Taxation and Government Intervention ppt

© 2003 McGraw-Hill Ryerson Limited.The Costs of Taxation The costs of taxation include: The direct cost of the revenue paid to... © 2003 McGraw-Hill Ryerson Limited.The Costs of Taxation

© 2003 McGraw-Hill Ryerson Limited.

Intervention

Chapter 7

Laugher Curve

Two economists meet on the street

Q How’s your wife?

A Relative to what?

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Taxation and Government

Government needs tax revenues to

function

Government Tax?

In order to answer how much

government should tax, we must know

the costs and benefits of taxation

The benefits result from the roles of

government

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Government Tax?

From previous chapters we know that

government’s roles include:

Providing a stable set of institutions and

Government Tax?

From previous chapters we know that

government’s roles include:

Creating an environment that fosters

economic stability and growth.

Providing public goods.

Adjusting for undesirable market results.

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The Costs of Taxation

The costs of taxation include:

The direct cost of the revenue paid to

The Costs of Taxation

When government raises taxes, there is

a loss of consumer and producer

surplus that is not gained by

government

This is known as deadweight loss

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The Costs of Taxation

Graphically the deadweight loss is

shown on a supply-demand curve as

the welfare loss triangle

representation of the welfare loss in

terms of misallocated resources caused

by a deviation from a supply-demand

equilibrium

The Costs of Taxation Fig 7-2, p 162

D

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The Costs of Taxation

There are additional costs of taxation

Resources must be allocated by

government to collect the tax and by

individuals to comply with it

The Benefits of Taxation

The benefits of taxation are the goods

and services that government provides

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The Benefits of Taxation

Some of these benefits are the part of

the basic institutional structure of a

market economy that allows it to

function efficiently

The basic legal system is an example.

The Benefits of Taxation

Other goods have the qualities of a

public good – fire and police services

are examples

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The Benefits of Taxation

Some benefits are provided for reasons

of equity or because they provide

positive externalities For example,

education and healthcare

The Benefits of Taxation

Measuring the benefits of these goods

is difficult since they are often provided

at a zero price

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Two Principles of Taxation

Government follows two general

principles when deciding about taxation

The benefit principle and

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 cost (opportunity cost) of the resources used

to produce the good

Examples are gasoline taxes and airport

taxes, both paid by travelers.

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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 Canadian income tax.

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Principles of Taxation

The elasticity concept helps provide

insight into the taxation debates

The more broadly the good or service is defined, the more inelastic its demand

Principles of Taxation

Governments should tax inelastic goods

or services – those are captured by

broad based taxes such as income and sales tax

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Principles of Taxation

In the language of consumer and

producer surplus, if the government

seeks to minimize the welfare loss, it

should tax goods with inelastic supplies and demands

The person who physically pays the tax

is not necessarily the person who bears the burden of the tax

The burden of the tax depends on

relative elasticity

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Elasticity

The tax burden is greater if a person

cannot easily change their behaviour

The more inelastic one’s relative supply and demand, the larger the tax burden

one will bear

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Tax? Fig 7-3a, p 166

Price

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D 1

Price

Policy Debates

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

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Premiums

Both employer and employee contribute

to the Employment Insurance

The burden falls mainly on employees

because, on average, labour supply is

less elastic than labour demand

Insurance Premium, Fig 7-4, p 168

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Sales Taxes

Sales taxes are those paid by retailers

on the basis of their sales revenue

Since sales taxes are broadly defined,

most consumers have little ability to

substitute

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

Sales Taxes

Some Canadians can substitute away

from consumption in Canada by

traveling abroad

With the growth of the Internet, many

more are now able to access tax-free

jurisdictions (cyberspace) and also

substitute away from Canadian

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Government Intervention

Taxation is but one way in which

government affects our lives

Other forms of government intervention include price controls

Price Ceiling

A price ceiling is a government-set

maximum price which the market price cannot exceed

Generally, the price ceiling is set below

market equilibrium price.

It is an implicit tax on producers and an

implicit subsidy to consumers

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Price Ceiling

Price ceiling causes a loss in producer

and consumer surpluses that is identical

to the welfare loss from taxation

Effect of Price Ceiling, Fig 7-5a, p 170

Price

P 0

Supply

Demand Producer

Consumer surplus

F D

Excess demand

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They can be seen as a tax on consumers

and a subsidy to producers.

Effect of Price Floor, Fig 7-5b, p 170

Price

P 0

Supply

Demand Producer

Consumer surplus

F

Excess supply

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Taxes and Price Controls

The effects of taxation and price

controls are similar

Both taxes and price controls create

deadweight losses

Taxes and Price Controls

However, price ceilings create

shortages and taxes do not

Shortages may create black markets

Alternative methods of allocation

develop because there is an imbalance between quantity demanded and

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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 consumers hold the balance of

political power, there will be strong

pressures to create price ceilings

If suppliers hold the political power,

there will be strong pressures to create price floors

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This activity is called rent seeking

Elasticities

An enormous amount of time and

resources is spent in attempts to

transfer surplus from one set of

individuals to another

They argue that often the taxes and the

benefits of government programs offset

each other and do not help society

significantly.

Elasticities

Public choice economists integrate an

economic analysis of politics with their

analysis of the economy

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Incentives to Restrict Supply

When demand is inelastic, producers

have incentives to lobby the

government to restrict supply

Farming is a good example

Advances in productivity increase

supply but they result in lower prices

Incentives to Restrict Supply

Since food has few substitutes, its

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Incentives to Restrict Supply

Because of the increase in supply, and inelastic demand, farmers are losing

revenue

There is an enormous incentive for

farmers to encourage government to

restrict supply or create a price floor

Incentives to Restrict Supply

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Price Controls

In the long run, supply and demand

tend to be much more elastic than in the short run

Therefore, price controls will cause

large shortages or surpluses in the long run

Effects of Price Controls, Fig 7-7, p 172

P 0

P 1

P 2

Short run supply

Price

Long run supply

D 1

Price ceiling

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Intervention

End of Chapter 7