SALES TAXES AND EXCISE TAXES

1 Describe the effects of income taxes and social security taxes, determine who pays these taxes, and explain which taxes create the greatest inefficiency.. 8.1 SALES TAXES AND EXCISE T

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.

2

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

8.1 SALES TAXES AND EXCISE TAXES

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

8.1 SALES TAXES AND EXCISE TAXES

3 The price rises to $105

8.1 SALES TAXES AND EXCISE TAXES

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

8.1 SALES TAXES AND EXCISE TAXES

 Tax Incidence and Elasticity of Demand

Perfectly Inelastic Demand: Buyer Pays Entire TaxPerfectly Elastic Demand: Seller Pays Entire Tax

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

8.1 SALES TAXES AND EXCISE TAXES

Figure 8.2(a) shows

raises the price by

20¢, and the buyer

pays all the tax

8.1 SALES TAXES AND EXCISE TAXES

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

8.1 SALES TAXES AND EXCISE TAXES

 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

8.1 SALES TAXES AND EXCISE TAXES

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

8.1 SALES TAXES AND EXCISE TAXES

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

8.1 SALES TAXES AND EXCISE TAXES

In Figure 8.3(a), the

market is efficient with

marginal benefit equal to

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

8.1 SALES TAXES AND EXCISE TAXES

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

8.1 SALES TAXES AND EXCISE TAXES

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

8.2 INCOME AND SOCIAL SECURITY 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.

8.2 INCOME AND SOCIAL SECURITY TAX

Figure 8.4 shows U.S

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

8.2 INCOME AND SOCIAL SECURITY TAX

The Effects of the Income Tax

8.2 INCOME AND SOCIAL SECURITY 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.

8.2 INCOME AND SOCIAL SECURITY TAX

8.2 INCOME AND SOCIAL SECURITY TAX

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

8.2 INCOME AND SOCIAL SECURITY TAX

8.2 INCOME AND SOCIAL SECURITY TAX

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

8.2 INCOME AND SOCIAL SECURITY TAX

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

8.2 INCOME AND SOCIAL SECURITY TAX

 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

8.2 INCOME AND SOCIAL SECURITY TAX

With no taxes, the wage

8.2 INCOME AND SOCIAL SECURITY TAX

2 The wage rate paid

8.2 INCOME AND SOCIAL SECURITY TAX

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

8.2 INCOME AND SOCIAL SECURITY TAX

A Social Security Payroll Tax

8.2 INCOME AND SOCIAL SECURITY TAX

With no taxes, the wage

rate is $6.00 an hour and

8.2 INCOME AND SOCIAL SECURITY TAX

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

8.3 FAIRNESS AND THE BIG TRADEOFF

 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

8.3 FAIRNESS AND THE BIG TRADEOFF

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

8.3 FAIRNESS AND THE BIG TRADEOFF

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

8.3 FAIRNESS AND THE BIG TRADEOFF

 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

8.3 FAIRNESS AND THE BIG TRADEOFF