Taxation and income distribution Today: Some basic tax theory.
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Taxation and income distribution Today: Some basic tax theory
Begin Unit 4 Today Parts of chapter 14 An introduction to some basic theories related to taxation
Taxation Taxes are typically used to finance public projects Deadweight loss comes with most forms of taxation This will be discussed in next lecture
Taxation and income distribution The US federal tax system has been set up so that people with high incomes have higher average tax rates Do people consume more leisure with high marginal tax rates? Usually yes Public project financing People with high tax rates probably have high willingness to pay for many public projects
Taxation and income distribution Income Category Average Federal Tax Rate Share of Federal Taxes Lowest Quintile5.6%1.1% Second Quintile12.15.2 Third Quintile15.710.3 Fourth Quintile19.819.0 Highest Quintile26.564.2 All Quintiles21.6100.0 Top 1%31.221.3 Source: Congressional Budget Office . These figures are based on projections that rely on assumptions about inflation and income growth. They include all tax law as of 2001. Table 14.3 Average federal tax rates and share of federal taxes by income quintile (2006)
Some terminology Statutory incidence Who legally has to pay for the tax Economic incidence How much does real income change to all parties due to a tax?
Some terminology Lump sum tax A tax that has to be paid no matter how a person behaves Proportional tax Average tax rate is independent of income Progressive tax Average tax rate increases with income Regressive tax Average tax rate decreases with income
Some terminology Unit tax A tax that is paid per unit of a good Ad valorem tax A tax that is a percentage of the purchase price
Partial equilibrium models With partial equilibrium models, only one market is examined at any one time Ignores possible spillover effects Usually easier to analyze than general equilibrium models Two types of taxes analyzed Unit tax Ad valorem tax
Unit tax You have likely seen unit taxes before Econ 1 (or equivalent) Econ 100A/B (or equivalent) Either the buyer or seller pays a given dollar amount for each unit sold or purchased
Ad valorem taxes Assume that the consumer pays an ad valorem tax Example: 6% sales tax (of the net price) imposed on the consumer The ad valorem tax shifts the demand curve by the same percentage (relative to the horizontal axis)
Ad valorem taxes Pounds of food per year Price per pound of food DfDf SfSf Q0Q0 QmQm QrQr P0P0 PmPm PrPr Df’Df’
Tax on gross price? …or net price? A tax on the gross price (paid by consumers) lowers the willingness to pay by the percentage of the tax Example 25% tax of gross price when demand is P = 4000 – 20Q New demand after tax is P = (1 – 0.25) (4000 – 20Q) P = 3000 – 15Q
Tax on gross price? …or net price? A tax on the net price (paid by consumers) is more complicated You need to find the new demand such that when the tax is added, you get the new demand Example 25% tax of net price when demand is P = 4000 – 20Q WTP with the tax is 5/4 of WTP without the tax In other words, WTP without the tax is 4/5 the WTP with the tax New demand after the tax is P = (1 – 4/5) (3000 – 20Q), which leads to P = 3200 – 16Q
Other types of taxes Taxes from working Income tax Social Security tax Hospital insurance tax (Medicare) Capital taxes Problem: Mobility of capital may move capital out of the country with taxation Taxes on profits Accounting profits Economic profits
Summary High income people pay a higher percentage of their income in taxes Different forms of taxation exist Unit tax Ad valorem tax Taxes on wages Capital taxes Profit taxes
Problem: Ad valorem tax Supply: P = Q Demand: P = 1710 – Q What is the equilibrium in the absence of a tax? What is the equilibrium if there is a 10% tax of the gross price?
No taxes Set Q = 1710 – Q Q = 855 Since P = Q from the supply curve, P = 855
With a tax A tax on the gross price implies that the willingness to pay goes down by 10% for each unit New demand is P = 1539 – 0.9Q Set Q = 1539 – 0.9Q Q = 810
With a tax What about price? Price without the tax is 810 This is the price that suppliers receive Price with tax is 810/0.9 = 900 This is the price that consumers pay