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More on taxation
Today: Studying taxation graphically
What should be taxed? Why?
Changes in consumption due to taxes Recall that people typically consume less of a
good or service once it is taxed Example: Yacht tax in the early 1990s
Tax on yachts over $100,000 purchased in the US People bought yachts in other countries Net economic impact
$16.6 million in taxes collected (less than the $31 million predicted)
Less income tax paid by workers (7,600 jobs lost in the US)
Today
Studying taxation graphically How do people react to taxes?
Deadweight loss Ramsey rule Equity/fairness Tax avoidance
Study of taxation graphically Individual behavior Excess burden in a market with horizontal
supply Taxes on labor Subsidies Pigouvian taxes
How do taxes affect individual behavior?
Pou
nds
of c
orn
per
year
Pounds of barley per year
E1
B1
C1
DF
A
Cb
Ca
B0
E2
iii
G
Market excess burden, horizontal supply
Pounds of barley per year
Pric
e pe
r po
und
of b
arle
y
a
Db
Sb
q1q2
ih
S’b
Pb
(1 + tb)Pb g f
d
Tax revenues
Excess burden of tax
Remember: Excess burden and deadweight loss mean the same thing
Taxing labor
Hours per year
Wag
e ra
te p
er h
our
SL
L1L2
a
g(1 – t)w
wf i
h
Excess burden
d
Subsidies lead to excess burden, too
Housing services per year
Pric
e pe
r un
it o
f h
ousi
ng s
ervi
ces
m
Dh
Sh’
h2h1
uq
Sh
(1 – s)Ph
Ph
n o
r
Excess burden
v
Recall: Pigouvian taxes reduce excess burden
Q per year
$
MB
0
MD
MPC
MSC = MPC + MD
Q1Q*
c
d
(MPC + cd)
Pigouviantax revenues
i
j
Recall double dividend hypothesis Industry with negative externality
Pigouvian tax Reduces excess burden If tax proceeds are used to reduce other
taxes, excess burden from these taxes are lowered
Criticism: An environmental tax could lead to an increase in the excess burden in the labor market
An economist’s analysis
Given an amount of revenue that is generated, taxes should be imposed such that one of the following goals is achieved Excess burden is minimized Social welfare is maximized
The real world
Taxes are often imposed that have the lowest amount of political resistance
Excess burden seems less important than revenue generation Sometimes efficiency is completely ignored
Efficient taxation/tax dodging Although the yacht tax was likely
implemented to be “equitable,” efficiency suffered on all margins Excess burden due to the tax Decreased overall tax revenue collected due to
jobs lost in the US What kinds of taxes lead to less excess
burden?
Efficient taxation
Assume that the amount of tax revenue collected is set at a constant level
Should everything be taxed at the same rate in order to make the most efficient outcome? Taxing each good at the same rate is known as
neutral taxation
Marginal excess burden
X per year
PX
DX
P0
X0
c
P0 + uXb
X1
∆X
a
ExcessBurden
P0 + (uX + 1) f
X2
i
∆x
ej
h
g
MarginalExcessBurden
The Ramsey rule
How do we tax to reduce excess burden? Ramsey rule
Percentage reduction in quantity demanded for every good is the same
Back to our old question: Should everything be taxed at the same rate in order to make the most efficient outcome? NO
One other concept to keep in mind Marginal excess burden generally increases as the tax
increases
Equity concerns
From the Ramsey rule, inelastic goods should be taxed at higher rates in order to gain efficiency Coffee Theater/opera Salt Many prescription drugs
Example: Insulin needed to live
Should we look at fairness, too? Many people believe that fairness is just as
important as efficiency This type of person would…
Probably not want to tax insulin Impose a higher tax on goods that high-income people
consume more of Not want to impose a lump sum tax
Tax evasion/tax avoidance
Tax evasion Not paying taxes that are legally owed to a
government Tax avoidance
Altering behavior to legally pay less in taxes
Examples of tax avoidance
Recall yacht tax in the early 1990s Tax on yachts over $100,000 purchased in the US Tax avoidance: People bought yachts in other countries Net economic impact in the US was negative
18th century tax in Brazil Tax on finished churches Tax avoidance: Build churches that were complete except
for some trivial part that was not built
This church is not “finished” since it is missing one of its towers
Other examples of tax avoidance Uffa Fox built a home made from a floating
bridge in Britain Fox would sail his home whenever tax collectors
would try to collect property tax Cyprus used to have a tax on finished
structures Many houses would had steel bars sticking out of
the top floor
One more tax avoidance example Thai tax on outside signs
Highest tax on signs in English only Medium tax on signs in English and Thai Lowest tax on signs in Thai only
How have people responded?
One more tax avoidance example Thai tax on outside signs
Highest tax on signs in English only Medium tax on signs in English and Thai Lowest tax on signs in Thai only
How have people responded? Put their store information on curtains inside the
store Make signs with English words in big letters and
Thai words in tiny writing
Tax evasion theory
Marginal benefit of cheating on taxes is constant $1 for each dollar in taxes avoided
Marginal cost is increasing Probability of getting caught cheating increases
as the number of “red flags” increases If MB > MC for some people (for the first
dollar in tax evasion), an underground economy develops
A tale of two people
(Dollars of underreporting)(Dollars of underreporting)
$ $MC = p * marginalpenalty
MC = p * marginalpenalty
MB = tMB = t
R* R* = 0
Summary: Efficient taxation/tax dodging Efficient taxation comes from the Ramsey
rule Percentage reduction in quantity demanded for
every good is the same Equity concerns are important in many
people’s minds Tax evasion and tax avoidance are used to
lower the amount of taxes a person pays Note that tax evasion is illegal
Are you a tax evader? Tax dodger? One more
lecture to go Wednesday
Read pages 380-385, 398-401, 406-409, and 415-419
Federal taxes Marriage penalty Labor decisions
with taxes