Admin RFH Private PG Public PG Tax Types Lecture 12: Tax Incidence November 11, 2014 3 Rules Extensions Admin RFH Private PG Public PG Overview Course Administration Ripped From Headlines Private Provision of Public Goods Public Provision of Public Goods Types of Taxation Three Rules of Tax Incidence Tax Incidence Extensions Tax Types 3 Rules Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Course Administration 1. Problem Set 11 is posted 2. Additional office hours: November 19, 3 to 5 pm 3. Back-of-the-envelope memo: due November 24 in class, on paper and also to a dropbox folder, details next class Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Problem Set 9: Cartels Requires private agreement among firms to restrict output to increase price above market price. • LCD price fixing, at least October 2001 to February 2006 • Sort of: Big four Chinese banks, with blessing of government • Maybe: butchers at Mexican markets • Libor rate-fixing: to make money on Libor-linked portfolios • Apple and book publishers agree to raise e-book prices • Glass manufacturers, mid-2000s • Laundry detergent in the EU: Procter and Gamble and Unilever, turned in by competitor! • South Africa: major diesel producers collude to raise prices Admin RFH Private PG Public PG Tax Types Ripped from the Headlines 3 Rules Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Level of Private Provision of Public Goods • Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Level of Private Provision of Public Goods • Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Level of Private Provision of Public Goods • Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods • Don’t blame the producer! Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Level of Private Provision of Public Goods • Suppose • Mr. 1 likes 6 units of the public good • Mr. 2 likes 5 units of the public good • Mr. 1 purchases 6 units • What is Mr. 2’s best response? • This is known as the “free rider problem” ≡ failure to contribute to public good • =⇒ in general, private markets underprovide public goods • Don’t blame the producer! Even goods that a whole group wants and is willing to pay for may not be provided. Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Example: Private Provision of Public Goods • Property owners in a neighborhood agree to levy taxes on themselves • Motivation: owners feel that public services are substandard • Use tax revenues to privately provide services, such as cleaning, marketing and security • Generally regarded as being successful – my research shows lowered crime in City of LA • Overcome the free-rider problem with mandatory contribution Admin RFH Private PG Public PG Tax Types 3 Rules Extensions When Does Private Market Provide Some Public Goods? • The smaller the group, the more likely the provision • When one, or a few, members care a lot – we see this in BIDs • Altruism • Warm glow Admin RFH Private PG Public PG Tax Types 3 Rules Can the Government Do Better? Due to the failure in the private market, one solution is for government to provide public goods. Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Can the Government Do Better? Due to the failure in the private market, one solution is for government to provide public goods. What do you think the problems are with this? • Free-rider problem again: optimal amount of public goods is sum of P given Q • Asking citizens to reveal their true demand is called “Lindahl pricing” • Yields optimal quantity of public goods • Consumers might not know their demand (do you know your demand for missiles?) • And consumers have an incentive to underestimate Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Can the Government Do Better? Due to the failure in the private market, one solution is for government to provide public goods. What do you think the problems are with this? • Free-rider problem again: optimal amount of public goods is sum of P given Q • Asking citizens to reveal their true demand is called “Lindahl pricing” • Yields optimal quantity of public goods • Consumers might not know their demand (do you know your demand for missiles?) • And consumers have an incentive to underestimate • Government provision “crowds out” private provision • Before the government firework show, you might have bought some of your own. Now you do not. Other examples? • Costs and benefits hard for government to measure Admin RFH Private PG Public PG Tax Types 3 Rules Externality Intuition Difference between MB and SMC , for Extra Units P DWL S = MC + EMC EMC P* S = MC PMKT D Q* QMKT Q Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Many Types of Taxation • Payroll tax • Income tax • Corporate tax • Wealth taxes • Property tax • Estate tax • Consumption tax • Sales tax • Excise tax – sales tax applied only to certain goods • Value added tax Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Type of Taxation Shifted Dramatically in US Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Taxation Type Varies Substantially by Country Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Key Tax Definitions • Tax base: that on which the tax is levied • Base for property tax is value of properties • Base for sales tax is value of sales • Tax rate: rate at which base is taxed • DC’s General tangible property and selected services tax rate is 5.75% • DC’s parking tax rate is 18% Admin RFH Private PG Public PG Tax Types 3 Rules Tax Fairness • Vertical equity • People with more money should may “more taxes” (total, or higher rate?) than people with less money Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Tax Fairness • Vertical equity • People with more money should may “more taxes” (total, or higher rate?) than people with less money • Horizontal equity • Tax equivalent goods equally • Don’t tax hot dogs and fail to tax sausages • Hard to define in practice Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions You Levy a Tax – Who Pays? The US income tax has shifted from a reliance on corporate taxes to income tax. Does this mean workers are paying more? “Who pays?” = tax incidence Admin RFH Private PG Public PG Tax Types 3 Rules Extensions You Levy a Tax – Who Pays? The US income tax has shifted from a reliance on corporate taxes to income tax. Does this mean workers are paying more? “Who pays?” = tax incidence Study the three rules of tax incidence 1. Statutory burden of tax 6= economic incidence of tax 2. Side of the market on which tax is imposed is irrelevant to distribution of tax burdens 3. Parties with inelastic supply or demand bear taxes Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Types of Taxation • specific excise tax: per unit tax • ad valorem tax: tax that is a fixed percentage of the sale price We will present everything with a specific excise tax. Results are equally applicable to an ad valorem tax. Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Types of Taxation • specific excise tax: per unit tax • ad valorem tax: tax that is a fixed percentage of the sale price We will present everything with a specific excise tax. Results are equally applicable to an ad valorem tax. U.S. excise tax examples • federal tax on bows, archery equipment and and arrow shafts • gasoline • wine, varying by type, highest on “naturally sparkling” Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Key Phrases Incidence ≡ who pays the tax, or who “bears the burden” of the tax. • Statutory incidence determined by who pays the tax to the government • Economic incidence determined by whose economic resources change due to the tax Admin RFH Private PG Public PG Tax Types 3 Rules 1. Statutory Incidence 6= Economic Incidence What Happens When you Levy a Tax on the Producer? price per gallon of gas S Po D Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules 1. Statutory Incidence 6= Economic Incidence What Are the New Equilibrium Price and Quantity? S’ price per gallon of gas S tax Po D Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules 1. Statutory Incidence 6= Economic Incidence How Much Extra is the Consumer Paying? S’ price per gallon of gas S tax Pn Po D Qn Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules 1. Statutory Incidence 6= Economic Incidence How Much Extra is the Producer Paying? S’ price per gallon of gas S tax consumer’s burden Pn Po D Qn Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules 1. Statutory Incidence 6= Economic Incidence Producer and Consumer Share the Burden of the Tax S’ price per gallon of gas S tax consumer’s burden Pn Po producer’s burden D Qn Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Defining Tax Burdens, Tax on Producer • consumer tax burden = (Pn − Po )+ per-unit tax payments by consumers = Pn − Po • producer tax burden = per-unit tax payments by producers −(Pn − Po ) = tax + (Po − Pn ) Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Finding New Supply • Suppose that the supply curve before the tax is Q = 2P + 2. • How does the supplier perceive a tax of $2/unit? Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Finding New Supply • Suppose that the supply curve before the tax is Q = 2P + 2. • How does the supplier perceive a tax of $2/unit? • Ps = Pt − 2, or Pt = Ps + 2 Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Finding New Supply • Suppose that the supply curve before the tax is Q = 2P + 2. • How does the supplier perceive a tax of $2/unit? • Ps = Pt − 2, or Pt = Ps + 2 • New market supply is Q = 2Pt + 2 Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Finding New Supply • Suppose that the supply curve before the tax is Q = 2P + 2. • How does the supplier perceive a tax of $2/unit? • Ps = Pt − 2, or Pt = Ps + 2 • New market supply is Q = 2Pt + 2 • But recall that producer doesn’t get Pt • Therefore, Q = 2(Ps + 2) + 2 = 2Ps + 2 + 2 = 2Ps + 4 Admin RFH Private PG Public PG Tax Types 3 Rules Extensions 2. Side of the Market on Which Tax is Imposed Irrelevant to Distribution of Tax Burden • Suppose that the gasoline tax is levied on the consumer, not the producer • This means you buy some gas and send a check to the government Admin RFH Private PG Public PG Tax Types 3 Rules Consumer Pays Tax What Happens When you Levy a Tax on the Consumer? price per gallon of gas S Po D Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Consumer Pays Tax What Are the New Equilibrium Price and Quantity? price per gallon of gas S Po t D’ Qo D quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Consumer Pays Tax How Much Lower Price Does the Producer Suffer? price per gallon of gas S Po Pn t D’ Qn Qo D quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Consumer Pays Tax How Much Does the Consumer Pay? price per gallon of gas S producer’s burden Po Pn t D’ Qn Qo D quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Consumer Pays Tax Producer and Consumer Share the Burden of the Tax price per gallon of gas S consumer’s burden producer’s burden Po Pn t D’ Qn Qo D quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Consider Burdens • When tax is levied on consumers • consumer burden = t − (Pn − Po ) = t + (Po − Pn ) • producer burden = Pn − Po + 0 Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Consider Burdens • When tax is levied on consumers • consumer burden = t − (Pn − Po ) = t + (Po − Pn ) • producer burden = Pn − Po + 0 • When tax is levied on producers • tax burden = (Pn − Po ) + t • producer burden = Po − Pn Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Tax Wedge • Tax wedge is sum of consumer and producer burdens • Does the wedge change if the tax is levied on consumers? Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions In-Class Problem The demand for rutabagas is Q = 2, 000 − 100P, and the supply of rutabagas is Q = 200P − 100. 1. Who bears the statutory incidence of a $2/unit tax on the sale of rutabagas? Re-write one of the curves appropriately. 2. Who bears the economic incidence of this tax? Admin RFH Private PG Public PG Tax Types 3 Rules 3. Inelastic Party Bears Tax Burden • Return to statutory tax burden levied on producers • Consider inelastic demand • Consider elastic demand Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Inelastic Demand What Does Inelastic Demand Look Like? price per gallon of gas S quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Inelastic Demand What is the Original Equilibrium P and Q? price per gallon of gas D S quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Inelastic Demand How Does the Tax Shift Production? price per gallon of gas D S Po Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Inelastic Demand What Are the New Equilibrium P and Q? price per gallon of gas S’ D S tax Po Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Inelastic Demand What is the Consumer’s Burden? price per gallon of gas S’ D S tax Pn Po Qo=Qn quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Inelastic Demand Consumer Cannot Run Away From Tax price per gallon of gas S’ D S tax Pn consumer’s burden Po Qo=Qn quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Elastic Demand What Does Elastic Demand Look Like? price per gallon of gas S Po quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Elastic Demand How Does Tax on Producer Shift Supply? price per gallon of gas S Po D Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Elastic Demand What are the New Equilibrium P and Q? S’ price per gallon of gas S tax Po D Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Elastic Demand Producer Bears Entire Burden S’ price per gallon of gas S tax Pn=Po D Qn Qo quantity of gas in billions of gallons Extensions Admin RFH Private PG Public PG Tax Types 3 Rules And the Same is True for Supply Extensions Admin RFH Private PG Public PG Tax Types 3 Rules 3 Extensions 1. Tax incidence in factor markets 2. (skip) Tax incidence in perfectly competitive markets 3. (skip) Balanced budget tax incidence Extensions Admin RFH Private PG Public PG Tax Types Tax Incidence in Factor Markets • Suppose a tax is levied on a factor of production • tax on labor • tax on capital, such as land or steel 3 Rules Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Tax Incidence in Factor Markets • Suppose a tax is levied on a factor of production • tax on labor • tax on capital, such as land or steel • Do wages decrease? Or do product prices increase? • Who bears the burden of the tax? Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Tax on Workers • Suppose the government decides to levy a tax on workers • It can either charge workers via a payroll tax • Or it can charge employers via a payroll tax • Does it matter? Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) How Does Tax on Workers (=Producers) Shift Supply? tax on workers tax on firms S Po S Po D Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) What Are the New Equilibrium P and Q? tax on workers tax on firms S’ S S t Po Po D Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) What is the Consumer (Labor Purchaser) Burden? tax on workers tax on firms S’ S S t Pn Po Po D Qn Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) What is the Producer (Worker/Supplier) Burden? tax on workers tax on firms S’ S S t Pn Po Po D Qn Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) What if Firms Pay the Payroll Tax? tax on workers tax on firms S’ S S t Pn Po Po D Qn Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) New Equilibrium P and Q? tax on workers tax on firms S’ S S t t Pn Po Po D D D’ Qn Qo Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) Producer (Worker) Burden? tax on workers tax on firms S’ S S t t Pn Po Po Pn D D D’ Qn Qo Qn Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) Consumer (Labor Purchaser) Burden? tax on workers tax on firms S’ S S t t Pn Po Po Pn D D D’ Qn Qo Qn Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax on Workers (Producers) vs. Tax on Firms (Consumers) Doesn’t Matter Who Pays the Tax tax on workers tax on firms S’ S S t t Pn Po Po Pn D D D’ Qn Qo Qn Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions But What If There is an Impediment to Adjustment? • Suppose that there is a minimum wage • Compare payroll tax levied on workers • To payroll tax levied on employers Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage How Does Tax on Workers=Producers Shift Supply? tax on workers tax on firms S S min wage Po Po D Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage What Are the New Equilibrium P and Q? tax on workers tax on firms S’ S S t min wage Po Po D Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage What is the Consumer (Labor Purchaser) Burden? tax on workers tax on firms S’ S S t Pn Po min wage Po D Qn Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage What is the Producer (Worker Supplier) Burden? tax on workers tax on firms S’ S S t Pn Po min wage Po D Qn Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage What if Firms Pay the Payroll Tax? tax on workers tax on firms S’ S S t Pn Po min wage Po D Qn Qo D Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage New Equilibrium P and Q? tax on workers tax on firms S’ S S t t Pn Po min wage Po D D D’ Qn Qo Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage What Quantity of Workers Can Firms Get? tax on workers tax on firms S’ S S t t Pn Po min wage Po Pdesired D D D’ Qn Qo Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage Who Bears the Burden? tax on workers tax on firms S’ S S t t Pn Po min wage Po Pdesired D D D’ Qn Qo Qmw Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Tax with a Minimum Wage Consumers of Labor (Firms) Bear the Burden tax on workers tax on firms S’ S S t t Pn Po min wage Po Pdesired D D D’ Qn Qo Qmw Qo Admin RFH Private PG Public PG Tax Types 3 Rules Extensions Summary of Taxes on Inputs • Barriers to reaching the competitive market equilibrium can matter for tax incidence • Other barriers include workplace norms, such as norm for not cutting nominal wages • More likely to see these features in input, rather than output markets • Therefore, the party on whom the tax is levied may matter more in input than output markets Admin RFH Private PG Public PG Tax Types Today: Tax Incidence • Tax incidence: who bears the burden of the tax • Statutory incidence 6= economic incidence • More elastic factor bears the burden of the tax 3 Rules Extensions Admin RFH Private PG Public PG Next Class • Last full lecture • Gruber Chapter 12: Social insurance Tax Types 3 Rules Extensions Admin RFH Private PG Public PG Tax Types 3 Rules Extensions In-Class Problem Answer 1. A tax on the sale means that the producer’s price is now 2 below the market price: Pp = Pt − 2. Re-write supply as Q = 200Pp − 100, or Q = 200(Pt − 2) − 100 = 200P − 500. 2. Original equilibrium is 2000 − 100P = 200P − 100, or 2100 = 300P, or P = 7. The new equilibrium sets the new supply equal to new demand. Put the demand and supply together: 200P − 500 = 2000 − 100P, or 300P = 2500, or P = 2500/300 = 8.33. The consumer pays $1.33 more; this is the consumer burden. The producer’s burden is 2 − 1.33 = 0.66 more.
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