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CHAPTER 15 TAXATION AND EFFICIENCY McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Excess Burden Defined A loss of welfare above and beyond taxes collected. Same as Deadweight Loss $20 Tax on Candy Bars? Consider white board example. 15-2 Excess Burden Defined Consider a Tax on Barley Pbt = (1+tb) Pb Note: Different Axes from last chapter. 15-3 Pounds of corn per year Excess Burden Defined A Government levies tax on barley Ca Cb E1 C1 i F B0 D B1 Pounds of barley per year 15-4 Pounds of corn per year Effect of Tax on Consumption Bundle A Ca G E2 Cb E1 C1 F B0 i ii D B1 Pounds of barley per year 15-5 Pounds of corn per year Excess Burden of the Barley Tax Note: No Excess Burden from Lump Sum Taxes A Ca G H Tax Revenues M Equivalent variation E2 Cb E1 C1 Excess Burden F B0 B3 I i ii D B1 Pounds of barley per year 15-6 Compensated vs. Uncompensated Uncompensated Response Consumption changes because of the tax and incorporates effects due to both losing income and tax-induced change in relative prices. Compensated Response Substitution Effect The tendency of an individual to consume more of one good and less of another because of a decrease in the price of the former relative to the latter 15-7 Income vs. Substitution Effect Income Effect The effect of a price change on the quantity demanded due exclusively to the fact that the consumer’s real income has changed Substitution Effect Compensated Effect 15-8 Pounds of corn per year Questions and Answers If the demand for a commodity does not change when it is taxed, does this mean that there is no excess burden? A • Uncompensated Response (E1 to E2) E1 Ca • Income Effect (E1 to E3) i • Substitution Effect (E3 to E2) J •Compensated Effect R E2 Cb C1 S E3 F B1 = B2 B3 K ii D Pounds of barley per year 15-9 Questions and Answers Lump Sum Tax Problems Tough Politically British Prime Minister Margaret Thatcher 15-10 Questions and Answers Does consumer maximization help us understand this? Whiteboard (1 tb ) Pb MRSbc Pc Pb MRTbc Pc 15-11 Questions and Answers Does an income tax entail an excess burden? Whiteboard MRSlb MRTlb MRSlc MRTlc MRSbc MRTbc 15-12 Price per pound of barley Excess Burden Measurement with Demand Curves (1 + tb)Pb Pb a Excess burden = ½ ηPbq1tb2 Tax revenues Excess burden of tax g f h d S’b i Sb Db q2 q1 Pounds of barley per year15-13 Appendix A – Formula for Excess Burden A = ½ * base * height = ½ * (di) * (fd) fd = ∆Pb = (1 + tb) * Pb – Pb = tb * Pb di = ∆q η = (∆q/∆Pb)(Pb/q) Price Elasticity ∆q = η(q/Pb)∆Pb since ∆Pb = tb * Pb ∆q = η(q/Pb)*(tbPb) = η * q * tb since di = ∆q A = ½(di)(fd) = ½(ηqtb)*(tbPb) = ½ * η * Pb * q * (tb)2 15-14 Appendix A – Formula for Excess Burden What do we get intuitively? Tax several goods small amounts. The Squared Term! Tax Doubles? Excess Burden Quadruples! 15-15 Appendix A – Formula for Excess Burden Airline-Tickets Federal Taxes = 10% n=1 Price Increases 1% Quantity Decreases 1% $86 billion = p*q Excess Burden > (.5)(86)((0.1)2 billion $ $430 million 15-16 Price per unit of housing services Excess Burden of a Subsidy Ph m Excess burden n (1 – s)Ph q o v Sh r u Sh’ Dh h1 h2 Housing services per year 15-17 Wage rate per hour Excess Burden of Income Taxation Excess burden = ½ εωL1t2 f w (1 – t)w g Excess burden SL d i h a L2 L1 Hours per year 15-18 Value of Marginal Product (VMP) Dollar value of the additional output produced for each hour worked Downward Slope? 15-19 The Allocation of Time Between Housework and Market Work Excess burden = ½ (ΔH)tw2 $ b (1 – t)VMPmkt a w1 $ w2 w1 (1 – t)w2 e VMPmkt 0 Hours worked in home per year d H* c H1 VMPhome Hours worked in 0’ market per year 15-20 Does Efficient Taxation Matter? Why no excess burden budget? Is efficiency the primary objective of government policy? Does excess burden mean a tax is bad? 15-21