When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Describe the effects of sales taxes and excise.

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

C H A P T E R C H E C K L I S T

Describe the effects of sales taxes and excise taxes, determine who pays these taxes, and explain why taxes create inefficiencies.

1

Describe the effects of income taxes and social security taxes, determine who pays these taxes, and explain which taxes create the greatest inefficiency.

Review ideas about the fairness of the tax system.

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3

8.1 SALES TAXES AND EXCISE TAXES

Tax Incidence

Tax incidence

The division of the burden of a tax between the buyer and the seller.

• If the price rises by the full amount of the tax, then the burden of the tax falls entirely on the buyer.

• If the price rises by a lesser amount than the tax, then the burden of the tax falls partly on the buyer and partly on the seller.

• If the price doesn’t change, then the burden of the tax falls entirely on the seller.


1. With no tax, the price of a CD player is $100 and 5,000 CD players a week are bought.

2. A $10 tax on CD players shifts the supply curve to S + tax.

Figure 8.1 shows the effects of a tax on CD players.


3. The price rises to $105—an increase of $5 a CD player.

5. Sellers receive $95—a decrease of $5 a CD player.

4. The quantity decreases to 2,000 CD players a week.


6. The government collects tax revenue of $20,000 a week—the purple rectangle.

The burden of the tax is split equally between the buyer and the seller— each pays $5 per CD player.

Tax Incidence and Elasticities 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.



Tax Incidence and Elasticity of Demand

Perfectly Inelastic Demand: Buyer Pays Entire Tax

Perfectly Elastic Demand: Seller Pays Entire Tax

Figures 8.2(a) and 8.2(b) illustrate these two extreme cases.


Figure 8.2(a) shows tax incidence in a market with perfectly inelastic demand—the market for insulin.

A tax of 20¢ a dose raises the price by 20¢, and the buyer pays all the tax.


Figure 8.2(b) shows tax incidence in a market with perfectly elastic demand—the market for pink marker pens.

A tax of 10¢ a pen lowers the price received by the seller by 10¢, and the seller pays all the tax.


Tax Incidence and Elasticity of Supply

Perfectly Inelastic Supply: Seller Pays Entire Tax

Perfectly Elastic Supply: Buyer Pays Entire Tax

Figures 8.2(c) and 8.2(d) illustrate these two extreme cases.


Figure 8.2(c) shows tax incidence in a market with perfectly inelastic supply—the market for spring water.

A tax of 5¢ a bottle lowers the price received by the seller by 5¢, and the seller pays all the tax.


Figure 8.2(d) shows tax incidence in a market with perfectly elastic supply—the market for sand.

A tax of 1¢ a pound increases the price by 1¢ a pound, and the buyer pays all the tax.

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.

The burden of the tax exceeds the tax revenue.

Excess burden

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

Taxes and Efficiency


In Figure 8.3(a), the market is efficient with marginal benefit equal to marginal cost.

Figure 8.3 shows the inefficiency of taxes.


A $10 tax shifts the supply curve to S + tax.

Consumer surplus and producer surplus shrink.

Figure 8.3(b) shows how taxes create inefficiency.

The government collects its tax revenue.

A deadweight loss arises.

Marginal benefit exceeds marginal cost.


The loss of consumer surplus and producer surplus is the burden of the tax, which equals the tax revenue plus the deadweight loss.

The deadweight loss is the excess burden of the tax.


8.2 INCOME AND SOCIAL SECURITY TAX

In 2002, 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 personal exemption and a standard deduction or other allowable deductions.

The Personal Income 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.

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.

THE TAX SYSTEM8.2 INCOME AND SOCIAL SECURITY TAX


Figure 8.4 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.

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.


The Effects of the Income Tax


Figure 8.5 shows the effects of a tax on labor income.

4. A deadweight loss arises.

With a 20% income tax:

2. The employer pays some of the tax.

3. The worker pays most of the tax.

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

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 its supply is highly elastic—perhaps perfectly elastic.



Figure 8.6 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.

Taxes on Land and Other 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.



Figure 8.7(a) shows a tax on land.

1. Supply is perfectly inelastic.

2. With a 40 percent tax, the supply curve is unchanged and the market price is unchanged.

3. The landowner pays the entire tax.

No deadweight loss arises—the tax is efficient.


Figure 8.7 (b) shows a high tax rate on Barbara Walter’s 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.


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 the sales tax and the income tax also apply to the social security tax.

We look at two extreme social security taxes: one on workers only and one on employers only.


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 S + tax.


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

3. The number of people employed decreases to 3,000.

4 Workers receive $5.00 an hour — a decrease of $1 an hour.


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.


A Social Security Payroll Tax

Payroll taxA 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.


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

1. A payroll tax of $1.25 an hour shifts the demand curve to D – tax.

2. The wage rate falls to $5 an hour—a decrease of $1.00 an hour.


3. The number of workers employed decreases to 3,000.

4. Employers’ total cost of labor rises to $6.25 an hour—the $5.00 wage rate plus the $1.25 payroll tax.

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

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

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 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 person’s marginal benefit from public goods.


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


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.


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.


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 loss—are 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.


When you have completed your study of this chapter, you will be able to C H A P T E R C H E C K L I S T Describe the effects of sales taxes and excise.

Documents

tax revenue

tax falls

progressive tax

tax places

tax rates

tax system

shows tax incidence

excise taxes slide