1. Taxation, income distribution, and efficiency
Today: Some basic tax theory

2. Begin Unit 4 Today Chapters 14 and 15
An introduction to some basic theories related to taxation

3. Taxation Taxes are typically used to finance public projects
Deadweight loss comes with most forms of taxation

4. 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?
To be answered later
Public project financing
People with high tax rates probably have high willingness to pay for many public projects
See Table 14.3, p. 327

5. Some terminology Statutory incidence Economic incidence
Who legally has to pay for the tax
Economic incidence
How much does real income change to all parties due to a tax?

6. Some terminology Lump sum tax Proportional tax Progressive 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

7. Some terminology Unit tax Ad valorem tax
A tax that is paid per unit of a good
Ad valorem tax
A tax that is a percentage of the purchase price

8. 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

9. 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

10. Partial Equilibrium Models$
Before Tax
After Tax
Consumers Pay
Suppliers Receive
Partial Equilibrium Models
$1.20
$1.40
$1.00
$1.20 S1 S0
Unit Tax on Commodities
Consumer Pays $1.20
Producer receives $1.20
Tax on Consumers of $.40 per gallon
D curve shifts down – D curve perceived by supplier-amount of money the supplier will receive
Tax wedge – tax induced spread between price paid by consumer and price received by producer
Tax on Producers of $.40/gal
Draw new supply curve
Consumer Pays $1.40
Producer receives $1.40
Economic incidence independent of statutory incidence D1 D0
Quantity

11. Ad valorem taxes Assume that the consumer pays an ad valorem tax
Example: 6% sales tax
The ad valorem tax shifts the demand curve by the same percentage (relative to the horizontal axis)
See Figure 14.7, p. 315

12. Other types of taxes Taxes from working Capital taxes Taxes on profits
Income tax
Social Security tax
Hospital insurance tax (Medicare)
Capital taxes
Taxes on profits
Accounting profits
Economic profits

13. Tax incidence and capitalization
Suppose that we value land as the net present value of the yearly income from the land
Assume that the land has value for T years
T could be infinity
Then the value of the land will be
PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T

14. Tax incidence and capitalization
Suppose that a new tax is implemented on each piece of land
Yearly income falls by the amount of the tax
New value of the land
PR’ = $(R0 – u0) + $(R1 – u1)/(1 + r) +
$(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)T
Value of the land drops by
u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T

15. Tax incidence and capitalization
Capitalization process
When a new tax is implemented, the new price falls by the net present value of the total taxes that will have to be paid

16. General equilibrium models
When a tax affects a large portion of the economy, partial equilibrium models may not accurately predict the overall effects to the economy
General equilibrium models are needed to analyze situations that affect more than one market

17. Changes in consumption due to taxes
Recall that people typically consume less of a good or service once it is taxed
Example: Yacht tax in the early 1990s
Tax on yachts over $100,000 purchased in the US
People bought yachts in other countries
Net economic impact
$16.6 million in taxes collected (less than the $31 million predicted)
Less income tax paid by workers (7,600 jobs lost in the US)

18. Study of taxation graphically
Individual behavior
See Figure 15.2, p. 333
Excess burden in a market with horizontal supply
See Figure 15.5, p. 340
Taxes on labor
See Figure 15.7, p. 343, and Figure 15.9, p. 347
Subsidies
See Figure 15.6, p. 342
Pigouvian taxes
See Figure 5.4, p. 83

19. Recall double dividend hypothesis
Industry with negative externality
Pigouvian tax  Reduces excess burden
If tax proceeds are used to reduce other taxes, excess burden from these taxes are lowered
Criticism: An environmental tax could lead to an increase in the excess burden in the labor market

20. An economist’s analysis
Given an amount of revenue that is generated, taxes should be imposed such that one of the following goals is achieved
Excess burden is minimized
Social welfare is maximized

21. The real world
Taxes are often imposed that have the lowest amount of political resistance
Excess burden seems less important than revenue generation
Sometimes efficiency is completely ignored

22. How does personal income get taxed?
The personal tax system used by the federal government requires many steps to understand
Chapter 17
Highlight the basic structure, marginal tax rates, and other aspects of the federal tax structure
For next lecture: Read p

23. Today vs. tomorrow
With a tax system currently in place, we should ask how changes in tax policy affect current and future behavior
Chapter 16 has more on this
Marginal excess burden
Tax avoidance versus tax evasion
Focus reading on p and for next lecture

24. Summary Taxation of efficient markets typically leads to excess burden
Unit tax
Ad valorem tax
Taxes on land lower the income potential for the land, lowering its value
Subsidies usually lead to excess burden also