Externalities, Public Goods, and Taxes: Understanding Costs and Benefits

1. CHAPTER 19-20 Externalities And Public Goods CHAPTER 21 Taxes, Social Insurance, and Income Distribution

2. Step 1 • 8-page packet (Section 5) is essential – Be sure to read to get basic definitions & concepts. This is the simplified version of Chapters 19 & 20.

3. Marginal Costs and Benefits Example: Pollution • The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution. • The marginal social benefit of pollution is the additional gain to society as a whole from an additional unit of pollution. • The socially optimal quantity of pollution is the quantity of pollution that society would choose if all the costs and benefits of pollution were fully accounted for.

4. The Socially Optimal Quantity of Pollution (Equilibrium Point) The socially optimal quantity of pollution is QOPT; at that quantity, the marginal social benefit of pollution is equal to the marginal social cost, corresponding to $200.

5. Reducing Externalities • Pigouvian Taxes – Taxes designed to reduce negative externalities (and costs) • Sometimes called Sin taxes • Example: Excise tax on cigarettes

6. Typical AP question If cigarette prices are determined in a free market, which of the following will be true? • The price of cigarettes will be too low, and quantity sold will be too high • Price will be efficient, but quantity sold will be too high • The price will reflect the marginal social benefit received by non-smokers • The price will overstate the true social cost imposed on non-smokers

7. If cigarette prices are determined in a free market, which of the following will be true? • The price of cigarettes will be too low, and quantity sold will be too high. • Price will be efficient, but quantity sold will be too high. • The price will reflect the marginal social benefit received by non-smokers. • The price will overstate the true social cost imposed on non-smokers.

8. Under which of the following conditions would an industry produce more than the socially efficient level of output? • The production or consumption of a good generates a positive externality. • The production or consumption of a good generates a negative externality. • The industry is a monopoly • The industry produces a public good • The industry produces a private good

9. Under which of the following conditions would an industry will produce more than the socially efficient level of output? • The production or consumption of a good generates a positive externality. • The production or consumption of a good generates a negative externality. • The industry is a monopoly • The industry produces a public good • The industry produces a private good

10. External Costs Key Point: • If negative externalities exist, producers aren’t paying for all of their costs. Society picks up some of the costs.

11. Public Goods • Rival in consumption: The same unit cannot be consumed by more than 1 person at one time. Example: Seat at Packer game • Non-rival in consumption: More than 1 person can consume the same good at the same time. Example: Watch Packer game on TV

12. Public Goods • Common Resources: Non-excludable, but rival in consumption. Example: Fish in Lake Michigan Example: Hickory nuts on state forest land Problem is Overuse There is no incentive to conserve a common resource.

13. An increase in the marginal social benefit of consuming a public good should result in A. a decrease in the public production of the good. B. an increase in the optimal quantity of the good C. a decrease in the optimal quantity of the good D. a decrease in the social costs associated with producing the good E. a decrease in the social costs associated with consuming the good

14. An increase in the marginal social benefit of consuming a public good should result in A. a decrease in the public production of the good. B. an increase in the optimal quantity of the good C. a decrease in the optimal quantity of the good D. a decrease in the social costs associated with producing the good E. a decrease in the social costs associated with consuming the good

15. CHAPTER 21 Taxes, Social Insurance, and Income Distribution

16. Principles of Tax Policy • Tax policy always has two goals: • A tax system achieves tax efficiency when it minimizes the costs to the economy of tax collection. • A tax system achieves tax fairness, or tax equity, when the “right” people actually bear the burden of taxes.

17. Principles of Tax Policy • Consumers are hurt by the tax because of higher prices, and producers are hurt to the extent that the price they receive falls. • The price elasticities of supply and demand determine the incidence of the tax. • The tax causes a loss in efficiency—a deadweight loss

18. Deadweight Loss of a Tax As a result, incentives are distorted and inefficiency arises: consumers consume less than is efficient and producers produce less than is efficient.

19. Principles of Tax Policy A tax system causes deadweight losses because taxes distort incentives. The most efficient tax will be the one that distorts incentives the least. The administrative costs of a tax are the resources used both to collect the tax and to pay it.

20. Tax Fairness According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending. According to the ability-to-pay principle of tax fairness, those with greater ability to pay a tax should pay more tax.

21. Equity versus Efficiency A lump-sum tax is the same for everyone, regardless of any actions people take. (Wis. car registration fee) A lump-sum taxis efficient because it does not distort incentives, but it is unfair. In any well-designed tax system, there is a trade-off between equity and efficiency in devising tax policy.

22. Understanding the Tax System Tax Bases and Tax Rate Structure Every tax consists of two pieces: a base and a structure: The tax base is the measure or value, such as income or property value, that determines how much tax an individual pays. The tax structure specifies how the tax is collected, it depends on the tax base.

23. Tax Bases and Tax Rate Structure • 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.

24. Tax Bases and Tax Rate Structure • A proportional tax is the same percentage of the tax base regardless of the taxpayer’s income or wealth. • A progressive tax takes a larger share of the income of high-income taxpayers than of low-income taxpayers. • A regressive tax takes a smaller share of the income of high-income taxpayers than of low-income taxpayers.

25. Equity, Efficiency, and Progressive Taxation The average tax rate on income is the ratio of income taxes paid by an individual to his or her income. The marginal tax rate on income is the additional tax an individual pays if his or her income goes up by $1. Progressive taxes can cause the marginal tax rate on income to be higher than the average tax rate on income.

26. For a progressive tax the marginal tax rate is greater than the average tax rate. As a result, progressive taxes result in reduced incentives for higher income people to work and invest compared to a proportional tax or a regressive tax. The Marginal Tax Rate vs. The Average Tax Rate for a Progressive Tax

27. Taxes in the United States • The United States has a mixture of progressive and regressive taxes, for two main reasons: • the difference between lower and upper levels of government, and • the fact that different taxes are based on different principles.

28. Understanding Government Spending Broadly speaking, governments spend money for three reasons: To provide public goods For Social insurance programs(government spending intended to protect people against financial risks). For redistribution of income programs (tax the well-off and use the money to support those less well off).

29. Understanding Government Spending Transfer payments: money that an individual receives from the government for which no good or service is produced for the government in exchange. Ex: Social security, unemployment benefits

30. Understanding Government Spending A means-tested program is available only to individuals who can show that they have a sufficiently low income to qualify; such programs clearly redistribute income. (food stamps)

31. Distribution of Federal Spending,Fiscal 2003 National defense and “nondefense discretionary” can be considered spending on public goods. Social Security, Medicare, and “other mandatory” (which includes unemployment insurance) are social insurance programs. Medicaid is income redistribution.

32. Historical Comparisons Historically, spending on defense—a public good—was the main component of federal spending, but today spending on social insurance, especially for older Americans, is considerably larger.

33. Total U.S. Federal Spending, Spending on Defense, and Spending on Social Security and Medicare

34. Government Spending as a Percent of GDP in 2002

35. Poverty and Public Aid Public aid—government spending that is means-tested and is intended to reduce poverty— is a relatively small part of government spending compared with social insurance.

36. Defining Poverty The poverty line is a minimum income that the government defines as adequate. Families whose income falls below the poverty line are considered poor.

37. Trends in the Poverty Rate Poverty fell sharply from the 1960s to the early 1970s but has not shown a clear downward trend since then.

38. Antipoverty Programs • Families below the poverty line receive three main types of government aid: • Welfare is monetary aid to poor families. • In-kind transfers provide poor families with specific goods and services. • A negative income tax is a program that supplements the earnings of low income families.

40. The Big Debate: Taxes, Transfers, and Income Distribution Income in the United States is quite unequally distributed among families, and this distribution has become more unequal in recent decades.

41. Percentage Increases in Household Income by Income Group, 1979–2002

42. The Case for Redistribution Since the wealthy have more ability-to-pay, their taxes should be higher. The drawback: redistribution involves a trade-off between equity and efficiency. They can’t be taxed to the point of no incentive.

43. The Case Against Redistribution • Government’s role should be limited to maintaining the rule of law, providing public goods, and controlling externalities. • The more conventional argument against taxing the rich and making transfers to the poor involves the trade-off between efficiency and equity. Is this fair? Is this efficient?

44. The Politics of Equity and Efficiency Tax policies are set by whomever has the political majority. The median voter theorem says that actual policies will most clearly reflect the preferences of the median voter.

45. The End of Chapter 21