Taxation 1

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Taxation 1

• Economics of Public Policy
• PADM 625
• Ben Muse

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What is a tax?

• an involuntary payment to the government by an
  individual or firm that does not entitle the
  payer to a quid pro quo benefit or to an
  equivalent value of goods and services in
  exchange.

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Three big taxation issues

• How much revenue will the tax generate?
• Who is going to pay the tax?
• What costs does the tax impose on society

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Another list of big issues

• Efficiency
• Administrative simplicity
• Flexibility
• Transparency
• Fairness

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Impact of a lump-sum tax
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Apples and bagels are the only goods

• Consumer has an income and faces prices for the
  two goods
• Can draw a budget line
• for simplicity normalize price of a unit of
  apples to 1

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Axes
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Add a budget constraint
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Highest indifference curve
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Lump-sum tax

• Each person pays the same amount
• The amount they pay does not depend in any way on
  their behavior
• Everyone pays the same using a lump sum tax to
  raise all government revenue in 1999 would have
  been 10,250 per person
• Fairness, practicality issues

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Lump-sum tax

• The tax reduces each persons income
• This shifts the budget constraint in parallel to
  itself
• Will decrease the quantities of normal goods
  demanded by consumers

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Effect of lump-sum tax
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New indifference curve
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Impact of an excise tax
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Excise tax

• A tax per unit of a good purchased
• Specific excise tax so many dollars per unit
• Ad valorem a percentage of the purchase price
  of the unit
• Well be looking at examples of the specific tax

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Budget constraint
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Add indifference curve
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Tax on bagels effectively increases price
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Original combination
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New indifference curve
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New combination
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Income and substitution effects

• When a price goes up
• There is an income effect - as a person
  effectively has less income to spend
• and a substitution effect - as a person
  substitutes out of the relatively more expensive
  good

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Comparing lump sum and excise taxes
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A consumers demand curve
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Consumer faces a price and makes a choice
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Add a lump sum tax

• As noted above,
• Imposing a lump sum tax on a person
• Will create an income effectand reduce the
  amount of the good demanded
• at any give price
• this effectively shifts the demand curve to the
  left

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Add a lump sum tax
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Add an excise tax

• As noted above,
• An excise tax has the effect of increasing the
  price for the good
• this has the effect of shifting a consumers
  demand for the good along the demand curve

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Add an excise tax
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Excise tax revenue

• The revenue from the excise tax
• will equal the product of
• the per unit tax
• and the number of units of the good the person
  continues to consume after the tax is imposed

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Excise tax revenue
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After tax demand curve

• Consumer demand curve wont change
• but demand curve faced by producers does
• The price the producers receive will be less than
  the price consumers pay by the amount of the tax

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Add an excise tax
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Add the after tax demand curve
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Excise and lump sum taxes

• If the excise tax raises the same amount of
  revenue as the lump sum tax
• it will be associated with a larger decrease in
  consumption of the good
• We are dealing with the substitution effect in
  addition to the income effect

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Add an excise tax
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Impact on firm decisions
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Firms decision process

• Firms try to balance marginal costs and
  marginal benefits of decisions
• Marginal revenue is the additional revenue
  associated with a small change in output
• If firm faces a constant price (P) its marginal
  revenue is equal to the price

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Firms decision process

• Marginal cost is the additional cost associated
  with an small increase in output
• We generally assume a firm faces increasing
  marginal costs
• the cost of an additional unit tends to increase
  as output increases

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Firms decisions
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Firms decisions
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Firms decisions
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Add in an excise tax

• Assume a fixed tax per unit of output
• To be paid by the firm
• This basically is an increase in the firms
  marginal cost of producing each unit
• Can represent this as an upward shift in marginal
  cost curve

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Firms decisions
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Source

• Bruce, Chapter 10
• Stiglitz, Joseph. Economics of the Public
  Sector. 3d edition. Norton, 2000.