MBMC Taxes and Efficiency

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 2 What is the impact of taxes? On market equilibriums? On efficiency? On distribution? (i.e. who pays them?)

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 3 Deadweight Loss The reduction in total economic surplus that results from the adoption of a policy

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 4 The Effect of a Tax on the Equilibrium Quantity and Price of Potatoes 6 Quantity (millions of pounds/month) Price ($/pound) D S 3 Without a tax P = $3/lb and Q = 3 million lbs/month S + tax 2.5 With a tax of $1/lb MC increases by $1/lb Supply shifts up by $1 P = $3.50; Q = 2.5 million Consumers and producers share the burden of the tax equally Producers receive $2.50/lb Consumers pay $3.50/lb

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 5 Total economic surplus = $9 million/month How a tax collected for a seller affects economic surplus The Market for Potatoes Without Taxes Price ($/pound) Quantity (millions of pounds/month) D S

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 6 The Deadweight Loss Caused by a Tax 6 Quantity (millions of pounds/month) Price ($/pound) D S S + tax 2.5 Deadweight loss caused by tax Transfer

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 7 The Deadweight Loss Caused by an externality 6 Quantity (millions of pounds/month) Price ($/pound) D S MEC 2.5 Deadweight loss caused by an externality

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 8 Taxes can eliminate Deadweight Loss 6 Quantity (millions of pounds/month) Price ($/pound) D S S+MEC 2.5 S+Tax

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 9 Deadweight loss eliminated by Pigouvian tax tax

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 10 Taxes and Efficiency How would you determine the impact of a tax on efficiency?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 11 Elasticity of Demand and the Deadweight Loss from a Tax Quantity (units/day) Price ($/unit) S + T S + T Deadweight loss Quantity (units/day) Price ($/unit) D 1 S D2D2 S The greater the elasticity of demand, the greater the deadweight loss from a tax

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 12 BUT… The less elastic the demand, the greater share of the tax paid by the consumer. What are the distributional implications of taxes on necessities? How effective are taxes as a policy to prevent addictive behavior?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 13 Taxes and Efficiency Who Pays a Tax? The more inelastic the demand, the more the consumer pays The more elastic the supply, the more the consumer pays. When supply is perfectly inelastic, the tax falls entirely on the producer

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 14 What do you think? If the demand for food is inelastic, why is it not taxed? What would be the impact of a tax on pollution? On deforestation? Why would a tax on land be efficient?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 15 Land Taxes

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 16 How do property taxes currently work? Tax on combined value of buildings and land. What is the impact on economic efficiency and distribution?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 17 Demand for Land What makes land valuable? Price is determined by demand What determines demand? Population, Basic needs Factor of production Natural features Public and private investments Speculation Rent is major expenditure for poor

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 18 Supply and demand of buildings S1S1 D P Q p1 q1 CS PS

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 19 S1S1 D P Q p1 q1 CS PS tax S2S2 p2 q2 tax Deadweight loss TAX ON BUILDINGS - production cost What happens to rent when the supply of buildings shifts?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 20 TAX ON LAND - no production cost D P Q tax S P1P1 tax? Q1Q1 tax “Buy land, they ain’t making any more.” -Will Rogers Q* P* What’s the deadweight loss? What’s the impact on speculation?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 21 Impact of shift in land tax Land prices fall Price*interest = Net Revenue if the net revenue from land can cover interest payments, it’s worth buying NR=income-taxes; taxes = P*tax rate P*i+P*t=Y P=Y/(i+t) The higher the tax, the lower the price of land More money goes to government, less goes to banks Ends speculation Speculative gains are taxed away Speculative demand and market instability

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Housing prices and speculation Chapter 7: Efficiency and Exchange Slide 22

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 23 Impact of shift in land tax What would be the impact of a land tax on real estate bubbles? Increases supply of buildings on most valuable land Where is the most valuable land? Rents fall Reduces urban sprawl No deadweight loss

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 24 Impact of a tax on oil Tax on in ground value of oil = Royalties Tax on negative externalities from oil = green tax How elastic is supply and demand for oil? Short term? Long term? Who pays tax?

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Taxes and inequality

MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7: Efficiency and Exchange Slide 26 General Principles: Tax the wealth created by nature and society: “tax what we take, not what we make” Tax bads, not goods