taxation and government intervention

Taxation and Government Taxation and Government InterventionIntervention

Chapter 7Chapter 7

Taxation and Government• For government to provide goods and services

such as national defense, social security, national parks, etc. it must have money.

• The Government raises money several ways including user fees and taxes.

• User Fees are fees paid by those that use the good or service: it is a price.

• Taxes may be paid by everyone or only those that use a good or service: who pays depends on the type of tax.

Types of Taxes

• There are many types of taxes:– Personal Income taxes– Corporate Income taxes– Excise Taxes– Value Added Taxes (VAT)– Property Taxes– Social Security Taxes– Sales Taxes

Tax Burden or Incidence• Who seems to pay the tax and who actually pays

the tax may not be the same person!• For example, suppose the federal government

institutes a 10% excise tax on luxury boats.• Suppose the consumer pays the tax up front: on the

purchase of a $100,000 luxury boat the consumer pays sales taxes of 5% and a luxury tax of 10% for a total price of $115,000 (there is no tax on tax).

• But what if the boat builder had to lower the price from $110,000 to $100,000 to sell the boat?

• In this case, the buyer appears to pay the luxury tax but in reality the boat builder pays the taxes.

• The entire burden of the tax falls on the boat builder.

What is the Role of Government?• The level of taxes is determined by the amount of

government services and goods provided.• The Government’s roles include:

– Providing a stable set of institutions, laws and rules.

– Promoting effective and workable competition.– Correcting for externalities.– Creating an environment that fosters economic

stability and growth.– Providing public goods.– Adjusting for undesirable market results.

The How Much Should Government Tax?

• The government must raise revenues equal to the cost of providing the amount of goods and services that its citizens demand.

The Costs of Taxation

• The costs of taxation include:– The direct cost of the revenue paid to

government– The loss of consumer and producer

surplus caused by the tax– The cost of administering the tax codes.


• When government institutes taxes, there is a loss of consumer and producer surplus that is not gained by government.• This is known as deadweight

loss.

The Costs of Taxation• Graphically the deadweight loss is

shown on a supply-demand curve as the welfare loss triangle.• The welfare loss triangle – a

geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.

Consumer SurplusProducer Surplus

• Consumer Surplus – the amount of consumers would be willing to pay (with perfect price discrimination) minus what they have to pay (at the market price) is the excess benefit consumers enjoy and is called consumer surplus.

• Producer Surplus – the amount producers receive for the total units sold (at the market price) minus what they would have received if they charged their cost for each unit.

• See pages 97-99 and page 158 for more info (in hardback Economics text). End of Chapter 4 in Microeconomics book.

The Costs of TaxationConsumer Surplus Before Tax: A + B + C

Consumer Surplus After Tax: AProducer Surplus Before Tax: D + E + F

Producer Surplus After Tax: FDeadweight Loss: C + E

S1

P1–t

Quantity

Price

P0

Q0

P1

Q1

Producer surplus

S0

Demand

Consumer surplus

Deadweight loss

taxA

B CD EF


• There are other costs of taxation.

• Resources must be devoted by the government to administer the tax codes and by citizens and businesses to comply with it.


• Payroll accounting has become so onerous, businesses large and small often pay payroll-accounting firms to keep up with changing federal and state payroll rules and actually issue paychecks for their clients’ employees.

The Benefits of Taxation

• The benefits of taxation are the goods and services that government provides.


• Some of these benefits are the part of the basic institutional structure of a market economy that allows it to work efficiently.

– The basic legal system is an example.


• Still others benefits take on the qualities of a public good – national defense, for example.


• Others benefits are provided for reasons of equity or because they provide positive externalities.


• The policy debate about the benefits of taxation generally focuses on goods that could be supplied by the market but are publicly supplied.

– Education and health care are examples.


• Measuring the benefits of these goods is difficult since they are not provided in a market setting.

The Two Principles of Taxation

• There are two principles of taxation widely recognized by tax experts as desirable features of a tax system.

1. The Benefit Principle2. The Ability to Pay Principle

Two Principles of Taxation

• The benefit principle states that the individuals who receive the benefit of the good or service should pay the tax necessary to supply the good.

– Examples are gasoline taxes and airport taxes, both paid by travelers.

Two Principles of Taxation

• The ability-to-pay principle states that individuals who are most able to bear the burden of the tax should pay the tax.

– The best example of this is a progressive tax, such as the U.S. income tax.

Difficulty of Applying the Principles of Taxation

• The principles of taxation are difficult to apply because, among other reasons, the two principles often conflict.


• In funding health care, for example, the poor should pay because they benefit the most, while under the ability-to-pay principle, the rich should pay.


• The elasticity concept helps us to understand the tradeoffs as well as who is likely to bear the burden of a tax.

Who Bears the Burden of a Tax?

• The supply and demand framework gives the answer to this question when the elasticities of the supply and demand curves are considered.

Burden Depends on Relative Elasticity

• The person who physically pays the tax is not necessarily the person who bears the burden of the tax.

• The burden of the tax is rarely shared equally since the elasticities are rarely equal.


• Elasticity is a measure of how easy it is for the supplier and consumer to change their behavior and substitute other goods.

• Consequently, the more one group (consumers or suppliers) is able or willing to change its behavior relative to the other group the more likely it is to avoid the tax burden.


• The relative burden of the tax dictates that the more relatively inelastic the behavior of one’s group (supply or demand), the larger the tax burden one will bear.


• If demand is more inelastic than supply, consumers will pay the higher share. If supply is more inelastic than demand, suppliers will pay the higher share.


• Who pays a tax is not necessarily who bears the burden.

• The person who actually pays the tax does not matter, and the person who bears the burden can differ from the person who pays.


• Since the free market system is very efficient, Governments with free market economies desire to change the behavior of suppliers and demander as little as possible.

• Hence, Governments should tax inelastic goods or services.

• In the language of consumer and producer surplus, if the government seeks to minimize welfare loss, it should tax goods with inelastic supplies and demands.


Supplier Pays Tax

Pric

e of

luxu

ry b

oats $70,000

60,00050,00040,00030,00020,00010,000

Quantity of luxury boats 600200 400

S1

Demand

S0

510

taxConsumer pays

Supplier pays


590

Pric

e of

luxu

ry b

oats $70,000

60,00050,00040,00030,00020,00010,000


S1S0

Demand is inelastic

Demand

taxConsumer pays

Supplier pays


Consumer Pays Tax

Pric

e of

luxu

ry b

oats $70,000

60,00050,00040,00030,00020,00010,000


D0

S0

510

tax

Consumer pays

Supplier pays

D1

Tax Incidence and Current Policy Debates

• The analysis of tax incidence is helpful when discussing current policy debates.

Social Security Taxes

• Social Security taxes are payroll taxes for a government-run retirement program.

• Both employer and employee contribute the same percentage of before-tax wages to the Social Security fund.


• The fact that both the employer and employee contribute the same percentage does not mean they share the burden equally.


• On average, labor supply tends to be less elastic than labor demand, so the Social Security tax burden is primarily on employees.

Sales Taxes

• Sales taxes are those paid by retailers on the basis of their sales revenue.

• Since sales taxes are broadly defined, consumers find it hard to substitute.

• Demand is inelastic so consumers bear the greater burden of the tax.

Sales Taxes

• Consumers can now buy on the internet where sales are not taxed so that retail stores will bear a greater burden of the tax levied on their sales.

Government Intervention

• Taxation is but one way in which government affects our lives.

• Other forms of government intervention include price controls.

Government Intervention as Implicit Taxation

• Government intervention can be seen as a combination tax and subsidy.

Price Ceilings

• A price ceiling is a government-set price below market equilibrium price.

• It is an implicit tax on producers and an implicit subsidy to consumers.

• This causes a loss in producer and consumer surpluses that is identical to the welfare loss from taxation.

Effect of Price Ceiling

Quantity

Price

Q1

Supply

DemandProducer surplus

Consumer surplus

Deadweight loss

P1 Price ceilingP0

Q0

Price Floors

• A price floor is a government-set price above equilibrium price.

• It is a tax on consumers and a subsidy to producers.

• Price floors transfer consumer surplus to producers.

Effect of Price Floor

Quantity

Price

P0

Q0Q1

Supply

DemandProducer surplus

P2 Price Floor

Consumer surplus

Deadweight loss

The Difference Between Taxes and Price Controls

• The effects of taxation and price controls are similar.

• They are different in that price ceilings create shortages and taxes do not.

• Shortages also create black markets.• Both taxes and price controls create

deadweight loss.

A Price Ceiling with Forced Supply

• The draft is an example of a price ceiling with forced supply.

• The draft is a military conscription law that requires young men to serve a set period of time in the armed forces at whatever pay the government chooses.


• A draft must be imposed when the wage offered by the army is below equilibrium and the quantity of soldiers supplied is below the quantity demanded.


• Those conscripted are forced to accept a lower wage than they would otherwise get, which is a transfer of surplus to the government.

Effect of a Draft on Surplus

QS QD=Draft

We

Quantity of soldiers

Wage

W0

Surplus transferred to the government

Demand

Supply

Deadweight loss caused by draft

Rent Seeking, Politics, and Elasticities

• Price controls reduce total producer and consumer surpluses.

• Governments institute them because people care more about their own surplus than they do about total surplus.

– If farmers have political power, they want crop subsidies or price supports.

– If renters have it, they want rent controls.


• Price controls exist because of political power.

• This activity is called rent seeking behavior – the effort to transfer surplus from one group to another.


• An enormous amount of time and money is spent in the political arena to increase one’s surplus at the expense of another group.

• They argue that often when all the rent seeking and tax consequences are netted out, there is no net gain to the public.


• Public choice economists integrate an economic analysis of politics with their analysis of the economy.


• There is a greater incentive for rent-seeking when demand and supply is inelastic.

Inelastic Demand and Incentives to Restrict Supply

• When demand is inelastic, producers have incentives to restrict supply.

• Farming is an example.

• Since food has few substitutes, its demand is inelastic.

• Inelastic demand means that prices fall faster than a rise in quantity sold.

• Revenues fall, and farmers are worse off.


• Advances in farming productivity increases supply but lowers prices.


• There is an enormous incentive for farmers to seek a price floor from government or through a producer cooperative.


P0

Q0

Total Revenue

P1

Q1 Quantity

Price

Revenue Gained

Revenue LostS1

S0

Demand

Inelastic Supply and Incentives to Restrict Prices

• Consumers are also rent seekers not just businesses.

• When supply is inelastic, consumers have incentives to restrict prices.

Inelastic Supply and Incentives to Restrict Prices

• When supply is inelastic and demand goes up, prices jump causing consumers to lobby for price controls.

• Rent control in New York City is an example.

Price Floors and Elasticity of Demand and Supply

PFPE

QD QS

Supply

Demand

Quantity

Price

Price floor with elastic supply and demand


Quantity

Price

Supply

Demand

Price floor with elastic supply and inelastic demand

PFPE

QD QS


Quantity

Price

SupplyDemand

Price floor with inelastic supply and demand

PFPE

QD QS

The Long-Run/Short-Run Problem of Price Controls

• The problem of price controls worsen from the short run to the long run.

• In the long run, supply and demand tend to be much more elastic than in the short run.


• So in the short run there will be small effects from the price controls, but huge effects in the long run.


• In the face of price controls, potential new competitors hate to enter the market thereby strangling supply

• Vacancy rates drop as potential new renters scramble to find shrinking affordable housing.

Long-Run and Short-Run Effects of Price Controls

P0

Q0 Quantity

P1

Q1

P2

Q2 Q3

Short run supply

D0

Price

Long run supply

D1

Price ceiling

Shortage

Taxation and Government Taxation and Government InterventionIntervention

End of Chapter 7End of Chapter 7

taxation and government intervention

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