1 1 Lesson Overview BA 210 Lesson I.8 Taxes Chapter 7 Taxes Taxes and their Effects Tax Incidence Tax Revenue Tax Rates and Revenue The Deadweight Loss

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Lesson OverviewLesson Overview

BA 210 Lesson I.8 Taxes

Chapter 7 TaxesChapter 7 TaxesTaxes and their EffectsTaxes and their EffectsTax IncidenceTax IncidenceTax RevenueTax RevenueTax Rates and RevenueTax Rates and RevenueThe Deadweight Loss of a TaxThe Deadweight Loss of a TaxDeadweight Loss and ElasticitiesDeadweight Loss and ElasticitiesThe Tax SystemThe Tax SystemControversy: WelfareControversy: WelfareSummarySummaryReview QuestionsReview Questions

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Excise taxes

• An excise tax is a tax on sales of a good.

• Excise taxes: raise the price paid by buyers, called the buyers’ price reduce the price received by sellers, called the sellers’ price


Taxes and their EffectsTaxes and their Effects

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The Supply and Demand for Hotel Rooms in Los Angeles

S

D

0 5,000 10,000 15,000

$140

120

100

80

60

40

20

E

B

Price of hotel room

Quantity of hotel roomsEquilibrium

quantity

Equilibrium price



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S1

S2

A

B

0 5,000 10,000 15,000

$140

120

100

80

60

40

20

Quantity of hotel rooms

Buyers’ Price of

hotel room

D

EExcise tax = $40

per room

Supply curve shifts upward by the amount

of the tax


An Excise Tax on Hotel Rooms An Excise Tax on Hotel Rooms can be analyzed by the can be analyzed by the Buyers’ Buyers’ priceprice … …


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A

B

0 5,000 10,000 15,000

$140

120

100

80

60

40

20


E

S

D2

D1

Excise tax = $40 per room

Demand curve shifts downward by the amount of the tax



Sellers’ Price of

hotel room

… … or can be analyzed by the or can be analyzed by the Sellers’ priceSellers’ price

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Tax IncidenceTax Incidence

• The incidence of a tax measures who really bears the tax burden.The incidence of a tax measures who really bears the tax burden.

• Who really bears the tax burden (in the form of higher prices to Who really bears the tax burden (in the form of higher prices to consumers and lower prices to sellers) does not depend on who consumers and lower prices to sellers) does not depend on who officially pays the tax. For example, the hotel or the hotel guest.officially pays the tax. For example, the hotel or the hotel guest.

• Depending on the shapes of supply and demand curves, the Depending on the shapes of supply and demand curves, the incidence of an excise tax may be divided differently.incidence of an excise tax may be divided differently.

• The wedge between the demand price and supply price becomes The wedge between the demand price and supply price becomes the government’s the government’s tax revenuetax revenue..


Tax Incidence

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D

S

$2.95

2.00

1.95

Price of gasoline (per gallon)

0 Quantity of gasoline (gallons)

Tax burden falls mainly on consumersExcise tax =

$1 per gallon

When the price elasticity of demand is much lower than the price elasticity of supply is high, the burden of an excise tax falls mainly on consumers.


An Excise Tax Paid Mainly By Consumers

Tax Incidence

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D

S

$6.50

6.00

1.50

Price of parking space

0Quantity of parking spaces

Tax burden falls mainly on producers

Excise tax = $5 per parking space

When the price elasticity of demand is high and the price elasticity of supply is low, the burden of an excise tax falls mainly on producers.


An Excise Tax Paid Mainly By Producers

Tax Incidence

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Tax Incidence SummaryTax Incidence Summary

• When the price elasticity of demand is higher than the price When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers. elasticity of supply, an excise tax falls mainly on producers. That makes sense because consumers have more substitutes in That makes sense because consumers have more substitutes in demand. demand.

• When the price elasticity of supply is higher than the price When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers. elasticity of demand, an excise tax falls mainly on consumers. That makes sense because producers have more substitutes in That makes sense because producers have more substitutes in supply. supply.

• So elasticity determines the incidence of an excise tax.So elasticity determines the incidence of an excise tax.


Tax Incidence

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S

B

60 5,000 10,000 15,000

$140

120

100

80

60

40

20


D

EArea = tax

revenue

Excise tax = $40 per room

A

Price of hotel room

The area of the shaded rectangle is:The area of the shaded rectangle is:Area = Height × Width Area = Height × Width

= $40 per room × 5,000 rooms = $200,000= $40 per room × 5,000 rooms = $200,000The The tax revenue tax revenue collected is:collected is:

Tax revenue = $40 per room × 5,000 rooms Tax revenue = $40 per room × 5,000 rooms = $200,000= $200,000


Tax Revenue

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Tax revenue summaryTax revenue summary

• The revenue collected by an excise tax is equal to the area of The revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity supply and demand curves and whose width is the quantity transacted under the tax.transacted under the tax.


Tax Revenue

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Tax Rates and RevenueTax Rates and Revenue

• A tax rate is the amount of tax people are required to pay per A tax rate is the amount of tax people are required to pay per unit of whatever is being taxed.unit of whatever is being taxed.

• In general, doubling the excise tax rate on a good or service In general, doubling the excise tax rate on a good or service won’t double the amount of revenue collected, because the tax won’t double the amount of revenue collected, because the tax increase will reduce the quantity of the good or service increase will reduce the quantity of the good or service transacted. transacted.

• In some cases, raising the tax rate may actually reduce the In some cases, raising the tax rate may actually reduce the amount of revenue the government collects.amount of revenue the government collects.


Tax Rates and Revenue

13 13Quantity of hotel rooms

Price of hotel room

S

60 ,000 7,500 10,000 15,000

$140

120

80

90

70

40

20

D

E

(a) An excise tax of $20.Revenue = $20 x 7,500 = $150,000

S

0 5,0002,500 10,000 15,000

$140

120

110

80

50

40

20

D

E

(b) An excise tax of $60.Revenue = $60 x 2,500 =

$150,000Price of

hotel room


Excise tax =

$20 per room

Excise tax =

$60 per room

Area = tax revenue

Area =

tax revenu

e


Tax Rates and RevenueTax Rates and Revenue

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A Tax Reduces Consumer and Producer SurplusA Tax Reduces Consumer and Producer Surplus

• A fall in the price of a good causes a gain in consumer surplus. A fall in the price of a good causes a gain in consumer surplus. Similarly, a price increase causes a loss in consumer surplus. Similarly, a price increase causes a loss in consumer surplus. So, in the case of an excise tax, the rise in the price paid by So, in the case of an excise tax, the rise in the price paid by consumers causes a loss in consumer surplus.consumers causes a loss in consumer surplus.

• Likewise, the fall in the price received by producers causes a Likewise, the fall in the price received by producers causes a loss in producer surplus.loss in producer surplus.

• Therefore, an excise tax reduces both consumer surplus and Therefore, an excise tax reduces both consumer surplus and producer surplus.producer surplus.


The Deadweight Loss of a TaxThe Deadweight Loss of a Tax

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QE Quantity

S

E

D

Pri c e

QT

PE

PC

PP

C

A B

F

Excise tax = T

Fall in consumer surplus due to tax

Fall in producer surplus due to tax


A Tax Reduces Consumer and Producer SurplusA Tax Reduces Consumer and Producer Surplus

The Deadweight Loss of a Tax

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The Deadweight Loss of a TaxThe Deadweight Loss of a Tax• Although consumers and producers are hurt by the tax, the Although consumers and producers are hurt by the tax, the

government gains revenue. The revenue the government government gains revenue. The revenue the government collects is equal to the tax per unit sold, collects is equal to the tax per unit sold, T, T, multiplied by the multiplied by the quantity sold, quantity sold, QQTT..

• But a portion of the loss to producers and consumers from the But a portion of the loss to producers and consumers from the tax is not offset by a gain to the governmenttax is not offset by a gain to the government. .

• The deadweight loss caused by the tax represents the total The deadweight loss caused by the tax represents the total surplus lost to society because of the tax — that is, the amount surplus lost to society because of the tax — that is, the amount of surplus that would have been generated by transactions that of surplus that would have been generated by transactions that now do not take place because of the tax.now do not take place because of the tax.

• The deadweight loss is the change in total surplus if the tax The deadweight loss is the change in total surplus if the tax revenue were simply given back to members of society --- for revenue were simply given back to members of society --- for example, as a type of welfare payment.example, as a type of welfare payment.



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QE

Quantity

S

E

D

Price

QT

PE

PC

PP

Deadweight loss

Excise tax = T



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• The administrative costs of a tax are the resources used by The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it.and above the amount of the tax, as well as to evade it.

• The total inefficiency caused by a tax is the sum of its The total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. The general rule deadweight loss and its administrative costs. The general rule for economic policy is that, other things equal, a tax system for economic policy is that, other things equal, a tax system should be designed to minimize the total inefficiency it should be designed to minimize the total inefficiency it imposes on society.imposes on society.



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Quantity

D

E

(a) Elastic Demand (b) Inelastic Demand

Quantity

D

S

E

S

Deadweight loss is larger when

demand is elastic

QE

QE

QT

QT

PE

PC

PP

PE

PC

PP

Excise tax = T

Excise tax = T

Deadweight loss is smaller when

demand is inelastic

Price Price


Deadweight Loss and ElasticitiesDeadweight Loss and Elasticities


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(c) Elastic Supply (d) Inelastic Supply

Quantity

Price

D

E

S

Quantity

D

E

S

PE

PC

PP

PE

PC

PP

QE

QE

QT

QT

Excise tax = T

Excise tax = T

Deadweight loss is smaller when supply is

inelastic

Deadweight loss is larger when

supply is elastic

Price




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• To minimize the efficiency costs of taxation, one should To minimize the efficiency costs of taxation, one should choose to tax only those goods for which demand or supply, or choose to tax only those goods for which demand or supply, or both, is relatively inelastic.both, is relatively inelastic.

• For such goods, a tax has little effect on behavior because For such goods, a tax has little effect on behavior because behavior is relatively unresponsive to changes in the price.behavior is relatively unresponsive to changes in the price.



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• In the extreme case in which demand were perfectly inelastic In the extreme case in which demand were perfectly inelastic (a vertical demand curve), the quantity demanded is (a vertical demand curve), the quantity demanded is unchanged by the imposition of the tax. As a result, the tax unchanged by the imposition of the tax. As a result, the tax imposes no deadweight loss.imposes no deadweight loss.

• Similarly, if supply were perfectly inelastic (a vertical supply Similarly, if supply were perfectly inelastic (a vertical supply curve), the quantity supplied is unchanged by the tax and there curve), the quantity supplied is unchanged by the tax and there is also no deadweight loss.is also no deadweight loss.



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Deadweight Loss and Elasticities

• If the goal in choosing whom to tax is to minimize deadweight loss, then taxes should be imposed on goods that have the most inelastic response—that is, goods and services for which consumers or producers will change their behavior the least in response to the tax.



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The Tax SystemThe Tax System• The tax base is the measure or value, such as income or The tax base is the measure or value, such as income or

property value, that determines how much tax an individual or property value, that determines how much tax an individual or firm pays.firm pays.

• The tax structure specifies how the tax depends on the tax The tax structure specifies how the tax depends on the tax base.base.

• Once the tax base has been defined, the next question is how Once the tax base has been defined, the next question is how the tax depends on the base. The simplest tax structure is a the tax depends on the base. The simplest tax structure is a proportional tax, also sometimes called a flat tax, which is the proportional tax, also sometimes called a flat tax, which is the same percentage of the base regardless of the taxpayer’s same percentage of the base regardless of the taxpayer’s income or wealth.income or wealth.


The Tax SystemThe Tax System

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Some important taxes and their tax bases are as follows:Some important taxes and their tax bases are as follows:

• Income tax: a tax that depends on the income of an individual Income tax: a tax that depends on the income of an individual or a family from wages and investmentsor a family from wages and investments

• Payroll tax: a tax that depends on the earnings an employer Payroll tax: a tax that depends on the earnings an employer pays to an employeepays to an employee

• Sales tax: a tax that depends on the value of goods sold (also Sales tax: a tax that depends on the value of goods sold (also known as an excise tax)known as an excise tax)

• Profits tax: a tax that depends on a firm’s profitsProfits tax: a tax that depends on a firm’s profits

• Property tax: a tax that depends on the value of property, such Property tax: a tax that depends on the value of property, such as the value of a homeas the value of a home

• Wealth tax: a tax that depends on an individual’s wealthWealth tax: a tax that depends on an individual’s wealth





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• Once the tax base has been defined, the next question is how Once the tax base has been defined, the next question is how the tax depends on the base. The simplest tax structure is a the tax depends on the base. The simplest tax structure is a proportional tax, also sometimes called a flat tax, which is the proportional tax, also sometimes called a flat tax, which is the same percentage of the base regardless of the taxpayer’s same percentage of the base regardless of the taxpayer’s income or wealth.income or wealth.

• State and, especially, local governments generally do not make State and, especially, local governments generally do not make much effort to increase the tax on high income or wealth . This much effort to increase the tax on high income or wealth . This is largely because they are subject to is largely because they are subject to tax competitiontax competition: a state : a state or local government that imposes high taxes on people with or local government that imposes high taxes on people with high incomes faces the prospect that those people may move high incomes faces the prospect that those people may move to other locations where taxes are lower. to other locations where taxes are lower.



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Controversy: WelfareControversy: Welfare




WelfareWelfare consists of actions or procedures — especially on the consists of actions or procedures — especially on the part of governments and institutions — striving to promote the part of governments and institutions — striving to promote the basic well-being of individuals in need. These efforts usually basic well-being of individuals in need. These efforts usually strive to improve the financial situation of people in need but strive to improve the financial situation of people in need but may also strive to improve their employment chances and many may also strive to improve their employment chances and many other aspects of their lives including sometimes their mental other aspects of their lives including sometimes their mental health. In many countries, most such aid is provided by family health. In many countries, most such aid is provided by family members, relatives, and the local community.members, relatives, and the local community.

Welfare in most countries is provided to those who are Welfare in most countries is provided to those who are unemployedunemployed, those with , those with illness or disabilityillness or disability, those of , those of old ageold age, , those with those with dependent childrendependent children. .



Microeconomics lessons on Microeconomics lessons on Revealed Preference Revealed Preference and on and on TaxesTaxes reveal that the controversy over the level of welfare and who reveal that the controversy over the level of welfare and who deserves welfare is caused by the controversy over the rationality deserves welfare is caused by the controversy over the rationality of those in need.of those in need.

If everyone were rational, then Revealed Preference shows If everyone were rational, then Revealed Preference shows someone that is someone that is unemployedunemployed has high consumption of leisure has high consumption of leisure time and, so, may be happier than someone that is time and, so, may be happier than someone that is employedemployed. . Likewise, Revealed Preference shows someone with Likewise, Revealed Preference shows someone with dependent dependent childrenchildren has high consumption of children as a commodity and, has high consumption of children as a commodity and, so, may be happier than someone without children. And so, may be happier than someone without children. And Revealed Preference shows people may be happier if they Revealed Preference shows people may be happier if they received tax break when young rather than welfare in received tax break when young rather than welfare in old ageold age..



Finally, even if welfare cash is not a subsidy for the consumption Finally, even if welfare cash is not a subsidy for the consumption of children and is not delayed until old age, welfare is still of children and is not delayed until old age, welfare is still controversial because of the deadweight loss of the tax that is controversial because of the deadweight loss of the tax that is needed to pay for welfare.needed to pay for welfare.



Question: Question: Consider the market for labor in the US, illustrated in Consider the market for labor in the US, illustrated in the accompanying table.the accompanying table.Suppose the US decides toSuppose the US decides toimpose a $4 tax on wages andimpose a $4 tax on wages andto give the revenue back as to give the revenue back as welfare.welfare.a. What is the quantity of labora. What is the quantity of laborbought and sold after the bought and sold after the imposition of the tax? What is imposition of the tax? What is wage paid by employers? What wage paid by employers? What is the wage received by workers? is the wage received by workers? b. Calculate the consumer surplus and the producer surplus after b. Calculate the consumer surplus and the producer surplus after the imposition of the tax. By how much has the imposition of the the imposition of the tax. By how much has the imposition of the tax reduced total surplus? tax reduced total surplus? c. How much revenue does the US earn from this tax?c. How much revenue does the US earn from this tax?


Wage Quantity of Labor

Demanded

Quantity of Labor

Supplied

$9 0 7

$8 0 6

$7 1 5

$6 2 4

$5 3 3

$4 4 2

$3 5 1

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Demanded

Quantity of Labor

Supplied

$9 0 7

$8 0 6

$7 1 5

$6 2 4

$5 3 3

$4 4 2

$3 5 1


Answer: Answer: a. The tax drives a wedge between the price paid by a. The tax drives a wedge between the price paid by consumers and the wage received consumers and the wage received by workers. Consumers now pay by workers. Consumers now pay $7, and workers receive $3. So $7, and workers receive $3. So after the imposition of the tax, after the imposition of the tax, the quantity bought and sold will the quantity bought and sold will be 1 unit of labor. be 1 unit of labor. b. Consumer surplus before the b. Consumer surplus before the tax was $3 (at wage = $5) and tax was $3 (at wage = $5) and is now $0 (at wage = $7). is now $0 (at wage = $7). Producer (worker) surplus before Producer (worker) surplus before the tax was $3 (at wage = $5) and is now $0 (at wage = $3). So, the tax was $3 (at wage = $5) and is now $0 (at wage = $3). So, the imposition of the tax reduced total surplus by $6. the imposition of the tax reduced total surplus by $6. c. The US earns a tax of $4 per unit sold, which is a total tax c. The US earns a tax of $4 per unit sold, which is a total tax revenue of $4. revenue of $4.


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Demanded

Quantity of Labor

Supplied

$9 0 7

$8 0 6

$7 1 5

$6 2 4

$5 3 3

$4 4 2

$3 5 1


Comment: Comment: The total tax revenue of $4 allows $4 of welfare to be The total tax revenue of $4 allows $4 of welfare to be dispersed. But consumers anddispersed. But consumers andproducers of labor are hurt $6,producers of labor are hurt $6,which is more than the welfarewhich is more than the welfarerecipients are helped. In thisrecipients are helped. In thissense, welfare decreased totalsense, welfare decreased totalprosperity in the US and, so,prosperity in the US and, so,is objectionable to a is objectionable to a UtilitarianUtilitarian,,who measures society’s who measures society’s well-being by total happiness. well-being by total happiness.


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SummarySummary

1. Excise taxes — taxes on the purchase or sale of a good—raise the price paid by consumers and reduce the price received by producers, driving a wedge between the two.The incidence of the tax—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax.

2. The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers.


SummarySummary

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3. The tax revenue generated by a tax depends on the tax rate and on the number of units transacted with the tax. Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs —resources used to collect the tax.

4. An excise tax generates revenue for the government, but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society. This deadweight loss is represented by a triangle, the area of which equals the value of the transactions discouraged by the tax. The greater the elasticity of demand or supply, or both, the larger the deadweight loss from a tax. If either demand or supply is perfectly inelastic, there is no deadweight loss from a tax.


SummarySummary

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5. An efficient tax minimizes both the sum of the deadweight loss due to distorted incentives and the administrative costs of the tax. However, tax fairness, or tax equity, is also a goal of tax policy.

6. There are two major principles of tax fairness, the benefits principle and the ability-to-pay principle. The most efficient tax, a lump-sum tax, does not distort incentives but performs badly in terms of fairness. The fairest taxes in terms of the ability-to-pay principle, however, distort incentives the most and perform badly on efficiency grounds. So in a well-designed tax system, there is a trade-off between equity and efficiency.


SummarySummary

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7. Every tax consists of a tax base, which defines what is taxed, and a tax structure, which specifies how the tax depends on the tax base. Different tax bases give rise to different taxes—the income tax, payroll tax , sales tax, profits tax , property tax, and wealth tax.

8. A tax is progressive if higher-income people pay a higher percentage of their income in taxes than lower-income people and regressive if they pay a lower percentage. Progressive taxes are often justified by the ability-to-pay principle. However, a highly progressive tax system significantly distorts incentives because it leads to a high marginal tax rate, the percentage of an increase in income that is taxed away, on high earners. The U.S. tax system is progressive overall, although it contains a mixture of progressive and regressive taxes.


SummarySummary

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Review QuestionsReview Questions


Review QuestionsReview Questions You should try to answer some of the following questions You should try to answer some of the following questions before the next class. before the next class. You will not turn in your answers, but students may request You will not turn in your answers, but students may request to discuss their answers to begin the next class. to discuss their answers to begin the next class. Your upcoming Exam 1 and cumulative Final Exam will Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually contain some similar questions, so you should eventually consider every review question before taking your exams.consider every review question before taking your exams.

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Review QuestionsReview Questions


Follow the linkFollow the linkhttp://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set7Answers.pdf

for review questions for Lesson I.8 that practices these skills: for review questions for Lesson I.8 that practices these skills: Compute the effects of an excise tax on price, quantity, and tax Compute the effects of an excise tax on price, quantity, and tax revenue.revenue.Show how the tax burden is divided between consumers and Show how the tax burden is divided between consumers and producers according to demand and supply elasticity.producers according to demand and supply elasticity.Compute the effects of an excise tax on consumer and producer Compute the effects of an excise tax on consumer and producer surplus.surplus.

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End of Lesson I.8End of Lesson I.8


BA 210 Introduction to BA 210 Introduction to MicroeconomicsMicroeconomics

Documents

1 1 Lesson Overview BA 210 Lesson I.8 Taxes Chapter 7 Taxes Taxes and their Effects Tax Incidence Tax Revenue Tax Rates and Revenue The Deadweight Loss