1. Chapter 7
Taxes

2. Taxes
An excise tax is placed on the sale of each unit of a good or service
Our example will be a $40 tax placed on the sale of hotel rooms, paid by the seller at time of sale.
Think of the tax as just an extra cost for suppliers

3. Taxes

4. Taxes

5. Taxes The tax is represented by a decrease in supply
The new equilibrium is between D and S2
The tax drives a “wedge” between D and S1
On either end of the wedge is supply price and demand price
We calculate the tax incidence with
1) the original market clearing price
2) the supply price
3) the demand price
Tax incidence – how the tax burden is shared between producers and consumers

6. Taxes
If the tax was placed on buyers of hotel rooms at time of sale rather than sellers;
The tax is represented by a downward shift of the demand curve
New equilibrium is found where D2 and S intersect
The wedge is driven between D1 and S
Tax incidence is figured the same as before

7. Taxes

8. Taxes
In fact, it doesn’t matter who officially pays the tax – the equilibrium outcome is the same

9. Incidence & Elasticity
Price elasticity of both supply and demand are what determines tax incidence
The next example of the market for gasoline illustrates how consumers can pay most of the tax
Free market equilibrium at $2
Excise tax of $1 (creates a wedge $1 high)
Supply price $1.95
Demand price $2.95
When the price elasticity of demand is low and the price elasticity of supply is high, the burden of an excise tax falls mainly on consumers.

10. Incidence & Elasticity

11. Incidence & Elasticity
The next example of the market for parking illustrates how producers can pay most of the tax
Free market equilibrium at $6
Excise tax of $5 (creates a wedge $5 high)
Supply price $1.50
Demand price $6.50
When the price elasticity of demand is high and the price elasticity of supply is low, the burden of an excise tax falls mainly on producers.

12. Incidence & Elasticity

13. Incidence & Elasticity
When Ed > Es, tax is mostly paid by producers
When Ed < Es, tax is mostly paid by consumers
When Ed > Es, tax burden is shared equally
In sentence form;
When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers. When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consum- ers.

14. Incidence & Elasticity
Application: Who pays the FICA tax?
Federal Insurance Contributions Act
Requires workers to contribute to Social Security (85%) Medicare (15%)
Employees pay 6.2% of earnings, employers pay 7.47%
For example someone earning $100 will pay $6.20 of it as FICA and their employer pays an additional $7.47.
Price elasticity of demand for labor is very elastic (Ed=3)
Price elasticity of supply for labor is very inelastic
Workers pay most of the tax

15. Incidence & Elasticity
[student example]

16. Incidence & Elasticity

17. Costs & Benefits of Taxation
Administrative costs
deadweight loss resulting from market distortion (quantity too low) and loss of allocative efficiency
Benefit – revenue for the government to operate and (hopefully) provide public goods in an allocative and productively efficient way

18. Costs of a Tax
The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it.
Accounting services
Legal services (for tax evaders)
Collection services
Legal services (for IRS)

19. Deadweight Loss

20. Deadweight Loss
Area:
B is deadweight loss that used to be consumer surplus
F is deadweight loss that used to be producer surplus
A is tax revenue that used to be consumer surplus
C is tax revenue that used to be producer surplus
Tax revenue will be used to provide government services
Deadweight loss isn’t good for anything, and is wasteful of society’s resources

21. Deadweight Loss

22. Deadweight Loss
Looking at four scenarios based on various elasticities we will find:
Deadweight loss is smaller when:
Demand is more inelastic
Supply is more inelastic
Deadweight loss is larger when:
Demand is more elastic
Supply is more elastic

23. Deadweight Loss

24. Deadweight Loss

25. Deadweight Loss

26. Deadweight Loss

27. Revenue from Tax
Graphically, the revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity transacted under the tax.

28. Revenue from Tax
Revenue = $40 * 5,000 = $200,000

29. Revenue from Tax
Revenue = $60 * 2,500 = $150,000

30. Revenue from Tax
A tax rate is the amount of tax people are required to pay per unit of whatever is being taxed.
An increase in the tax rate causes goods to bring more revenue per unit (price effect) which increases revenue and also be more expensive so that fewer units to be sold (quantity effect) which decreases revenue

31. Revenue from Tax
When supply and demand are both very price elastic (flat), increasing the tax rate will lead to a large quantity effect
When supply and demand are both very price inelastic (steep), increasing the tax rate will lead to a small quantity effect

32. Analysis

33. Tax Fairness Two principles of tax fairness
Benefits principle – those who benefit from the public spending should bear the burden of the tax
Ability-to-pay principle – those who can better afford to bear the burden of a tax should pay more of the tax
Efficiency v. Equity Tradeoff

34. Types of Taxes
A lump-sum tax is the same for everyone, regardless of any actions people take. A regressive tax.
Example: you are forced to pay a $50 fee to work in Wilkes- Barre. If you earn $5,000 per year that is 1% of income. If you earn $50,000 per year that is 0.1% of income.
A regressive tax takes a smaller share of the income of high- income taxpayers than of low- income taxpayers.

35. Types of Taxes
A proportional tax is the same percentage of the tax base regardless of the taxpayer’s income or wealth.
Example: 10% tax on income. A person earning $10,000 pays 10% of their income. So does a person earning $200,000.

36. Types of Taxes
The marginal tax rate is the percentage of an increase in income that is taxed away.
A progressive tax takes a larger share of the income of high- income taxpayers than of low- income taxpayers.
Example: The tax rate on the first $10,000 is 10% and increases to 15% on all further income.

37. Types of Taxes
The tax base is the measure or value, such as income or property value, that determines how much tax an individual or firm pays.
The tax structure specifies how the tax depends on the tax base.
An income tax is a tax on an individual’s or family’s income.
A payroll tax is a tax on the earnings an employer pays to an employee.
A sales tax is a tax on the value of goods sold.
A profits tax is a tax on a firm’s profits.
A property tax is a tax on the value of property, such as the value of a home.
A wealth tax is a tax on an individual’s wealth.

38. Types of Taxes Equity v. Efficiency Example
Proportional rate where everyone pays 25%
Progressive where highest earners pay 75%, else 0%

39. Taxes in the USA

40. Taxes in the USA

41. Taxes in the USA

42. Taxes in the USA

43. Tax payment | % Calculation
If income is $20,000
First $9,075 pays 10% = $907.50
Next $10,925 pays 15% = $1,638.75
Total federal income tax payment : $2, or 12.7% of gross (before tax) income
You try to calculate for income of $59,000

44. Tax Rates by State
FYI
PA state income tax is 3.07% regardless of income
NY state income tax is 4% to 8.82% dependent on income
CA state income tax is 1% to 13.3% dependent on income
DE state income tax is 2.2% to 6.6% dependent on income
FL state income tax does not exist
CA is highest top bracket