Ch 29. Public Choice Theory & the Economics of Taxation

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.

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

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.

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.

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.

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. -- 1999, the top 10 % paid 30.6%.

“…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.

(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 (equally @ $1). S Price (Per Bottle) Quantity (Millions of Bottles Per Month) Tax $2 D

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.

Tax Incidence Supply Elasticity and the Incidence of an Excise Tax Tax Q 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.

(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

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. 0 5 10 15 20 25 30 35 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

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

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