Taxes and Economic Efficiency

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Taxes and Economic Efficiency

• Economics of Public Policy
• PADM 625
• Ben Muse

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Excess burden

• The excess burden of a tax is the lost consumers
  and producers surpluses associated with the
  behavioral changes induced by the tax.
• This is a loss in social welfare associated with
  the tax in addition to the administrative costs
  of the tax

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Excess burden of taxes

• Bruce cites (one study) estimating the excess
  burden of the total U.S. tax system
• at between 4 and 7 of GDP
• or between 13 and 23 of the revenue collected
• lowest estimate 350 billion 1999 dollars

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Excess burden of an excise tax
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Impose an excise tax

• Consider the imposition of an excise tax.
• For example, a 100 municipal tax imposed on car
  dealers for each car they sell
• Tax effectively increases the marginal cost of
  each car sold by 100

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Excess burden of an excise tax
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Excess burden of an excise tax
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Lost consumers and producers surplus)
Consumers surplus
Producers surplus
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Measuring the excess burden

• The size of the excess burden
• Represented by the area of the triangle
• Area of a triangle is equal to
• one-half the product of the base and the height

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Measuring the excess burden

• The base is the excise tax rate
• The height is the change in the quantity
  purchased
• Excess burden (EB) (-1/2)t?Q
• If the tax is 100, and the quantity change is
  200 cars
• EB (-1/2)100200 10,000

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Tax rate and tax burden

• The excess burden increases disproportionately to
  the excise tax rate
• In our simple model with linear supply and demand
  curves, the excess burden increases with the
  square of the tax rate

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The square rule
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Impose a tax
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Double the tax excess burden increases
disproportionately
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Suggests an important tax policy rule

• For the purpose of collecting revenue, high tax
  rates, particularly on a narrow category of
  goods, should be avoided.

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Burdens of an excise tax

• Figure 12.3, page 359
• Total burden on taxpayers is the sum of revenues
  raised and the excess burden
• Revenues rise then fall
• Excess burden rises at an increasing rate
• Total burden rises at a decreasing rate

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Broadening the tax base

• When goods are independent
• That is, when substitute and complement
  relationships are weak
• The excess burden of the system is the sum of the
  excess burdens for each good

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Broadening the tax base

• It makes sense to keep the tax rates low by
  taxing more goods
• This allows the collection of a given amount of
  revenue with lower excess burden than if all the
  taxes were piled on one or two goods

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Broadening the tax base

• It makes sense to keep the tax rates low by
  taxing more goods
• This allows the collection of a given amount of
  revenue with lower excess burden than if all the
  taxes were piled on one or two goods
• Base broadening

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Offsetting tax distortions

• Not all, or even most goods are independent of
  each other
• Generally they are substitutes (The price
  decrease in one good reduces the demand for the
  other)
• Or complements (the price decrease in one good
  increases the demand for the other).

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Substitutes and complements

• Substitutes oil, gas, and electricity for home
  heating hamburger and chicken for dinner
• Complements Polaroid film and a Polaroid camera
  right and left shoes

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Impact of increase in price of a substitute good
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Impact of increase in price of a complementary
good
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Substitutes

• Red and white wine are substitutes
• A tax is imposed on red wine
• People substitute white wine for red to some
  extent
• This creates an excess burden because, absent the
  tax, people would have preferred red

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Substitutes

• So they are consuming some white wine under
  circumstances when they would have preferred to
  drink red
• A new tax on white wine would offset, to some
  extent, the excess burden associated with the tax
  on red
• Since it would discourage people from making the
  substitution

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Complements

• Taxing complements is more complicated
• Taxing either causes consumption of the other to
  fall more than if it alone had been taxed
• People substitute untaxed goods for the
  complements

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Complements

• This may or may not increase excess burden
• Base broadening works against the negative impact
  here
• Goods are more likely to be substitutes than
  complements for this reason it is generally
  better to tax more goods at lower rates

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Uniform tax system

• I originally asked you to read this material.
• I will not hold you responsible for it on the
  exam. This is the bottom half of page 363
  through page 365.

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Sources

• Bruce, Chapter 12