Transcript Figure 11.1 A Price Distorting Tax Versus A Lump

Chapter 11
Taxation, Prices, Efficiency,
and the Distribution of Income
1
Lump-Sum Taxes

A Lump-sum tax is a fixed tax that is
owed by everyone and is not subject to
anything taxpayers can change.

It is independent of income,
consumption, or wealth.

An example is a Head Tax, which is
constant for everyone.
2
Inefficiency in Taxation and the LumpSum Tax

Inefficiency in taxation results from the ability
to avoid taxes by avoiding a taxed activity.

Because lump-sum taxes are unavoidable,
they serve as the benchmark by which other
taxes are measured in terms of efficiency.
3
Price Distorting Taxes

A price distorting tax alters the relative
price of goods.
4
Figure 11.1 A Price Distorting Tax Versus
A Lump-Sum Tax
Expenditure on Other Goods
per Year (Dollars)
A
T
L
Y*
T
YT
Y1
E'
E
E''
U1
0
U2
B'
L'
QT QL
Q1
Gasoline per Year (Gallons)
U3
B
5
Individual Excess Burden of a Tax
The individual excess burden of a tax
is the loss in well-being when a
taxpayer pays taxes under a pricedistorting tax instead of under a lumpsum tax.
6
Community Charges in the U.K.

The Thatcher government replaced local
property taxes with a form of lump-sum tax
called “the community charge.’’

The tax was set by each local council and
charged a fixed amount per adult taxpayer.

Despite its efficiency, the lump-sum tax was
viewed as so unfair by many taxpayers that
they refused to pay it.
7
Unit Taxes

A unit tax adds to the price by a fixed
amount. Examples include the 32 cents
per pack of cigarettes and 24 cents per
gallon of gasoline in federal taxes.
8
Tax Terms

The Gross Price (PG) is the price paid
by consumers.

The Net Price (PN) is the price received
by producers after the tax is paid.

PN = PG – T
9
Figure 11.2 Impact of A Unit Tax on
Market Equilibrium
ST = MSC +$0.25
Price (Dollars)
S = MSC
Tax Revenue
1.15 = PG
1.00
0.90 = PN
C
Excess Burden
B
A
T = $0.25
DQ
0
D = MSB
Q1Q*
Gasoline per Year (Gallons)
10
Excess Burden of a Unit Tax
DWL = 1/2TDQ
=1/2 ×T2 × (Q*/P*) × (ESED)/(ES – ED)
(A Step-by-step algebraic derivation is in the appendix to
Chapter 11)
11
Implication of the DWL Calculation

A doubling of the per-unit tax
quadruples the Deadweight Loss.
12
Figure 11.3 Excess Burden When Demand or
Supply is Perfectly Inelastic
A
Demand
Supply
after Tax
B
Supply
Price
Price
Supply
Demand
Net Price
after Tax
0
q
Quantity per Month
0
q
Quantity per Month
13
Efficiency Loss Ratio of a Tax

The Efficiency Loss Ratio is the
deadweight loss per dollar of revenue
raised DWL/R .

Estimates of U.S. tax system place
ELR at between 25 and 40 cents per
dollar of tax revenue raised.
14
Incidence of a Tax

The Legal Incidence is the burden of a tax
as determined by those who are legally
obligated to pay the tax.

The Economic Incidence is the burden of a
tax as determined by how much the
parties are affected in terms of paying
higher prices, or receiving lower prices.
15
Shifting of Taxes

Forward Shifting is the transfer of the
burden of a tax from the seller, who is
legally obligated to pay it, to a buyer.

Backward Shifting is the transfer of the
burden of a tax from the buyer, who is
legally obligated to pay it, to a seller.
16
Ad-Valorem Taxes

Ad-Valorem Taxes add a fixed
percentage to the price of a good.

The primary example is sales taxes.
17
Incidence of an Ad-valorem tax
DWL = 1/2 TDQ
T = tPG
= 1/2 t2PG2(Q*/P*) × (ESED)/(ES – ED)
if t is very small, then this is
approximately
= 1/2 t2P*Q*(ESED)/(ES – ED)
18
Using Excise Taxes on Alcohol to
Internalize Externalities

Federal taxes on alcohol are per-unit
rather than ad-valorem.



32 cents per six-pack of beer ($.10/oz)
$13.50 per gallon of 100 proof liquor
($.25/oz)
Externalities associated with alcohol
are estimated at $0.48 per ounce (of
hard liquor).
19
Figure 11.4 Impact of an Ad Valorem Tax on Labor
Wages (Dollars)
Excess S
Burden
WG = 5.20
5.00
E
E'
WN = 4.16
Tax Revenue
D = Gross Wage
Net Wage = WG (I – t)
0
Q1 Q*
Labor Hours per Year
20
Independence of Legal and Economic
Incidence

Economically, it does not matter whether the
buyer or seller is legally liable for a tax.

The economic incidence of the tax is
determined by supply and demand
elasticities, the amount of the tax, and the
original equilibrium price and quantity.
21
Figure 11.5 Incidence of a Tax Collected From Buyers
S = MSC
C
Price (Dollars)
PG + T =1.15
1.00
PG = 0.90
A
B
D = MSB
D' = MSB – T
0
Q1Q*
Price per Year (Gallons)
22
Figure 11.6 The More Inelastic the Demand, the
Greater the Portion of a Tax Borne by Buyers
Price (Dollars)
S = MC + $0.25
C
1.20
1.15
1.00
.95
.90
S = MC
E
B
A
DQ’
D’
DQ’
0
D
Q1 Q2 Q*
Gasoline per Year (Gallons)
23
Price (Cents)
Figure 11.7 Impact of a Tax on a Good with
a Perfectly Elastic Supply
E'
60
MC + T = S'
E
50
MC = S'
D
0
Q1
Q*
Housing per Month Square Feet
24
Figure 11.8 Tax Incidence When
Market Supply is Perfectly Inelastic
Wages (Dollars)
S
E
WG*
tw*G
WN= WG*(1-t)
F
D=W
WN= WG*(1-t)
0
Q*
Labor Hours per Year
25
Shifting Under Imperfect Competition

Monopolists can shift less of a given
tax forward to consumers than can a
competitive industry.
26
Figure 11.9 Shifting Under Monopoly
Price
MC + T
PMT DPM
PM
P*T
DP*
P*
MC
D
DQM
DQ*
MR
QMT QM Q*T Q*
Output per Year
27
General Equilibrium Analysis and Shifting

When one good is taxed and another good is
not taxed, the impact of the tax is not
confined to the taxed good.

Because a tax on one good lowers the profit
that can be made to firms producing it, they
may shift their productive resources to the
other good so as to maximize their after-tax
rate-of-return in both markets.

This has the effect of equalizing the after-tax
rate-of-return.
28
Figure 11.10 Multimarket Analysis of Excess Burden
Price
A
B
E2
E1
PF(1 + t)
PF
A
DQF
S'
S
E2
PC(1 + t)
S'
E1
PC
B
S
DC
DQC
DF
QF2 QF1
Food per Year
0
QC2
QC1
Clothing per Year
29
Figure 11.11 Multi-market Analysis Incidence
A
B
S' = MC + T
S
S
S'
Price
E2
PG
P*
PN
E1
P
P F'
E1
E2
D
0
Q' Q*
Clothing per Year
D
0
Q F Q F'
Food per Year
30
Government Taxes and Expenditures and
the Distribution of Income

The Tax Incidence is who bears the burden of a tax.

The Expenditure Incidence is who receives the
benefits of a government program.

The Budget Incidence is the net analysis of a
program’s tax and expenditure incidence.

The Differential Tax Incidence is the change in the
tax incidence that results from substituting one equal
yield tax for another.
31
The Lorenz Curve

The Lorenz Curve maps the cumulative
percentage of households against their
cumulative percentage of income.
32
Figure 11.12 A Lorenz Curve
Percentage of Real Income
100
E
Line of Equal Distribution
75
y
60
50
25
20
10
5
3
0
Area A
Area B
x
10 25
50
75
Percentage of Households
D
100
33
The Gini Coefficient

The Gini Coefficient is the ratio of the
area between the Lorenz curve and the
perfect equality line (Area A in the
previous slide) to the area under the
perfect equality line (Areas A and B).
34
Effective Tax Rates for All Federal
Taxes, 1998
Income Category
(in quintiles)
Effective Tax
Rate (percent)
Lowest
4.5
Second
13.3
Third
18.9
Fourth
22.1
Highest
28.7
35