Transcript Taxation and Government Intervention

Taxation and Government
Intervention
Chapter 7
Taxation and Government
• For government to provide goods and services
such as national defense, social security,
national parks, etc. it must have money.
• The Government raises money several ways
including user fees and taxes.
• User Fees are fees paid by those that use the
good or service: it is a price.
• Taxes may be paid by everyone or only those
that use a good or service: who pays depends
on the type of tax.
Types of Taxes
• There are many types of taxes:
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Personal Income taxes
Corporate Income taxes
Excise Taxes
Value Added Taxes (VAT)
Property Taxes
Social Security Taxes
Sales Taxes
Tax Burden or Incidence
• Who seems to pay the tax and who actually pays the
tax may not be the same person!
• For example, suppose the federal government
institutes a 10% excise tax on luxury boats.
• Suppose the consumer pays the tax up front: on the
purchase of a $100,000 luxury boat the consumer pays
sales taxes of 5% and a luxury tax of 10% for a total
price of $115,000 (there is no tax on tax).
• But what if the boat builder had to lower the price
from $110,000 to $100,000 to sell the boat?
• In this case, the buyer appears to pay the luxury tax
but in reality the boat builder pays the taxes.
• The entire burden of the tax falls on the boat builder.
What is the Role of Government?
• The level of taxes is determined by the amount of
government services and goods provided.
• The Government’s roles include:
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Providing a stable set of institutions, laws and rules.
Promoting effective and workable competition.
Correcting for externalities.
Creating an environment that fosters economic
stability and growth.
– Providing public goods.
– Adjusting for undesirable market results.
The How Much Should Government Tax?
• The government must raise revenues
equal to the cost of providing the amount
of goods and services that its citizens
demand.
The Costs 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.
The Costs of Taxation
• When government institutes taxes,
there is a loss of consumer and producer
surplus that is not gained by government.
• This is known as deadweight loss.
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.
Consumer Surplus
Producer Surplus
• Consumer Surplus – the amount of consumers
would be willing to pay (with perfect price
discrimination) minus what they have to pay (at
the market price) is the excess benefit
consumers enjoy and is called consumer
surplus.
• Producer Surplus – the amount producers
receive for the total units sold (at the market
price) minus what they would have received if
they charged their cost for each unit.
• See pages 97-99 and page 158 for more info
(in hardback Economics text). End of Chapter
4 in Microeconomics book.
The Costs of Taxation
Consumer Surplus Before Tax: A + B + C
Consumer Surplus After Tax: A
Producer Surplus Before Tax: D + E + F
Producer Surplus After Tax: F
Deadweight Loss: C + E
Price
Consumer
surplus
S1
S0
A
P1
P0
P1–t
B
C
D
E
tax
Deadweight
loss
F
Producer
surplus
Q1
Demand
Q0
Quantity
The Costs of Taxation
• There are other costs of taxation.
• Resources must be devoted by the
government to administer the tax
codes and by citizens and businesses
to comply with it.
The Costs of Taxation
• Payroll accounting has become so
onerous, businesses large and small often
pay payroll-accounting firms to keep up
with changing federal and state payroll
rules and actually issue paychecks for
their clients’ employees.
The Benefits of Taxation
• The benefits of taxation are the goods
and services that government provides.
The Benefits of Taxation
• Some of these benefits are the part of
the basic institutional structure of a
market economy that allows it to work
efficiently.
– The basic legal system is an example.
The Benefits of Taxation
• Still others benefits take on the
qualities of a public good – national
defense, for example.
The Benefits of Taxation
• Others benefits are provided for
reasons of equity or because they
provide positive externalities.
The Benefits of Taxation
• The policy debate about the benefits of
taxation generally focuses on goods that
could be supplied by the market but are
publicly supplied.
– Education and health care are examples.
The Benefits of Taxation
• Measuring the benefits of these goods is
difficult since they are not provided in a
market setting.
The Two Principles of Taxation
•
There are two principles of taxation
widely recognized by tax experts as
desirable features of a tax system.
1. The Benefit Principle
2. The Ability to Pay Principle
Two Principles of Taxation
• The benefit principle states that the
individuals who receive the benefit of
the good or service should pay the tax
necessary to supply the good.
– Examples are gasoline taxes and airport
taxes, both paid by travelers.
Two Principles of Taxation
• The ability-to-pay principle states that
individuals who are most able to bear the
burden of the tax should pay the tax.
– The best example of this is a
progressive tax, such as the U.S. income
tax.
Difficulty of Applying the
Principles of Taxation
• The principles of taxation are difficult
to apply because, among other reasons,
the two principles often conflict.
Difficulty of Applying the
Principles of Taxation
• In funding health care, for example, the
poor should pay because they benefit the
most, while under the ability-to-pay
principle, the rich should pay.
Difficulty of Applying the
Principles of Taxation
• The elasticity concept helps us to
understand the tradeoffs as well as who
is likely to bear the burden of a tax.
Who Bears the Burden of a Tax?
• The supply and demand framework gives
the answer to this question when the
elasticities of the supply and demand
curves are considered.
Burden Depends on Relative Elasticity
• 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
equally since the elasticities are rarely
equal.
Burden Depends on Relative Elasticity
• Elasticity is a measure of how easy it is
for the supplier and consumer to change
their behavior and substitute other
goods.
• Consequently, the more one group
(consumers or suppliers) is able or willing
to change its behavior relative to the
other group the more likely it is to avoid
the tax burden.
Burden Depends on Relative Elasticity
• The relative burden of the tax dictates
that the more relatively inelastic the
behavior of one’s group (supply or
demand), the larger the tax burden one
will bear.
Burden Depends on Relative Elasticity
• 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.
Burden Depends on Relative Elasticity
• Who pays a tax is not necessarily who
bears the burden.
• The person who actually pays the tax
does not matter, and the person who
bears the burden can differ from the
person who pays.
Difficulty of Applying the
Principles of Taxation
• Since the free market system is very
efficient, Governments with free market
economies desire to change the behavior of
suppliers and demander as little as possible.
• Hence, Governments should tax inelastic goods
or services.
• In the language of consumer and producer
surplus, if the government seeks to minimize
welfare loss, it should tax goods with inelastic
supplies and demands.
Who Bears the Burden of a Tax?
Price of luxury boats
Supplier Pays Tax
S1
$70,000
60,000
50,000
40,000
30,000
20,000
10,000
tax
Consumer pays
S0
Supplier pays
Demand
510
200
400
600 Quantity of luxury boats
Price of luxury boats
Who Bears the Burden of a Tax?
$70,000
60,000
50,000
40,000
30,000
20,000
10,000
Demand is inelastic
S1
S0
tax
Consumer pays
Supplier pays
Demand
590
200
400
600 Quantity of luxury boats
Who Bears the Burden of a Tax?
Price of luxury boats
Consumer Pays Tax
$70,000
60,000
50,000
40,000
30,000
20,000
10,000
S0
Consumer pays
Supplier pays
tax
D0
D1
510
200
400
600 Quantity of luxury boats
Tax Incidence and Current Policy
Debates
• The analysis of tax incidence is helpful
when discussing current policy debates.
Social Security Taxes
• Social Security taxes are payroll taxes
for a government-run retirement
program.
• Both employer and employee contribute
the same percentage of before-tax
wages to the Social Security fund.
Social Security Taxes
• The fact that both the employer and
employee contribute the same
percentage does not mean they share
the burden equally.
Social Security Taxes
• 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 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.
Sales Taxes
• Consumers can now buy on the internet
where sales are not taxed so that retail
stores will bear a greater burden of the
tax levied on their sales.
Government Intervention
• Taxation is but one way in which
government affects our lives.
• Other forms of government intervention
include price controls.
Government Intervention as
Implicit Taxation
• Government intervention can be seen as
a combination tax and subsidy.
Price Ceilings
• A price ceiling is a government-set price
below market equilibrium price.
• It is an implicit tax on producers and an
implicit subsidy to consumers.
• This causes a loss in producer and
consumer surpluses that is identical to
the welfare loss from taxation.
Effect of Price Ceiling
Price
Consumer
surplus
Deadweight
loss
P0
P1
Supply
Price ceiling
Producer
surplus
Demand
Q1
Q0
Quantity
Price Floors
• A price floor is a government-set price
above equilibrium price.
• It is a tax on consumers and a subsidy to
producers.
• Price floors transfer consumer surplus
to producers.
Effect of Price Floor
Price
Consumer
surplus
Supply
Price Floor
P2
Deadweight
loss
P0
Producer
surplus
Demand
Q1
Q0
Quantity
The Difference Between Taxes and Price Controls
• The effects of taxation and price
controls are similar.
• They are different in that price ceilings
create shortages and taxes do not.
• Shortages also create black markets.
• Both taxes and price controls create
deadweight loss.
A Price Ceiling with Forced Supply
• The draft is an example of a price ceiling
with forced supply.
• The draft is a military conscription law
that requires young men to serve a set
period of time in the armed forces at
whatever pay the government chooses.
A Price Ceiling with Forced Supply
• A draft must be imposed when the wage
offered by the army is below equilibrium
and the quantity of soldiers supplied is
below the quantity demanded.
A Price Ceiling with Forced Supply
• Those conscripted are forced to accept
a lower wage than they would otherwise
get, which is a transfer of surplus to the
government.
Effect of a Draft on Surplus
Wage
Supply
Surplus transferred
to the government
Deadweight loss
caused by draft
We
W0
Demand
QS
QD=Draft
Quantity of soldiers
Rent Seeking, Politics, and Elasticities
• Price controls reduce total producer and
consumer surpluses.
• Governments institute them because
people care more about their own surplus
than they do about total surplus.
Rent Seeking, Politics, and Elasticities
• Price controls exist because of political
power.
– If farmers have political power, they
want crop subsidies or price supports.
– If renters have it, they want rent
controls.
Rent Seeking, Politics, and Elasticities
• An enormous amount of time and money
is spent in the political arena to increase
one’s surplus at the expense of another
group.
• This activity is called rent seeking
behavior – the effort to transfer
surplus from one group to another.
Rent Seeking, Politics, and Elasticities
• Public choice economists integrate an
economic analysis of politics with their
analysis of the economy.
• They argue that often when all the
rent seeking and tax consequences
are netted out, there is no net gain to
the public.
Rent Seeking, Politics, and Elasticities
• There is a greater incentive for rentseeking when demand and supply is
inelastic.
Inelastic Demand and Incentives to
Restrict Supply
• When demand is inelastic, producers
have incentives to restrict supply.
• Farming is an example.
Inelastic Demand and Incentives to
Restrict Supply
• Advances in farming productivity
increases supply but lowers prices.
• Since food has few substitutes, its
demand is inelastic.
• Inelastic demand means that prices
fall faster than a rise in quantity sold.
• Revenues fall, and farmers are worse
off.
Inelastic Demand and Incentives to
Restrict Supply
• There is an enormous incentive for
farmers to seek a price floor from
government or through a producer
cooperative.
Inelastic Demand
and Incentives to Restrict Supply
Price
S0
P0
S1
Revenue Lost
Revenue Gained
P1
Total Revenue
Demand
Q0 Q1
Quantity
Inelastic Supply and Incentives to
Restrict Prices
• Consumers are also rent seekers not just
businesses.
• When supply is inelastic, consumers have
incentives to restrict prices.
Inelastic Supply and Incentives to
Restrict Prices
• When supply is inelastic and demand goes
up, prices jump causing consumers to
lobby for price controls.
• Rent control in New York City is an
example.
Price Floors and Elasticity of Demand and
Supply
Price floor with elastic supply and demand
Price
Supply
PF
PE
Demand
QD
QS
Quantity
Price Floors and
Elasticity of Demand and Supply
Price floor with elastic supply and inelastic demand
Price
Supply
PF
PE
Demand
QD
QS
Quantity
Price Floors and
Elasticity of Demand and Supply
Price floor with inelastic supply and demand
Price
Demand
Supply
PF
PE
QD QS
Quantity
The Long-Run/Short-Run Problem of
Price Controls
• The problem of price controls worsen
from the short run to the long run.
• In the long run, supply and demand tend
to be much more elastic than in the
short run.
The Long-Run/Short-Run Problem of
Price Controls
• So in the short run there will be small
effects from the price controls, but
huge effects in the long run.
The Long-Run/Short-Run Problem of
Price Controls
• In the face of price controls, potential
new competitors hate to enter the
market thereby strangling supply
• Vacancy rates drop as potential new
renters scramble to find shrinking
affordable housing.
Long-Run and Short-Run Effects of Price
Controls
Price
Short run
supply
P1
P2
P0
Long run
supply
Price ceiling
D1
D0
Q0 Q1
Q2
Q3
Shortage
Quantity
Taxation and Government
Intervention
End of Chapter 7