Public Choice Theory and the Economics of Taxation

29 Public Choice Theory and the Economics of Taxation

Chapter Objectives • The Difficulties of Conveying Economic Preferences Through Majority Voting • “Government Failure” and Why It Occurs • Different Tax Philosophies and Ways to Distribute a Nation’s Tax Burden • Principles Related to Tax Shifting, Tax Incidence, and Efficiency Losses From Taxes

O 29.1 Public Choice Theory • Government Failures • Revealing Preferences Through Majority Voting • Inefficient Voting Outcomes • Inefficient “No” Vote • Inefficient “Yes” Vote Graphically…

Revealing Preferences Through Majority Voting • Our democratic process relies heavily on majority voting • Majority voting does not always produce efficient outcomes b/c it fails to incorporate strength of preference of the individual voter • Inefficient “no” vote – Read p.565 and see Figure 29.1 a • Inefficient “yes” vote – Read p.565 and see Figure 29.1 b • Inefficient voting may lead to underallocation or overallocation of resources

Benefit; Tax Benefit; Tax 0 0 Public Choice Theory Inefficient Voting Outcomes Inefficient Majority “No” Vote Inefficient Majority “Yes” Vote $700 Adams $350 $350 Benson Conrad $300 $300 $250 $200 Benson $100 Conrad Adams “YES” “NO” “NO” “NO” “YES” “YES” “NO” Wins! “YES” Wins! Inefficient Since Inefficient Since MSB > MSC MSB < MSC $1,150 > $900 $800 < $900

O 29.2 Public Choice Theory • Interest Groups • Political Logrolling • Logrolling – Vote Trading • Paradox of Voting • Preferences • Voting Outcomes • Median-Voter Model

Paradox of Voting • Situation in which society may not be able to rank its preferences consistently through paired-choice majority voting • Read Voting Outcomes p.567 • Median-voter model – under majority rule, median voter will in a sense determine election outcome

Government Failure • Special-Interest Effect • Pork-Barrel Politics • Rent-Seeking Behavior • Clear Benefits, Hidden Costs • Limited and Bundled Choice • Bureaucracy and Inefficiency • Imperfect Institutions

Government Failure • Government failure – inefficiency due to characteristics of public sector • Special-interest effect – small group of well-informed beneficiaries obtain a gov policy that give them large gains at the expense of greater number of persons • Ex. pork-barrel politics

Government Failure • Rent-seeking behavior – appeal to gov for special benefits at the taxpayers’ or someone else’s expense • Ex. tax breaks that benefit specific corporations, extensive occupational licensing

Apportioning the Tax Burden • Benefits-Received Principle • Ability-to-Pay Principle • Tax Progressivity • Progressive • Regressive • Proportional • Applications

Principles of Taxation • 1. benefits-received principle – those who benefit most from government-supplied g&s should pay in proportion to the amount of benefits they receive • Ex. tax on gasoline • 2 Major Drawbacks: • 1. Difficulty in measuring benefits received • 2. Logical application to antipoverty programs

Principles of Taxation • 2. Ability-to-pay principle – those with larger incomes should pay more in taxes (both relative and absolute terms)

Three tax structures • Defined by relationship b/w avg tax rate and income • 1. progressive – tax rate increases as income increases • Ex. Federal indiv. Income tax • 2. proportional – tax rate remains the same regardless of income • Ex. corporate income tax • 3. regressive – average tax rate declines as income increases • Ex. sales tax

G 29.1 Tax Incidence • Elasticity and Tax Incidence • Division of Burden • Elasticities • Efficiency Loss of a Tax • Tax Revenues • Efficiency Loss • Role of Elasticities

Tax Incidence • Who ends up paying a tax? • Elasticity and tax incidence: • 1. with a specific supply, the more inelastic the demand for the product, the larger the portion of tax shifted to consumer • 2. with a specific demand, the more inelastic the supply, the larger the portion of the tax paid by the producer

P 14 12 10 Price (Per Bottle) 8 6 4 2 0 5 10 15 20 25 Q Quantity (Millions of Bottles Per Month) Tax Incidence Incidence of an Excise Tax S’ S Tax $2 D

P P 0 0 Q Q Tax Incidence Demand Elasticity and the Incidence of an Excise Tax St St Tax Tax S S a Pi a Pe b P1 P1 b De Pb Pa c c Dt Q2 Q1 Q2 Q1 Tax Incidence and Elastic Demand Tax Incidence and Inelastic Demand

P P 0 0 Q Q Tax Incidence Supply Elasticity and the Incidence of an Excise Tax St S Tax Tax St a Pe S a Pi b b P1 P1 Pa c Pb c D D Q1 Q1 Q2 Q2 Tax Incidence and Elastic Supply Tax Incidence and Inelastic Supply

Efficiency Loss of a Tax • Aka deadweight loss of tax • Loss is society’s sacrifice to net benefit , because the tax reduces levels of production and consumption below levels of economic efficiency • See Figure 29.5

P 14 12 10 Price (Per Bottle) 8 6 4 2 0 5 10 15 20 25 Q Quantity (Millions of Bottles Per Month) Tax Incidence Efficiency Loss of a Tax S’ Tax Paid by Consumers S Tax $2 Efficiency Loss (or Deadweight Loss) Tax Paid by Producers D

Incidence of U.S. Taxes • Personal Income Tax • Corporate Income Tax • Sales and Excise Taxes • Property Taxes • The U.S. Tax Structure

GLOBAL PERSPECTIVE Incidence of U.S. Taxes Taxes on Goods and Services as a Percentage of Total Tax Revenues 0 5 10 15 20 25 30 35 United Kingdom Netherlands Germany Italy Sweden Canada France Japan United States 32.7 30.8 29.2 26.9 26.4 26.3 25.4 20.1 17.6 Source: Organization for Economic Cooperation and Development, 2002

Government Failure Last Word “…In the News” • E.P.A. House Building • Chicago “Wilderness” Program • Bison Meat, Cauliflower, and Pumpkin Supports • Catfish as Livestock Spending • 9,300 Special Projects in 2003 • Waste and Fraud in Katrina Relief Spending

public choice theory logrolling paradox of voting median-voter model government failure special-interest effect rent-seeking benefits-received principle ability-to-pay principle progressive tax regressive tax proportional tax tax incidence efficiency loss of a tax Key Terms

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Public Choice Theory and the Economics of Taxation