Taxation, income distribution, and efficiency

Today: Some basic tax theory

Begin Unit 4

Today Chapters 14 and 15 An introduction to some basic theories related to

taxation

Taxation

Taxes are typically used to finance public projects

Deadweight loss comes with most forms of taxation

Taxation and income distribution The US federal tax system has been set up

so that people with high incomes have higher average tax rates Do people consume more leisure with high

marginal tax rates? To be answered later

Public project financing People with high tax rates probably have high

willingness to pay for many public projects See Table 14.3, p. 327

Some terminology

Statutory incidence Who legally has to pay for the tax

Economic incidence How much does real income change to all parties

due to a tax?

Some terminology

Lump sum tax A tax that has to be paid no matter how a person

behaves Proportional tax

Average tax rate is independent of income Progressive tax

Average tax rate increases with income Regressive tax

Average tax rate decreases with income

Some terminology

Unit tax A tax that is paid per unit of a good

Ad valorem tax A tax that is a percentage of the purchase price

Partial equilibrium models

With partial equilibrium models, only one market is examined at any one time Ignores possible spillover effects Usually easier to analyze than general equilibrium

models Two types of taxes analyzed

Unit tax Ad valorem tax

Unit tax

You have likely seen unit taxes before Econ 1 (or equivalent) Econ 100A/B (or equivalent)

Either the buyer or seller pays a given dollar amount for each unit sold or purchased

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

0 1 2 3 4 5 6 7 8

Before Tax After Tax

Consumers Pay

Suppliers Receive

$1.40

$1.00

$1.20

$1.20

D0

S0

D1

S1

Partial Equilibrium Models

Quantity

$

Ad valorem taxes

Assume that the consumer pays an ad valorem tax Example: 6% sales tax

The ad valorem tax shifts the demand curve by the same percentage (relative to the horizontal axis) See Figure 14.7, p. 315

Other types of taxes

Taxes from working Income tax Social Security tax Hospital insurance tax (Medicare)

Capital taxes Taxes on profits

Accounting profits Economic profits

Tax incidence and capitalization Suppose that we value land as the net

present value of the yearly income from the land Assume that the land has value for T years T could be infinity

Then the value of the land will be

PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T

Tax incidence and capitalization Suppose that a new tax is implemented on

each piece of land Yearly income falls by the amount of the tax

New value of the land PR’ = $(R0 – u0) + $(R1 – u1)/(1 + r) +

$(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)T

Value of the land drops by

u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T

Tax incidence and capitalization Capitalization process

When a new tax is implemented, the new price falls by the net present value of the total taxes that will have to be paid

General equilibrium models

When a tax affects a large portion of the economy, partial equilibrium models may not accurately predict the overall effects to the economy

General equilibrium models are needed to analyze situations that affect more than one market

Changes in consumption due to taxes Recall that people typically consume less of a

good or service once it is taxed Example: Yacht tax in the early 1990s

Tax on yachts over $100,000 purchased in the US People bought yachts in other countries Net economic impact

$16.6 million in taxes collected (less than the $31 million predicted)

Less income tax paid by workers (7,600 jobs lost in the US)

Study of taxation graphically

Individual behavior See Figure 15.2, p. 333

Excess burden in a market with horizontal supply See Figure 15.5, p. 340

Taxes on labor See Figure 15.7, p. 343, and Figure 15.9, p. 347

Subsidies See Figure 15.6, p. 342

Pigouvian taxes See Figure 5.4, p. 83

Recall double dividend hypothesis Industry with negative externality

Pigouvian tax Reduces excess burden If tax proceeds are used to reduce other

taxes, excess burden from these taxes are lowered

Criticism: An environmental tax could lead to an increase in the excess burden in the labor market

An economist’s analysis

Given an amount of revenue that is generated, taxes should be imposed such that one of the following goals is achieved Excess burden is minimized Social welfare is maximized

The real world

Taxes are often imposed that have the lowest amount of political resistance

Excess burden seems less important than revenue generation Sometimes efficiency is completely ignored

How does personal income get taxed? The personal tax system used by the federal

government requires many steps to understand Chapter 17

Highlight the basic structure, marginal tax rates, and other aspects of the federal tax structure

For next lecture: Read p. 380-406

Today vs. tomorrow

With a tax system currently in place, we should ask how changes in tax policy affect current and future behavior Chapter 16 has more on this

Marginal excess burden Tax avoidance versus tax evasion

Focus reading on p. 353-362 and 370-376 for next lecture

Summary

Taxation of efficient markets typically leads to excess burden Unit tax Ad valorem tax

Taxes on land lower the income potential for the land, lowering its value

Subsidies usually lead to excess burden also