1. Ch 29. Public Choice Theory & the Economics of Taxation

2. A. Public choice theory – economic. analysis of gov’t decision making,
A. Public choice theory – economic analysis of gov’t decision making, politics, & elections.
-- How/when/how much should gov’t intervene w/ externalities?
-- Candidates offer alternative packages and voters choose.

3. Public Choice Theory Inefficient Voting Outcomes Inefficient
Majority “No” Vote
Inefficient
Majority “Yes” Vote
-- Majority
voting can
produce
inefficient
decisions.
-- (a) Majority
voting leads
to rejection
of a public
good that
produce a
greater public
benefit than cost.
-- (b) Results in
accepting a public
good with a higher
cost than benefit.
Benefit; Tax
$700
Adams
$350
$350
Benson
Conrad
$300
$300
$250
$200
Benson
$100
Conrad
Adams
“YES”
“NO”
“NO”
“NO”
“YES”
“YES”
“NO” Wins!
“YES” Wins!
Inefficient Since
Inefficient Since
MSB > MSC
MSB < MSC
$1,150 > $900
$800 < $900

4. 1. Special interest effect 2. Rent seeking 3. Limited & bundled choice
B. Gov’t failure
1. Special interest effect
2. Rent seeking
3. Limited & bundled choice
4. Bureaucracy
-- Failure due to inefficiency from certain characteristics of the public sector.
-- Special interests: small group trying to get specific outcomes.
-- Rent: payment beyond what’s necessary to keep a resource supplied; securing
favorable gov’t policies that result in rent (higher profit or income) than normal.
-- Bundled choice deals with Congress passing an Appropriations Bill that has
many amendments (many w/ nothing to do with the bill); vote yea or nay.

5. 1. Benefits-received principle 2. Ability-to-pay principle
C . The tax burden
1. Benefits-received principle
2. Ability-to-pay principle
-- Benefits-received of taxation asserts businesses & households should purchase
the goods & services of gov’t in same way as other commodities like a gas tax
for road repairs. But, could the unemployed pay a tax for job training?
-- Ability-to-pay taxation asserts that taxes are based on income & wealth.
-- No scientific way to determine how much a person is able to pay in taxes.

6. 16th Amendment (Congress to levy the Income Tax, 1913)
Applied to mostly the rich when ratified in 1913.
Extended to nearly everyone to finance WWII.
1943, withholding system adopted to ensure collections.

7. 1. Progressive –  rate w/  income.
D. Taxes:
1. Progressive –  rate w/  income.
2. Proportional – rate stays same.
3. Regressive -  rate w/  income.
-- The Federal tax system is Progressive.
-- Overall U.S. tax system is only slightly Progressive (small redistribution of wealth).
-- Many state & local tax systems are Regressive.
-- In 1999, the lowest 20% of households paid an average of 4.6% Federal taxes.
, the top 10 % paid 30.6%.

8. “…nothing can be said to be certain except death and taxes.”
-- Ben Franklin
Types of Taxes:
-- Personal income tax
-- Corporate income tax
-- Payroll tax
-- Property tax
-- Sales tax
-- Excise tax (sin tax on
alcohol or
cigarettes)
-- California’s ‘Proposition 13’ passed in 1978 capped the amount of property tax.

9. (Millions of Bottles Per Month)
Tax Incidence
Incidence of an Excise Tax 2 4 6 8 10 12 14 5 15 20 25 Q P S’
-- An excise tax of
a specified amount,
here $2 per unit,
shifts the supply
curve upward by
the amount of the
tax per unit: the
vertical distance
between S & St.
-- This results in a
higher price ($9) to
consumers and a lower
after-tax price ($7) to
producers.
-- Thus, consumers &
producers share the tax
burden $1). S
Price (Per Bottle)
Quantity
(Millions of Bottles Per Month)
Tax $2 D

10. Tax Incidence Demand Elasticity and the Incidence of an Excise Tax
-- (a) if demand
is elastic in
the relevant
price range,
price rises
modestly
(P1 to Pe) with
an excise tax.
-- Producer
bears most
of burden.
-- (b) If demand
is inelastic, the
price to the buyer
rises drastically
(P1 to Pi), most of
tax on consumer. Q P P Q St St
Tax
Tax S S a Pi a Pe b P1 P1 b De Pb Pa c c Dt Q2 Q1 Q2 Q1
Tax Incidence and
Elastic Demand
Tax Incidence and
Inelastic Demand
Elastic demand: product or resource demand whose price
elasticity is greater than 1.
 Inelastic demand: coefficient is less than 1.

11. Tax Incidence Supply Elasticity and the Incidence of an Excise Tax TaxQ P P Q
-- With elastic
supply, an
excise tax
results in a
large price
increase
(P1 to Pe),
tax paid
mostly by
consumers.
-- (b) If supply
is inelastic, the
price rise is
small (P1 to Pi),
and seller bears
most of tax. St S
Tax
Tax St a Pe S a Pi b P1 P1 b Pa c Pb c D D Q2 Q1 Q2 Q1
Tax Incidence and
Elastic Supply
Tax Incidence and
Inelastic Supply
Elastic supply: product or resource supply whose price
elasticity is greater than 1.
 Inelastic supply: coefficient is less than 1.

12. (Millions of Bottles Per Month)
Tax Incidence
Efficiency Loss of a Tax 2 4 6 8 10 12 14 5 15 20 25 Q P
-- The levy of a $2 tax
per bottle of wine
increases the price
per bottle from
$8 to $9 and reduces
the equilibrium
quantity from
15 to 12.5 million.
-- Tax revenue to
the gov’t is $25
million (area efac).
-- The efficiency loss
of the tax arises from
the 2.5 million decline
in output, the amount
of that loss is shown
as triangle abc. S’
Tax Paid by
Consumers S
Price (Per Bottle)
Quantity
(Millions of Bottles Per Month)
Tax $2
Efficiency
Loss (or
Deadweight
Loss)
Tax Paid by
Producers D

13. Incidence of U.S. Taxes
Taxes on Goods and Services as a Percentage of Total Tax Revenues
GLOBAL PERSPECTIVE
-- A number of
industrialized nations
rely on a goods &
services tax
– sales tax,
value-added taxes,
and specific excise
taxes – than the
U.S. does.
-- A value-added tax only
applies to the difference
between the value of a
firm’s sales and the
value of its
purchases from
other firms.
United Kingdom
Netherlands
Germany
Italy
Sweden
Canada
France
Japan
United States
32.7
30.8
29.2
26.9
26.4
26.3
25.4
20.1
17.6
Source: Organization for Economic Cooperation and Development, 2002

14. Facts About Income Inequality
Lorenz Curve and Gini Ratio 20 40 60 80
100 e
Lorenz Curve
(Actual Distribution)
The
Lorenz
Curve
Percentage of Households
Percentage of Income
Perfect Equality d A B c
Complete
Inequality b a f
Gini Ratio =
Area A
Area A + Area B

15. Facts About Income Inequality
Effect of Gov’t Redistribution 20 40 60 80
100
Percentage of Households
Percentage of Income
Lorenz Curve
After Taxes and
Transfers
Lorenz Curve
Before Taxes and
Transfers
Impact of Government Taxes and Transfers