Chapter 13: Taxation and Efficiency Econ 330: Public Finance Dr Chapter 13: Taxation and Efficiency Econ 330: Public Finance Dr. Reyadh Faras Dr. Reyadh Faras

Taxation and Efficiency  Excess Burden Defined  (Graph)   Dr. Reyadh Faras

  Excess burden is the loss in individual’s utility due to imposing a tax. One way of measuring the loss in utility is by using the equivalent variation: The amount of income we would have to take away from the consumer (before imposing the tax) to induce it to move from the high to the low indifference curve. The EV measures the loss caused by the tax as the size of the reduction in income that would cause the same decrease in utility as the tax. The EV is the amount by which we need to shift the original budget constraint. Dr. Reyadh Faras

Does every tax entail an excess burden? Consider a lump sum tax (an amount paid regardless taxpayer’s behavior) that shifts the budget line inward parallel to the original line (because it does not change relative prices). In addition, because the consumer attains the same utility level as in the case of the commodity tax, the budget line must be tangent to the new indifference curve. Because tax  revenue collected from a lump sum tax equals its EV, it has no excess burden. Dr. Reyadh Faras

1. A tax that changes relative prices generates an excess burden. Generally: 1. A tax that changes relative prices generates an excess burden. 2. A tax that changes relative prices is inefficient since it lowers individual utility more than is necessary to raise a given amount of revenue. Dr. Reyadh Faras

1. If lump sum taxes are so efficient, why aren’t they widely used? Questions and Answers 1. If lump sum taxes are so efficient, why aren’t they widely used?      2. Are there any results from welfare economics that would help us understand why excess burden arise? Dr. Reyadh Faras

3. Does an income tax entail an excess burden? 4. If the demand for a commodity does not change when it is taxed, does this mean that there is no excess burden? Dr. Reyadh Faras

Excess Burden Measurement with Demand Curves Excess burden can be reinterpreted using (compensated) demand curves, relying on the concept of consumer surplus. Assume a tax at rate t is imposed on a good, the price becomes (1+t)P.   Dr. Reyadh Faras

The Excess Burden of a Subsidy A subsidy is just a negative tax and is associated with an excess burden. Assume a subsidy at rate s is provided for a good, the price becomes (1-s)P.   Dr. Reyadh Faras

The Excess Burden of Income Taxation The theory of excess burden applies just as well to factors of production as it does to commodities. Assume an income tax at rate t is imposed, the wage becomes (1-t)w.   Dr. Reyadh Faras