1. Taxes and Subsidies

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Commodity Taxes
Subsidies
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3. Policy Shapes Incentives and Behavior
Not only are more children born in late December than in early January, but also the extra births appear to be clustered among those who have the most to gain from a tax deduction
Unless you’re a cynic, or an economist, I realize you might have trouble believing that the intricacies of the nation’s tax code would impinge on something as sacred as the birth of a child. But it appears that you would be wrong.
- David Leonhardt The New York Times

4. Taxes
"In this world nothing can be said to be certain, except death and taxes."
- Benjamin Franklin
“The difference between death and taxes is death doesn't get worse every time Congress meets.”
- Will Rogers Will Rogers
“No nation has ever taxed itself into prosperity”
- Ronald Reagan
“No Nation ever borrowed itself into prosperity”
- Unknown
“It’s as if people think that if the government imposed a tax on cows, the tax would be paid by the cows.”
- Hebert Stein
Instructor Notes:

5. Taxes
“The power to tax is the power to destroy.” - John Marshall, American Jurist, Statesman
“The Income Tax has made more liars out of the American people than golf has.”
– Will Rogers
Rich bachelors should be heavily taxed. It is not fair that some men should be happier than others.”
– Oscar Wilde
“Oh my God, what happened to my paycheck?”
- Mike Mace, on receiving his first full-time paycheck in December 1977
Instructor Notes:

6. Milton Friedman on taxes:
“Inflation is taxation without legislation”
“I am favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it's possible.”
“We have a system that increasingly taxes work and subsidizes non-work.”
“The real cost of government is measured by what government spends, not by receipts labeled taxes.”
Instructor Notes:

7. A Commodity Tax is a tax on goods.
Taxes
A Commodity Tax is a tax on goods.
Some truths about commodity taxation:
Who pays the tax does not depend on who writes the check to the government;
Who pays the tax does depend on the relative elasticities of demand and supply;
Commodity taxation raises revenue and creates lost gains from trade (dead-weight loss).
Instructor Notes:

8. A Tax on Sellers Shifts the Supply Curve Up by the Tax
Who Pays the Tax?
A Tax on Sellers Shifts the Supply Curve Up by the Tax
Quantity
Price
Buyers pay more than before…
And sellers receive less than before
Supply With Tax
Demand
Supply No Tax
Qno tax
Price (No Tax) a
tax
Price Paid by Buyers
b (new equilibrium)
tax
Price Received by Sellers
Qwith tax

9. A Tax on Apple Sellers
A $1 Tax on Sellers Shifts the Supply Curve Up by $1
Price rises by less than the tax ($1)

10. A $1 Tax on Buyers Shifts the Demand Curve Down by $1
A Tax on Apple Buyers
A $1 Tax on Buyers Shifts the Demand Curve Down by $1
Result? Same as if tax were levied on Sellers… Price rises by less than the tax ($1)

11. The Tax “Wedge”
Since it doesn’t matter whether buyers or sellers are taxed, we can graph the tax as a simple “wedge”
Quantity
Price
Supply
Demand
Price Paid by Buyers: $2.65 b
QDemanded with $1 tax
The $1 tax wedge a d
Price Sellers Receive: $1.65
If the tax is $1, the price buyers pay must be $1 more than the price sellers receive.

12. Who Pays the Tax? Depends.
Who pays the tax? It depends on the relative elasticities of supply and demand. The less elastic side of the market will pay the greater share of a tax (bear more of the burden of a tax).

13. When Demand is More Elastic than Supply Sellers Pay More of the Tax
The Burden of a Tax
When Demand is More Elastic than Supply Sellers Pay More of the Tax
Quantity
Price
Demand
Supply
Qno tax
Price (No Tax) a
Qwith tax
Price Paid by Buyers
Price Received by Sellers b d
tax
Instructor Notes: Figure 7.9: When Demand is More Elastic than Supply Sellers Pay More of the Tax
Note that the price paid by buyers is only a little bit above the price without the tax while the price received by sellers falls well below the price without the tax. Thus, when demand is more elastic than supply, sellers pay more of the tax.

14. When Supply is More Elastic than Demand Buyers Pay More of the Tax
The Burden of a Tax
When Supply is More Elastic than Demand Buyers Pay More of the Tax
Quantity
Price
Qwith tax
Price Paid by Buyers
Price Received by Sellers b d
tax
Demand
Supply
Qno tax
Price (No Tax) a
Instructor Notes: Figure 7.10: When Demand is More Elastic than Supply Sellers Pay More of the Tax
Note that the price received by sellers is only a little bit below the price without the tax while the price paid by buyers rises well above the price without the tax. Thus, when supply is more elastic than demand, buyers pay more of the tax.

15. In a long-distance relationship, who will do more of the driving
In a long-distance relationship, who will do more of the driving? Does the “tax” fall more heavily to the more committed partner?
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16. Sales of boats down 52.7%; Net loss of 30,000 jobs;
This pleasure boat seems like a good thing to tax…
Or not: The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the retail sale of luxury goods like pleasure boats with a sales price above $100,000. Expected tax revenue? $9 billion. Reality?
Sales of boats down 52.7%;
Net loss of 30,000 jobs;
The federal government paid out > $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues.

17. The Burden of a Tax
The Omnibus Budget Reconciliation Act of 1990 applied a 10% federal luxury tax to the first retail sale of luxury goods such as pleasure boats with a sales price above $100,000. The tax was originally projected to generate revenues of $9 billion over five years after passage. The tax was widely popular among policy makers as a way to shift the burden of deficit reduction to those who can best afford it (i.e. the Rich).

18. The results were not what was expected by policy makers:
The Burden of a Tax
The results were not what was expected by policy makers:
Sales of boats down 52.7%;
Net loss of 30,000 jobs;
The federal government paid out over $7 million more in unemployment benefits to those workers than it collected in luxury tax revenues.

19. The Burden of a Tax
The elasticity of supply for boats was evidently less elastic than the elasticity of demand for boats. The federal luxury tax was quickly (and quietly) repealed in 1993

20. The Burden of a Tax
You had to be an ignoramus to believe the luxury tax was only going to soak the rich. The only people it hurt was working people like myself,” -Judy Ott, an assembly worker at the Viking Yacht Company’s plant in New Jersey. “All these people suffered needlessly because the politicians in Washington needed a symbol to sell the American people a new tax increase,” - Viking’s co-founder Robert T. Healey.

21. The Burden of a Tax
So the next time you vote for politicians who are going to “stick it” to the rich or corporations via taxes, remember the “little guys” who will lose their jobs as a result. Why could the current efforts in the U.S. and California (no less than THREE ballot initiatives to raise taxes on the rich) cause more harm than good? “Democracy is two wolves and a sheep voting on what’s for dinner”

22. The Burden of a Tax Other applications:
Health Insurance Mandates and Tax Analysis
Mandates requiring employers to provide health insurance to their workers may reduce wages if labor supply is less elastic than demand for workers.

23. Health Insurance Mandates and Tax Analysis
The Burden of a Tax
Health Insurance Mandates and Tax Analysis
Many people believe that healthcare benefits are paid by their employer
Most don’t realize that their wages are lower as a result
Healthcare tax mandate on employers raises the cost of labor supply

24. The Burden of a Tax
Which side of the market is more inelastic, the demand for labor or the supply of labor?
Firms can substitute capital (machines) for labor, move overseas to avoid the tax, or simply close down
Employees are unlikely to be able to quite working (if taxed) or less likely move overseas than their employers
For most workers, the elasticity of their supply of labor is lower than their employers’ elasticity of demand for labor

25. Health Insurance Mandates and Tax Analysis
The Burden of a Tax
Health Insurance Mandates and Tax Analysis
It is likely that workers will bear most of the cost of mandated health insurance via lower wages
This is not to say that the law is a bad idea
What is a bad idea is voters believing that somehow healthcare has been made “free.”
They are being duped by less-than-forthcoming politicians, i.e. they are depending on your economic ignorance

26. Same argument applies to FICA and similar payroll taxes
The Burden of a Tax
Same argument applies to FICA and similar payroll taxes
Workers bear most of the tax burden even though employers “pay half the tax” via wages lower than without FICA
Why? The labor supply curve is more inelastic than the labor demand curve
There is no free lunch (the politician’s weapon of choice)

27. The Burden of a Tax Other applications: Who Pays the Cigarette tax?
If manufacturers of cigarettes can easily dodge state taxes (via smuggling), then it’s possible the tax will not discourage smoking.
National cigarette taxes are more effective in deterring smoking: no interstate tax-dodging occurs.

28. Who Pays the Cigarette Tax?
The Burden of a Tax
Who Pays the Cigarette Tax?
Smokers have an inelastic demand for cigarettes of about .5
Cigarette companies have a very high elasticity of supply to any one state since they can easily ship their products to other states with relatively lower taxes
Buyers bear nearly all of the tax

29. The Burden of a Tax Real world example:
Taxes range from $.07 in S. Carolina to $2.57/pack in New Jersey
Cigarettes sell for $3.35/pack in S. Carolina, while cigarettes in New Jersey are priced at $6.45
After-tax price received by sellers is $3.28 in SC compared to $3.88 in NJ
Prices vary probably due to differences in related costs

30. In 2010, New York contemplated a $1/pack cigarette tax
In 2010, New York contemplated a $1/pack cigarette tax. This video highlights the costs of the tax. Click on the picture. (1:22 minutes)
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31. A Tax Generates Revenue and Creates a Deadweight Loss
The Effects of a Tax
A Tax Generates Revenue and Creates a Deadweight Loss
Price
Quantity
Consumer Surplus- consumers get this
Deadweight Loss- No one gets this
Pno tax
700 = Qno tax
Demand
Supply
Price Buyer Pays = $2.65
Tax Revenue
= $500
tax
Price Seller Receives = $1.65
Instructor Notes: Figure 7.11: A Tax Generates Revenue and Creates a Deadweight Loss
Tax Revenue- the government gets this
Producer Surplus- producers get this
500 = Qtax

32. The Deadweight Loss of a Tax
Another example of DWL: Imagine that you want to go to New York on a trip. You value the trip at $50 and a bus ticket costs $40. Do you take the trip? A. Yes. The value ($50) of the trip exceeds the cost of the ticket ($40) so you travel to New York. How much consumer surplus (net value) do you get from the trip? A. $10=$50-$40.

33. The Deadweight Loss of a Tax
The government taxes bus tickets which raises the price of a bus ticket to $60. Do you take the trip? A. No. The value of the trip is now less than the price of the ticket. What happened to the $10 consumer surplus which you used to get when there was no tax? A. It's gone since no trip takes place. Did the government get any tax revenue from you? A. No. Key idea: Consumers lose but the government does not gain from trips that are not taken.

34. What is the tax revenue that the government collects from the tax on gadgets?
$350
$450
$100
$550
$350 = $1 (tax) x 350 (Q sold at the new price)
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35. Deadweight Loss and Elasticity
Deadweight Losses are Larger the More Elastic the Demand Curve:
If the demand is inelastic, a tax will not deter many trades.

36. Subsidies
A subsidy is a reverse tax where the government gives money to consumers (or producers).
Subsidy = Price Received by Sellers – Price Paid by Buyers
Some facts about subsidies:
Who gets the subsidy does not depend on who receives the check from the government;
Who benefits from the subsidy does depend on the relative elasticities of demand and supply;
Subsidies must be paid for by taxpayers and they create inefficient increases in trade (deadweight loss).

37. The Subsidy “Wedge”
A subsidy drives a wedge between the price received by sellers and the price paid by the buyers.
Quantity
Price
Supply
Demand
Price received by Sellers: $2.40
QDemanded with $1 subsidy b
The $1 subsidy wedge a d
Price paid by Buyers: $1.40
If the subsidy is $1, the price buyers pay must be $1 less than the price sellers receive.

38. Subsidies
When demand is more elastic than supply, suppliers bear more of the burden of a tax and receive more of the benefit of a subsidy.

39. King Cotton and the Deadweight Loss of Water Subsidies
Who benefits most from the large agricultural water subsidy?
Farmers in California’s Central Valley typically pay $20-$30 an acre-foot for water that costs $200-$500 an acre-foot
Hint: which is more elastic: demand or supply for cotton?
California cotton suppliers
California cotton buyers
Since supply is less elastic than demand, suppliers will receive more of the benefit of any subsidy.
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40. King Cotton and the Deadweight Loss of Water Subsidies
In the Central Valley of California, farmers pay $20-$30 an acre-foot for water that costs $200-$500 an acre-foot
The difference represents the government subsidy
Rice, cotton, alfalfa are grown in a “Cadillac Desert”
Other subsidies abound
Ex) crop subsidies for cotton
Ex) Subsidized water used to grow subsidized corn to feeds cows producing subsidized milk

41. Subsidies
All of these subsidies represent “deadweight loss” since such crops can be grown more cheaply elsewhere
Who benefits from the water subsidy?
Cotton suppliers or cotton buyers?
Remember that the benefit of a subsidy falls on the more inelastic side of the market
Elasticity of demand for California cotton is much higher than the elasticity of supply. Why?

42. Subsidies
Demand elasticity is very high since cotton grown outside of California is a perfect substitute (i.e. many substitutes)
Supply elasticity is lower as a result, hence subsidy flows to producers
Without the subsidies, there would be much less water intensive farming
Would definitely affect the debate on environmental issues in Central Valley

43. Subsidies Should Los Angeles subsidize the Cirque du Soleil?
See the post on government subsidy of LA’s production of Cirque de Soleil
Here is the text of the article: (Panel OKs $30-million loan for Cirque du Soleil in Hollywood) A five-member committee of the Los Angeles City Council voted this morning to move ahead with a $30- million loan that would bring a decade of Cirque du Soleil performances to the Kodak Theatre in Hollywood.
The council’s Housing, Community and Economic Development Committee unanimously forwarded the loan proposal to the full council for a vote, saying the deal would boost the economy by drawing tourists to the Hollywood & Highland shopping mall, where the theater is located.
Under the proposed loan agreement, TheatreDreams LA/CHI would promise to create no fewer than 858 jobs and stage the acrobatic show 368 times per year.
“This is really going to be, outside of the Academy Awards, the landmark show in Hollywood,” said Council President Eric Garcetti, whose district includes the mall.
The Community Development Department, which is processing the loan, estimated the city already has invested $127 million in the Hollywood & Highland complex, with a majority of that money going toward the construction of the underground parking garage and the theater.
On Tuesday, Councilman Dennis Zine questioned whether so much federal loan money should be devoted to a single economic development project. But Councilman Tony Cardenas said this morning that critics were taking aim at the deal simply because the facility is “so high-profile and so pretty.”
CIM Group, which owns Hollywood & Highland, sought the loan. The company is also relying on the city for financial help with development projects planned in Mid-City and Reseda. CIM Group leases the Kodak Theatre from the city, and its Urban Real Estate Fund is part of TheatreDreams LA/CHI. Under the proposal, the theater will continue to serve as the home of the annual Academy Awards ceremony.
-- David Zahniser
Photo: Christian Fitzharris clowns around a crowd gathered in May in Santa Monica. Credit: Ken Hively / Los Angeles Times.
Should Los Angeles subsidize the Cirque du Soleil?
In 2009 the Los Angeles City Council approved a $30m loan for a 10-year Production of Cirque du Soleil in Hollywood
What are the costs? Benefits?
Should the government be in the entertainment business? See Alex Tabarrok’s post here

44. Wage Subsidies
The minimum wage is the clearest example of a price floor in the United States. Such a policy, however, can hurt low-skilled workers by reducing employment. Some economists believe that a better approach would be to subsidize employers (demanders of labor). This approach leads to a higher wage and a higher level of employment.

45. Some Subsidies have Serious Benefits: Wage Subsidies Increase Employment
A wage subsidy costs the government money but increases employment from Qm to Qs (and reduces welfare payments)
Quantity of Labor
Wage
Supply of Labor
Demand for Labor
Wage received by Workers: $12 b Qs
The $4 subsidy wedge
Market Wage: $10.50 a
Wage paid by Firms: $8 d
Nobel Prize Winner Edmund Phelps is a big fan of wage subsidies. A subsidy to firms that hire low-wage workers drives a wedge between the wage received by workers ($12) and wage paid by firms ($8). The subsidy increses the wages received by workers
and reduces the wage paid by firms. As a result, employment increses from Qm to Qs. The cost of the subsidy to the government
is the subsidy amount, $4, times the number of workers employed, Qs. Qd Qm

46. Wage Subsidies
Suggested by Edmund Phelps. Nobel Prize winner in Economics It would be expensive, paid by taxpayers Would result in more low skilled workers being employed Costs could be offset by social benefits: less crime, less dependency, etc Similar to EITC program

47. Which of the following statements are true?
I. A $0.50 tax on each fishing lure sold raises the price per lure by $0.50.
II. A tax on sellers is equivalent to a tax on buyers.
III. A tax on buyers is analyzed by shifting the demand curve up by the amount of the tax.
I and II
II and III
II only
I, II, and III
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48. If demand of some good is more elastic than supply and a tax is imposed on the consumption of the good, who will bear more of the burden of the tax?
Producers, because consumers have a greater ability to change their behavior in response to the tax.
Both parties will share the burden equally.
Consumers, because they pay the tax out of pocket.
The government, because the tax will cause less of the good to be produced and consumed.
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49. Demand should be perfectly inelastic. Demand should be elastic.
Junk food has been criticized for being unhealthy and too cheap, enticing the poor to adopt unhealthy lifestyles. Suppose that the state of Oklakansas imposes a tax on junk food. What needs to be true for the tax to actually deter the most people from eating junk food: Should junk food demand be elastic or should it be inelastic?
Demand should be perfectly inelastic.
Demand should be elastic.
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