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Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is legalized robbery. Calvin Coolidge CHAPTER 8 Copyright © 2010.

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Presentation on theme: "Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is legalized robbery. Calvin Coolidge CHAPTER 8 Copyright © 2010."— Presentation transcript:

1 Taxation and Government Intervention 8 Collecting more taxes than is absolutely necessary is legalized robbery. Calvin Coolidge CHAPTER 8 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2 Taxation and Government Intervention 8 Chapter Goals Show how equilibrium maximizes consumer and producer surplus Demonstrate how an effective price ceiling is the equivalent of a tax on producers and a subsidy to consumers Explain why the person who physically pays the tax is not necessarily the person who bears the burden of the tax Demonstrate the burden of taxation to consumers and producers Define rent seeking and show how it is related to elasticity State the general rule of political economy 8-2

3 Taxation and Government Intervention 8 Producer and Consumer Surplus Consumer surplus is the value the consumer gets from buying a product, less its price It is the area above the supply curve but below the price the producer receives (the price line) Producer surplus is the value the producer sells a product for less the cost of producing it It is the area below the demand curve and above the price the consumer pays (the price line) 8-3 Recall that the area of a triangle is ½ bh.

4 Taxation and Government Intervention 8 S D P Q Consumer surplus = area of red triangle = ½($5)(5) = $12.5 Producer surplus = area of green triangle = ½($5)(5) = $12.5 Producer and Consumer Surplus The combination of producer and consumer surplus is maximized at market equilibrium CS PS $

5 Taxation and Government Intervention 8 S D P Q Consumer surplus decreases = area of red triangle = ½($4)(4) = $8 Producer surplus increases = areas of green triangle and rectangle = ½($4)(4)+($2)(4)= $16 Producer and Consumer Surplus The combination of producer and consumer surplus decreases when price is greater than equilibrium price CS Suppose P=$6 PS Lost surplus (deadweight loss) = ½($2)(1) $

6 Taxation and Government Intervention 8 S D P Q The Burden of Taxation P Q If there is no tax, market equilibrium is reached and consumer and producer surplus is maximized 8-6

7 Taxation and Government Intervention 8 S0S0 D P Q Both producer and consumer surplus decrease A tax paid by the supplier shifts the supply curve up by the amount of the tax (=t) The Burden of Taxation P 1-t P0P0 P1P1 Q0Q0 Q1Q1 Positive government revenue S1S1 t Deadweight loss exists 8-7

8 Taxation and Government Intervention 8 The Burden of Taxation The costs of taxation include: The administrative costs of compliance which are the resources used by the government to administer the tax and individuals and businesses to comply with it – we dont graphically illustrate this, but its very real The deadweight loss which is the loss of consumer and producer surplus that is not gained by the government Direct cost of the tax paid to the government by consumers and producers 8-8

9 Taxation and Government Intervention 8 The Burden of Taxation The tax burden (incidence): 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 The more inelastic ones relative demand and supply, the larger the tax burden one will bear The person who physically pays the tax is not necessarily the person who bears the burden of the tax 8-9

10 Taxation and Government Intervention 8 What Goods Should Be Taxed? Goal of GovernmentMost effective when Raise revenue, limit deadweight lossDemand or supply is inelastic Change behaviorDemand or supply is elastic ElasticityWho bears the burden? Demand inelastic and supply elasticConsumers Supply inelastic and demand elasticProducers Both supply and demand elasticShared, but the group whose S or D is more inelastic pays more 8-10

11 Taxation and Government Intervention 8 The Burden of Taxation S0S0 D P Q S1S1 P0P0 P1P1 S0S0 D P Q S1S1 P0P0 P1P1 Q0Q0 Q1Q1 tt Demand is relatively elastic Demand is relatively inelastic P 1-t Q0Q0 Q1Q1 Producers pay more Consumers pay more 8-11

12 Taxation and Government Intervention 8 The Burden of Taxation Fraction of tax borne by demander Fraction of tax borne by supplier How to calculate the fraction of the tax borne by consumers and producers: 8-12

13 Taxation and Government Intervention 8 The Burden of Taxation S0S0 D P Q S1S1 P0P0 P1P1 t The tax burden is independent of who pays the tax P 1-t Q0Q0 Q1Q1 S D0D0 P P0P0 P1P1 t P 1+t Q0Q0 Q1Q1 D1D1 Q Supplier pays the tax, supply shifts Consumer pays the tax, demand shifts 8-13

14 Taxation and Government Intervention 8 Tax Incidence and Current Policy Debates 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 Although the employer and employee contribute the same percentage, they do not share the burden equally Both employer and employee contribute the same percentage of before-tax wages to the Social Security fund 8-14

15 Taxation and Government Intervention 8 Tax Incidence and Current Policy Debates Sales Taxes Demand is inelastic so consumers bear the greater burden of the tax Since sales taxes are broadly defined to include most goods and services, consumers find it hard to substitute to avoid the tax As consumers increase purchases on the Internet where sales are not taxed, retail stores will bear a greater burden of the sales tax Sales taxes are paid by retailers on the basis of their sales revenue 8-15

16 Taxation and Government Intervention 8 Government Intervention as Implicit Taxation An effective price floor is a government set price above the market equilibrium An effective price ceiling is a government set price below the market equilibrium price Government intervention in the form of price controls can be viewed as a combination tax and subsidy It acts as an implicit tax on producers and an implicit subsidy to consumers that causes a welfare loss identical to the loss from taxation It acts as a tax on consumers and a subsidy for producers that transfers consumer surplus to producers 8-16

17 Taxation and Government Intervention 8 S D P Q Application: The Effect of a Price Ceiling P0P0 Q0Q0 A price ceiling transfers surplus from producers to consumers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price ceiling P1P1 An effective price ceiling is set below market equilibrium price Shortage 8-17

18 Taxation and Government Intervention 8 S D P Q Application: The Effect of a Price Floor P0P0 Q0Q0 A price floor transfers surplus from consumers to producers, generates deadweight loss, and reduces equilibrium quantity Q1Q1 Price floor P1P1 An effective price floor is set above market equilibrium price Surplus 8-18

19 Taxation and Government Intervention 8 The Difference Between Taxes and Price Controls Taxes leave people free to choose how much to supply and consume as long as they pay the tax Price ceilings create shortages and taxes do not Shortages may also create black markets 8-19

20 Taxation and Government Intervention 8 Rent Seeking, Politics, and Elasticities Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus Lobbying for price controls, which transfer surplus from one group to another, is an example of rent-seeking behavior Public choice economists argue that when all rent seeking and tax consequences are netted out, there is often not a net gain to the public Rent-seeking activities are activities designed to transfer surplus from one group to another 8-20

21 Taxation and Government Intervention 8 Inelastic Demand and Incentives to Restrict Supply Supplies have an incentive to restrict supply when demand is inelastic, because, by doing so, they will increase their revenues When demand is inelastic, increases in productivity that shift the supply curve out result in lower revenue for the suppliers 8-21

22 Taxation and Government Intervention 8 A C B Inelastic Demand and Incentives to Restrict Supply S0S0 D P Q S1S1 P0P0 P1P1 Q0Q0 Q1Q1 Revenue gained When demand is relatively inelastic, suppliers have incentive to restrict quantity to increase total revenue Revenue lost 8-22

23 Taxation and Government Intervention 8 Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand increases, prices increase causing consumers to lobby for price controls When supply is inelastic, consumers have incentives to restrict prices Rent control in New York City is an example 8-23

24 Taxation and Government Intervention 8 Application: Price Floors and Elasticity S D P Q P0P0 P1P1 S D P Q P0P0 Q0Q0 Q1Q1 The surplus created by a price floor is larger if demand and supply are elastic Q0Q0 Q1Q1 Surplus Price floor Surplus P1P1 8-24

25 Taxation and Government Intervention 8 Long-Run and Short-Run Effects on Price Control S short-run D1D1 P Q P0P0 P LR Q0Q0 Q LR Higher long-run elasticity of supply results in smaller price increases when demand increases S long-run D0D0 P SR Q SR 8-25

26 Taxation and Government Intervention 8 Chapter Summary Consumer surplus is the net benefit a consumer gets from purchasing a good Equilibrium maximizes the combination of consumer and producer surplus Producer surplus is the net benefit a producer gets from selling a good Taxes create a loss of consumer and producer surplus known as deadweight loss, which is graphically represented by the welfare loss triangle 8-26

27 Taxation and Government Intervention 8 Chapter Summary The cost of taxation to consumers and producers includes the actual tax paid, the deadweight loss, and the costs of administering the tax Price ceilings and floors, like taxes, result in loss of consumer and producer surplus Relative elasticities determine who bears the burden of the tax. The more inelastic ones demand or supply, the larger the burden of the tax 8-27

28 Taxation and Government Intervention 8 Chapter Summary Price floors transfer consumer surplus to producers; they are a tax on consumers and a subsidy to producers The more elastic supply and/or demand is, the greater the surplus with an effective price floor and the greater the shortage is with an effective price ceiling Price ceilings transfer producer surplus to consumers; they are a tax on producers and a subsidy to consumers 8-28

29 Taxation and Government Intervention 8 Preview of Chapter 9: International Trade Policy, Comparative Advantage, and Outsourcin g Present some important data of trade Explain why economists and laypeoples views of trade differ Discuss three determinants of the terms of trade Explain the principle of comparative advantage Distinguish between inherent and transferable comparative advantages Explain how free trade associations both help and hinder international trade Explain why economists generally oppose trade restrictions Discuss three policies countries use to restrict trade 8-29


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