Taxes

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8
Taxes
CHAPTER
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C H A P T E R C H E C K L I S T

• When you have completed your study of this
  chapter, you will be able to

Explain how taxes change prices and quantities,
are shared by buyers and sellers, and create
inefficiency.
Explain how income taxes and Social Security
taxes change wage rates and employment, are
shared by employers and workers, and create
inefficiency.
Review ideas about the fairness of the tax system.
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8.1 TAXES ON BUYERS AND SELLERS

• Tax Incidence
• Tax incidence
• The division of the burden of a tax between the
  buyer and the seller.
• When a good is taxed, it has two prices
• A price that includes the tax
• A price that excludes the tax
• Buyers respond to the price that includes the
  tax.
• Sellers respond to the price that excludes the
  tax.

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8.1 TAXES ON BUYERS AND SELLERS

• The tax is like a wedge between the two prices.
• Suppose that the government puts a 10 tax on
  MP3 players.
• How does the price that buyers pay change?
• How does the price sellers receive change?
• How is the burden of a tax shared between the
  buyer and the seller?

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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.1(a) shows what happens when the
government taxes buyers of the MP3 players.

• 1. With no tax, the price is 100 and 5,000
  players a week are bought.

2. A 10 tax on buyers of MP3 players shifts the
demand curve to D tax.
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8.1 TAXES ON BUYERS AND SELLERS

• 3. The price paid by buyers rises to 105an
  increase of 5 a player.

4. The price received by sellers falls to 95a
decrease of 5 a player.
5. The quantity decreases to 2,000 players a week.
6. The governments tax revenue is 20,000 a week.
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8.1 TAXES ON BUYERS AND SELLERS
Figure 8.1(b) shows what happens when the
government taxes sellers of the MP3 players.

• 1. With no tax, the price is 100 and 5,000
  players a week are bought.

2. A 10 tax on sellers of MP3 players shifts
the supply curve to S tax.
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8.1 TAXES ON BUYERS AND SELLERS

• 3. The price paid by buyers rises to 105an
  increase of 5 a player.

4. The price received by sellers falls to 95a
decrease of 5 a player.
5. The quantity decreases to 2,000 players a week.
6. The governments tax revenue is 20,000 a week.
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8.1 TAXES ON BUYERS AND SELLERS

• Taxes and Efficiency

• A tax places a wedge between the buyers price
  (marginal benefit) and the sellers price
  (marginal cost).
• The equilibrium quantity is less than the
  efficient quantity and a deadweight loss arises.

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8.1 TAXES ON BUYERS AND SELLERS

• Figure 8.2 shows the inefficiency of taxes.

In Figure 8.2(a), the market is efficient with
marginal benefit equal to marginal cost.
Total surplusthe sum of2. Consumer surplus
and 3. Producer surplusis maximized.
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8.1 TAXES ON BUYERS AND SELLERS

• Figure 8.2(b) shows how taxes create inefficiency.

A 10 tax shifts the supply curve to S tax.
1. Marginal benefit exceeds 2. Marginal cost.
3. Consumer surplus and4. Producer surplus
shrink.
5. The government collects its tax revenue.
6. A deadweight loss arises.
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8.1 TAXES ON BUYERS AND SELLERS
The loss of consumer surplus and producer surplus
is the burden of the tax.
The burden of the tax equals the tax revenue plus
the deadweight loss.
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8.1 TAXES ON BUYERS AND SELLERS

• Excess burden
• The deadweight loss from a taxthe amount by
  which the burden of a tax exceeds the tax revenue
  received by the government.

The excess burden is 15,000. (3,000 ? 10 ? 2)
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8.1 TAXES ON BUYERS AND SELLERS

• Incidence, Inefficiency, and Elasticity
• The incidence of a tax and its excess burden
  depend on the elasticites of demand and supply
• For a given elasticity of supply, the buyer pays
  a larger share of the tax the more inelastic is
  the demand for the good.
• For a given elasticity of demand, the seller pays
  a larger share of the tax the more inelastic is
  the supply of the good.

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8.1 TAXES ON BUYERS AND SELLERS

• Tax Incidence and Elasticity of Demand
• Perfectly Inelastic Demand Buyer Pays and
  Efficient
• Perfectly Elastic Demand Seller Pays and
  Inefficient
• Figures 8.3(a) and 8.3(b) illustrate these two
  extreme cases.

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8.1 TAXES ON BUYERS AND SELLERS

• Figure 8.3(a) shows tax incidence in a market
  with perfectly inelastic demandthe market for
  insulin.

A tax of 20 a dose raises the price by 20, and
the buyer pays all the tax.
Marginal benefit equals marginal cost, so the
outcome is efficient.
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8.1 TAXES ON BUYERS AND SELLERS

• Figure 8.3(b) shows tax incidence in a market
  with perfectly elastic demandthe market for pink
  pens.

A tax of 10 a pink pen lowers the price received
by the seller by 10, and the seller pays all the
tax.
A deadweight loss arises, so the outcome is
inefficient.
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8.1 TAXES ON BUYERS AND SELLERS

• Tax Incidence, Inefficiency, and Elasticity of
  Supply
• Perfectly Inelastic Supply Seller Pays and
  Efficient
• Perfectly Elastic Supply Buyer Pays and
  Inefficient
• Figures 8.4(a) and 8.4(b) illustrate these two
  extreme cases.

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8.1 TAXES ON BUYERS AND SELLERS

• Figure 8.4(a) shows tax incidence in a market
  with perfectly inelastic supplythe market for
  spring water.

A tax of 5 a bottle does not change the price
paid by the buyer but lowers the price received
by the seller by 5.
Marginal benefit equals marginal cost, so the
outcome is efficient.
The seller pays the entire tax.
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8.1 TAXES ON BUYERS AND SELLERS

• Figure 8.4(b) shows tax incidence in a market
  with perfectly elastic supplythe market for sand.

A tax of 1 a pound increases the price by 1 a
pound, and the buyer pays all the tax.
A deadweight loss arises, so the outcome is
inefficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• The Personal Income Tax

• In 2004, the personal income tax raised
• More than 1 trillion for the federal government
• About 300 billion for state and local
  governments
• The amount of income tax that a person pays
  depends on her or his taxable income and on the
  tax rates.
• Taxable income
• Total income minus a personal exemption and a
  standard deduction (or other allowable
  deductions).

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

Marginal tax rate The percentage of an additional
dollar of income that is paid in tax. Average
tax rate The percentage of income that is paid in
tax.
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8.2 INCOME AND SOCIAL SECURITY TAX
THE TAX SYSTEM

• A tax can be progressive, proportional, or
  regressive.
• Progressive tax
• A tax whose average rate increases as income
  increases.
• Proportional tax
• A tax whose average rate is constant at all
  income levels.
• Regressive tax
• A tax whose average rate decreases as income
  increases.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Figure 8.5 shows U.S. tax rates in 2001.

1. Marginal tax rate increases with income.
2. Average tax rate increases with income
The personal income tax is a progressive tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• The Effects of the Income Tax

• Tax on Labor Income
• Firms can substitute machines for labor, so the
  demand for labor is elastic.
• Most people must work for their income, so the
  supply of labor is inelastic.
• With elastic demand and inelastic supply, the
  worker bears the greater burden of the income tax.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Figure 8.6 shows the effects of a tax on labor
  income.

With a 20 income tax
1. The supply of labor decreases, the wage rate
rises, and the after-tax wage rate falls.

2. The employer pays some of the tax.
3. The worker pays most of the tax.
4. A deadweight loss arises.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Taxes on Capital Income
• Taxing the income from capital works like taxing
  the income from labor.
• One crucial difference capital is
  internationally mobile and so the supply of
  capital is highly elasticperhaps perfectly
  elastic.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Figure 8.7 shows the effect of a tax on capital
  income.

1. The supply of capital is perfectly elastic.
2. With a 40 percent tax on capital income, the
interest rate rises.
3. The firm pays the entire tax.
4. A large deadweight loss arises.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Taxes on Income from Land and Unique Resources
• Works in the same way as taxing the income from
  other sources except for one crucial difference.
• The supply of land is highly inelastic.
• The tax on land income is fully borne by the
  landowners and the quantity of land is unaffected
  by the tax.
• With no change in the quantity of land, the tax
  on land income creates no deadweight loss or
  excess burden and is efficient.

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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Figure 8.8(a) shows a tax on income from land.

1. Supply is perfectly inelastic.
2. With a 40 percent tax, the supply of land is
unchanged and the market rent is unchanged.
3. The landowner pays the entire tax.
No deadweight loss arisesthe tax is efficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• Figure 8.7 (b) shows a high tax rate on Barbara
  Walters income.

1. Supply is perfectly inelastic.
2. With a 40 percent tax, the supply curve is
unchanged and the market price is unchanged.
3. Barbara Walters pays the entire tax.
No deadweight loss arises and the tax is
efficient.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• The Social Security Tax

The Social Security tax law says that the tax is
to be shared equally by workers and
employers. But the principles that determine the
incidence of other taxes youve studied in this
chapter also apply to the Social Security tax. We
look at two extreme Social Security taxes one on
workers only and one on employers only.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security Tax on Workers

• With no taxes, the wage rate is 6.00 an hour and
  4,000 people are employed.

1. A 20 percent Social Security tax on workers
shifts the supply curve to LS tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• 2. The wage rate paid by employers rises to 6.25
  an houran increase of 25 cents an hour.

3. The number of people employed decreases to
3,000.
4 Workers receive 5 an houra decrease of 1 an
hour.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX

• 5. The government collects tax revenue shown by
  the purple rectangle.

Workers pay most of the tax because the supply of
labor is more inelastic than the demand for labor.
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8.2 INCOME AND SOCIAL SECURITY TAX

• A Social Security Tax on Employers

Payroll tax A tax on employers based on the wages
they pay their workers. Figure 7.4 on the next
slide shows the effects of a payroll tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
A Social Security Tax on Employers

• With no tax, the wage rate is 6.00 an hour and
  4,000 people are employed.

1. A tax on employers of 1.25 an hour shifts the
demand curve to LD tax.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
2. The wage rate falls to 5.00 an houra
decrease of 1.00 an hour.
3. The number of workers employed decreases to
3,000.
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8.2 INCOME TAX AND SOCIAL SECURITY TAX
4. Employers total cost of labor rises to 6.25
an hourthe 5.00 wage rate plus the 1.25
payroll tax.
5. The government collects tax revenue shown by
the purple rectangle.
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8.3 FAIRNESS AND THE BIG TRADEOFF

• Whenever political leaders debate tax issues, it
  is fairness, not efficiency, that looms above all
  other considerations.
• There are two conflicting principles of fairness
  of taxes
• The benefits principle
• The ability-to-pay principle

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8.3 FAIRNESS AND THE BIG TRADEOFF

• The Benefits Principle
• Benefits principle
• The proposition that people should pay taxes
  equal to the benefits they receive from public
  goods and services.
• This arrangement is fair because it means that
  those who benefit most pay the most.
• But to implement it, we would need an objective
  way of measuring each persons marginal benefit
  from public goods and services.

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8.3 FAIRNESS AND THE BIG TRADEOFF

• The Ability-to-Pay Principle
• Ability-to-pay principle
• The proposition that people should pay taxes
  according to how easily they can bear the burden.
  
• A rich person can more easily bear the burden of
  providing public goods than a poor person can, so
  the rich should pay higher taxes than the poor.
• This principle compares people according to
• Horizontal equity
• Vertical equity

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8.3 FAIRNESS AND THE BIG TRADEOFF

• Horizontal equity
• The requirement that taxpayers with the same
  ability to pay the same taxes.
• Vertical equity
• The requirement that taxpayers with a greater
  ability to pay bear a greater share of the taxes.

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8.3 FAIRNESS AND THE BIG TRADEOFF

• The Marriage Tax Problem
• In the U.S. tax code, a married couple is
  considered a single taxpayer.
• This arrangement means that if they each earn the
  same income as before a marriage, the married
  couple might pay more tax than they did before
  marriage.

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8.3 FAIRNESS AND THE BIG TRADEOFF

• The Big Tradeoff
• Questions about the fairness of taxes conflict
  with efficiency questions and create the big
  tradeoff.
• Taxes on capital incomes create the greatest
  deadweight lossare the most inefficient.
• But most of the capital is owned by a small
  number of rich people, so (most people believe)
  taxes on capital are the fairest.
• Our tax system is an evolving attempt to juggle
  to two goals of efficiency and fairness.

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Taxes in YOUR Life

• The Tax Foundation has calculated Tax Freedom
  Day
• the day by when the average U.S. citizen has
  worked long
• enough to pay a years tax bill.
• In 2004, Tax Freedom Day was 17 April107 days
• 38 days to pay personal income taxes
• 30 days to pay Social Security taxes
• 16 days to sales and excise taxes
• 11 days to pay property taxes
• 9 days to pay corporate income taxes
• 3 days to pay all other taxes
• Work out your own Tax Freedom Day.