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 butin 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.
The Costs of Taxation
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 Surplus Producer 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 Taxation Consumer Surplus Before Tax: A + B + C Consumer Surplus After Tax: A Producer Surplus Before Tax: D + E + F Producer Surplus After Tax: F Deadweight Loss: C + E
S1
P1–t
Quantity
Price
P0
Q0
P1
Q1
Producer surplus
S0
Demand
Consumer surplus
Deadweight loss
tax
A
B
C
D
E
F
The Costs of Taxation
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.
The Costs of Taxation
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.
The Benefits of Taxation
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.
The Benefits of Taxation
Still others benefits take on the qualities of a public good – national defense, for example.
The Benefits of Taxation
Others benefits are provided for reasons of equity or because they provide positive externalities.
The Benefits of Taxation
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.
The Benefits of Taxation
Measuring the benefits of these goods is difficult since they are not provided in a market setting.
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.
Burden Depends on Relative Elasticity
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.
Burden Depends on Relative Elasticity
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.
Burden Depends on Relative Elasticity
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.
Burden Depends on Relative Elasticity
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.
Difficulty of Applying the Principles of Taxation
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.
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.
Social Security Taxes
The fact that both the employer and employee contribute the same percentage does not mean they share the burden equally.
Social Security Taxes
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
Demand
Producer surplus
Consumer surplus
Deadweight loss
P1
Price ceiling
P0
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
Q0
Q1
Supply
Demand
Producer 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 Price Ceiling with Forced Supply
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.
A Price Ceiling with Forced Supply
Those conscripted are forced to accept a lower wage than they would otherwise get, which is a transfer of surplus to the government.
