Taxation & Government Intervention Chapter 6 Taxation & Government Intervention

Adjust for Undesired Market Results A progressive tax is one whose rates increase as a person's income increases. Canadian income tax is an example. A regressive tax is one whose effect decreases as income rises. Canadian sales tax is an example.

Adjust for Undesired Market Results A proportional tax is one whose rates are constant at all income levels, regardless of the taxpayer's total annual income.

Adjust for Undesired Market Results Demerit goods and activities are those considered to be bad for a person, although one may like them. Addictive drugs are a demerit good; using addictive drugs is a demerit activity.

Adjust for Undesired Market Results Merit goods and activities are things believed to be good for a person, although one may not engage in them. Motorcycle helmets are a merit good; using helmets while driving a motorcycle is a merit activity.

Market Failures and Government Failures Market failures are reasons for government intervention. Market failures are situations where the market does not lead to a desired result.

Market Failures and Government Failures Government intervention, however, need not improve the outcome. Government failures are situations where the government intervenes and makes the situation worse.

Costs of Taxation The costs of taxation include: The direct cost of the revenue paid to government The loss of consumer and producer surplus caused by the tax The administrative costs of collecting the tax.

Costs of Taxation The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.

Costs of Taxation Price S1 Consumer surplus S0 Demand A tax P1 Q1 B C Deadweight loss P0 Q0 E D P1–t Producer surplus F Quantity

Benefit Principle The benefit principle states that the individuals who receive the benefit of the good or service should pay the cost (opportunity cost) of the resources used to produce the good. Examples are gasoline taxes and airport taxes, both paid by travelers.

Ability-to-Pay Principle The ability-to-pay principle –individuals who are most able to bear the burden of the tax should pay the tax. The best example of this is a progressive tax, such as the Canadian income tax.

Applying the Principles of Taxation

Burden Depends on Relative Elasticity The person who physically pays the tax is not necessarily the person who bears the burden of the tax. The burden of the tax depends on relative elasticity. The burden of the tax is rarely shared equally since elasticities are rarely equal.

Who Bears the Burden of a Tax? Demand is inelastic. S1 Price of luxury boats $70,000 60,000 50,000 40,000 30,000 20,000 10,000 Quantity of luxury boats 600 200 400 S0 Demand tax Consumer pays Supplier pays 590

Who Bears the Burden of a Tax?

Inelastic Demand and Incentives to Restrict Supply When demand is inelastic, producers have incentives to lobby the government to restrict supply. Farming is a good example. Advances in productivity increase supply but they result in lower prices.

Long-Run Problems of Price Controls In the long run, supply and demand tend to be much more elastic than in the short run. Therefore, price controls will cause large shortages or surpluses in the long run.

Long-Run and Short-Run Effects of Price Controls Quantity Price Short run supply D0 D1 Long run supply P1 Q1 P2 Q2 P0 Q0 Price ceiling Q3 Shortage