1 The Players and the Goals In this experiment, each team controls a firm that sells to a group of consumers. Firms select what price to charge.  Lower price means consumers purchase more units.  Higher price means consumers purchase fewer units.

2 The Players and the Goals Goal: make the most profit possible. Profit = Revenue – Cost (Price per unit) (Units sold) ($1) (Units sold)

3 Example You will see a demand schedule like the one to the right. The chart shows the number of units you will sell depending on what price you decide to charge. You must choose what price to charge for your product so as to maximize your profit.

4 Example Suppose you charge $10.00 per unit. How many units will you sell? 750 What is your revenue? ($10) (750) = $7,500 What is your cost? ($1) (750) = $750 What is your profit? $7,500 – $750 = $6,750

5 Example Suppose you charge $20.00 per unit. How many units will you sell? 550 What is your revenue? ($20) (550) = $11,000 What is your cost? ($1) (550) = $550 What is your profit? $11,000 – $550 = $10,450

6 Example Suppose you charge $10.00 per unit. Profit = $6,750 Suppose you charge $20.00 per unit. Profit = $10,450 Of these, $20.00 is the better price to charge.

7 Round 1 Choose the price you will charge for your product. Every unit you sell costs you $1 to produce.

8 Round 1

9 Statutory vs. Economic Tax Burden (or tax incidence) Statutory tax burden is the amount of tax collected from a person. Economic tax burden is the amount of tax paid by a person. Example: With no taxes, the price of gas is $3.00 per gallon. The government imposes a 50 cent per gallon tax on gasoline. The tax is collected from the producer. In response to the tax, the producer raises the price of gas to $3.50. Who bears the statutory and economic burdens of the tax?  Statutory burden is on the producer, but economic burden is on the consumer.

10 Statutory vs. Economic Tax Burden (or tax incidence) Statutory tax burden is the amount of tax collected from a person. Economic tax burden is the amount of tax paid by a person. Example: With no taxes, the price of gas is $3.00 per gallon. The government imposes a 50 cent per gallon tax on gasoline. The tax is collected from the producer. In response to the tax, the producer does not change the price of gas. Who bears the statutory and economic burdens of the tax?  Statutory burden is on the producer and economic burden is on the producer.

11 Statutory vs. Economic Tax Burden (or tax incidence) Statutory tax burden is the amount of tax collected from a person. Economic tax burden is the amount of tax paid by a person. Example: With no taxes, a person earns $50,000 per year. The government imposes a $10,000 income tax. The tax is collected from the worker. In response to the tax, the employer gives the worker a $5,000 raise. Who bears the statutory and economic burdens of the tax?  Statutory burden is on the worker, but economic burden is shared between the worker and the employer.

12 Sales/Excise Tax When the government imposes a tax, the price the consumer pays is no longer the same as the price the producer receives. Example: $10 per unit tax.  The consumer pays $35 per unit, but the producer receives only $25 per unit. We call the $35 the “consumer price” or the “price including tax” and the $25 the “producer price” or the “price excluding tax.”

13 Round 2: Statutory Tax Burden is on Consumers In this round, consumers will pay an additional $5 per unit tax. The price consumers pay is the price you charge plus $5.  The statutory tax burden is on the consumer.

14 Round 2 In this round, consumers will pay an additional $5 per unit tax. The consumer price is the price you charge plus the $5 tax. If you charge, $7, how many units will consumers buy? 77 What is your profit? ($7)(77) – ($1)(77) = $462

15 Round 2 Choose the price you will charge for your product (the price excluding tax). The price the consumer pays is $5 more than the price you charge. Every unit you sell costs you $1 to produce.

16 Round 2

17 Round 3: Statutory Tax Burden is on Producers In this round, producers will pay a $5 per unit tax for every unit they sell. The price consumers pay is the price you charge.  The statutory tax burden is on the producer.

18 Round 3 In this round, producers will pay a $5 per unit tax. The price you receive is now $5 less than the price you charge. If you charge, $7, how many units will consumers buy? 101 What is your profit? ($7 – $5)(101) – ($1)(101) = $101

19 Round 3 Choose the price you will charge for your product (you will pay the government $5 of this price). The price you receive is $5 less than the price you charge. Every unit you sell costs you $1 to produce.

20 Round 3

21 Luxury versus Necessity Consumption of luxury goods is more sensitive to price changes. Consumption of necessity goods is less sensitive to price changes. Example: At a price of $10 per ticket, Mark will see 10 movies per year. At a price of $12 per ticket, Mark will cut back to 5 movies per year.  20% rise in price results in a 50% reduction in consumption  Mark’s consumption is highly sensitive to price changes.  For Mark, movies are a luxury good.

22 Luxury versus Necessity Consumption of luxury goods is more sensitive to price changes. Consumption of necessity goods is less sensitive to price changes. Example: At a price of $10 per ticket, Scott will see 10 movies per year. At a price of $12 per ticket, Scott will cut back to 9 movies per year.  20% rise in price results in a 10% reduction in consumption  Scott’s consumption is less sensitive to price changes.  For Scott, movies are a necessity good.

23 Round 4 Choose the price you will charge for your product. Every unit you sell costs you $1 to produce. There is no tax.

24 Round 4

25 Round 5 Choose the price you will charge for your product (the price excluding tax). The price the consumer pays is $5 more than the price you charge. Every unit you sell costs you $1 to produce.

26 Round 5

27 Tax rates and tax revenue In an attempt to increase tax revenue, the government increases the tax rate from $5 per unit to $20 per unit.

28 Round 6 Choose the price you will charge for your product (the price excluding tax). The price the consumer pays is $20 more than the price you charge. Every unit you sell costs you $1 to produce.

29 Round 6

30 Results Producer’s loss due to the tax = $600 – $ = $ Government’s gain due to the tax = $ Consumers pay a higher price per unit for fewer units.

31 Results Government has no control over who ultimately pays a tax.

32 Results Raising tax rates does not necessarily raise tax revenues.

33 Does it work this way in the real world?

34 By law, workers pay one-half of Social Security taxes and employers pay the other half. Who bears the economic burden of the Social Security tax?

35 Source:Social Security Administration and the U.S. Bureau of Labor Statistics.

36 Average annual wage growth when SS tax increases = 1.0% Average annual wage growth when SS tax does not change = 1.3% Source:Social Security Administration and the U.S. Bureau of Labor Statistics.

37 Average annual wage growth when SS tax increases = 1.0% Average annual wage growth when SS tax does not change = 1.3% Increasing SS tax slows average wage growth by 0.3%. When SS tax rate increases, it increases (on average) by 0.3% Employer passes on employer’s half of SS tax increases to the worker in the form of lower wages.

38 Does increasing the Social Security tax rate increase Social Security tax revenues?

39 Source:U.S. Bureau of Labor Statistics.

40 Source:U.S. Bureau of Labor Statistics.

41 Does increasing capital gains tax rates increase tax revenues?

42 Source:Gwartney, J.D. and R.G. Holcombe, Optimal Capital Gains Tax Policy. Report to the Joint Economic Committee of the United States Congress.

43 Source:Gwartney, J.D. and R.G. Holcombe, Optimal Capital Gains Tax Policy. Report to the Joint Economic Committee of the United States Congress.

44 Does taxing luxuries raise tax revenue?

Deficit Reduction Law: The “Luxury Tax” Goal: Raise tax revenue by raising taxes on “the rich.” Means:10% excise tax on recreational planes. Result:80 fewer planes sold $130 million lost sales 480 lost jobs Estimated tax revenue:$6 million. Actual tax revenue: $530,000.  Economic burden of the tax fell almost entirely on blue-collar workers.  Government gained $1,100 for every job a worker lost. Source:Joint Committee on Taxation, “Methodology and Issues in the Revenue Estimating Proecess” (JCX-2-95), January 23, 1995.

46 Does increasing tax rates for the rich increase tax revenues?

47 Note:Marginal, not average, tax rates influence people’s behaviors. Example Erin earns $80,000 and is taxed 20% on each dollar she earns. Xavier earns $80,000 and is taxed 10% on the first $71,111 and 100% on each dollar over $71,111. Erin’s tax bill is $16,000. Xavier’s tax bill is ($71,111)(0.1)+($80,000 – $71,111) = $16,000. Each faces an average tax rate of $16,000 / $80,000 = 20%. Which has incentive to earn more money?

48 Source:Bureau of Economic Analysis

49 Does increasing tax rates for anyone raise revenues?

50 Source:Bureau of Economic Analysis

51 Tax rates aren’t the whole story. What about tax credits, deductions, exemptions, etc.?

52 Source:Clifford Thies, Shenandoah University A person who is earning $25,000 gets a $1,000 raise. After changes in taxes, credits, and benefits, the person is $1,400 worse off than before the raise. $25, %

53 But we have to raise taxes to pay for spending, and we need more spending to stimulate the economy.

54 Source: Bureau of Economic Analysis 1955 – 2009 On average, a 1% increase in both spending and taxes is associated with a 0.85% decrease in economic growth.

55 Source: Bureau of Economic Analysis Average growth rates in government spending in the quarters prior to and after recessions that began at quarter t (quarterly, – ). The average recession four quarters. Historically, government spending has been counter-cyclical  it increases during expansions and decreases during recessions. Even if stimulus spending worked, evidence suggests that the government can’t get its timing right.

56 zOMG! Do something! The rich are getting richer while the poor are getting poorer!

57 Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668. % of Households in Each Income Bracket (2006$) In 1980, 16% of US households earned less than $15,000 (in 2006 dollars). In 1980, 8% of US households earned more than $100,000 (in 2006 dollars).

58 % of Households in Each Income Bracket (2006$) Ten years later, the proportion of US households earning less than $15,000 (in 2006 dollars) had shrunk to 15%... …and the proportion earning over $100,000 had grown to 13% (in 2006 dollars). Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668.

59 % of Households in Each Income Bracket (2006$) From 1980 to 2006, the proportion of households earning less than $75,000 (in 2006 dollars) shrank from 83% to 70%... …while the proportion earning over $75,000 (in 2006 dollars) grew from 17% to 30%. Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668.

60 Conclusions 1.Tax revenue is a constant fraction of GDP. 2.Tax policy aimed at raising revenue will fail. Tax policy should be aimed at maximizing GDP growth. 3.Government cannot control who pays tax. 4.Tax policy aimed at targeting particular groups will fail. Tax policy should be aimed at minimizing economic drag. 5.Stimulus spending with tax increases actually causes the economy to contract. 6.Even if stimulus spending worked, evidence suggests that the government can’t get the timing right.

61 In which world would each person rather live? (prices are the same in the two worlds) In world #1, Person 10 earns 11% of all income. In world #2, Person 10 earns 15% of all income.

62 Compiled from data published in 2003 Statistical Abstract of the United States, U.S. Bureau of the Census, and provided by the Social Security Administration Expected annual Social Security tax payments Expected annual Social Security benefits Expected Tax and Benefits for Median Worker

63 Compiled from data published in 2003 Statistical Abstract of the United States, U.S. Bureau of the Census, and provided by the Social Security Administration Expected annual Social Security tax payments Expected annual benefits from privatized account This chart assumes that 100% of the worker’s current Social Security taxes are diverted to a private investment account yielding an 8% annual return.

64 Government spending and the ratchet effect