tax on gasoline would cause a larger DWL in the long run than in the short run.

38. ACTIVE LEARNING 3: Answers C. Insulin vs. Caribbean Cruises From Chapter 6: Insulin is a necessity and therefore less price-elastic than a Caribbean Cruise So, a tax on a Caribbean Cruise would cause a larger DWL than a tax on insulin.

39. ACTIVE LEARNING 3: Discussion question • The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants. • Which should it tax?

40. The Effects of Changing the Size of the Tax • Policymakers often change taxes, raising some and lowering others. • What happens to DWL and tax revenue when taxes change? We explore this next….

41. P new DWL S T 2T D initial DWL Q Q1 Q2 DWL and the Size of the Tax Initially, the tax is T per unit. Doubling the tax causes the DWL to more than double.

42. new DWL P S 3T D initial DWL Q Q3 Q1 DWL and the Size of the Tax Initially, the tax is T per unit. Tripling the tax causes the DWL to more than triple. T

43. DWL Tax size DWL and the Size of the Tax Summary When a tax increases, DWL rises even more. Implication When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit. When tax rates are high, raising them is very harmful, and cutting them is very beneficial.

44. P PB S PB T 2T PS D PS Q Q1 Q2 0 Revenue and the Size of the Tax When the tax is small, increasing it causes tax revenue to rise.

45. P PB PB S 3T D PS PS Q Q3 Q2 0 Revenue and the Size of the Tax When the tax is larger, increasing it causes tax revenue to fall. 2T

46. Tax revenue Tax size 0 Revenue and the Size of the Tax The Laffer curve shows the relationship between the size of the tax and tax revenue. The Laffer curve

47. 0 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. • The costs to taxpayers include: • the tax payment itself • deadweight losses • administrative burden

48. 0 Administrative Burden • includes the time and money people spend to comply with tax laws • encourages the expenditure of resources on legal tax avoidance • e.g., hiring accountants to exploit “loopholes”to reduce one’s tax burden • is a type of deadweight loss • could be reduced if the tax code were simplified but would require removing loopholes, politically difficult

49. 0 Marginal vs. Average Tax Rates • average tax rate • total taxes paid divided by total income • measures the sacrifice a taxpayer makes • marginal tax rate • the extra taxes paid on an additional dollar of income • measures the incentive effects of taxes on work effort, saving, etc.

50. income average tax rate marginal tax rate 0 Lump-Sum Taxes • A lump-sum tax is the same for every person • Example: lump-sum tax = $4000/person $20,000 20% 0% $40,000 10% 0%