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Taxes: How Congress Decides Who Pays

This chapter explores how taxes affect prices, quantities, and efficiency, as well as the fairness of the tax system. It explains the incidence of taxes on buyers and sellers and the impact of income and Social Security taxes on wage rates and employment.

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Taxes: How Congress Decides Who Pays

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  1. Does Congress decide who pays • the taxes?

  2. 8 Taxes CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to • 1Explain how taxes change prices and quantities, are shared by buyers and sellers, and create inefficiency. • 2 Explain how income taxes and Social Security taxes change wage rates and employment, are shared by employers and workers, and create inefficiency. • 3 Review ideas about the fairness of the tax system.

  3. 8.1 TAXES ON BUYERS AND SELLERS • Tax Incidence • Tax incidenceis the division of the burden of a tax between the buyer and the seller. • When a good is taxed, it has two prices: • A price that includes the tax • A price that excludes the tax • Buyers respond to the price that includes the tax. • Sellers respond to the price that excludes the tax.

  4. 8.1 TAXES ON BUYERS AND SELLERS • The tax is like a wedge between the two prices. • Suppose that the government puts a $10 tax on MP3 players. • How does the price paid by the buyer change? • How does the price received by the seller change? • How is the burden of a tax shared between the buyer and the seller?

  5. 8.1 TAXES ON BUYERS AND SELLERS Figure 8.1(a) shows what happens when the government taxes buyers of the MP3 players. 1. With no tax, the price is $100 and 5,000 players are bought. 2. A $10 tax on buyers shifts the demand curve to D– tax.

  6. 8.1 TAXES ON BUYERS AND SELLERS 3. The buyer’s price rises to $105—an increase of $5 a player. 4. The seller’s price falls to $95—a decrease of $5 a player. 5. The quantity decreases to 2,000 players a week. 6. The government’s tax revenue is $20,000.

  7. 8.1 TAXES ON BUYERS AND SELLERS Figure 8.1(b) shows what happens when the government taxes sellers of the MP3 players. 1.With no tax, the price is $100 and 5,000 players a week are bought. 2. A $10 tax on sellers of MP3 players shifts the supply curve to S+ tax.

  8. 8.1 TAXES ON BUYERS AND SELLERS 3.The buyer’s price rises to $105—an increase of $5 a player. 4. The seller’s price falls to $95—a decrease of $5 a player. 5. The quantity decreases to 2,000 players a week. 6. The government’s tax revenue is $20,000.

  9. 8.1 TAXES ON BUYERS AND SELLERS • Taxes and Efficiency • A tax places a wedge between the buyers’ price (marginal benefit) and the sellers’ price (marginal cost). • The equilibrium quantity is less than the efficient quantity and a deadweight loss arises.

  10. 8.1 TAXES ON BUYERS AND SELLERS Figure 8.2 shows the inefficiency of taxes. In Figure 8.2(a), the market is efficient with marginal benefit equal to marginal cost. Total surplus—the sum of2. Consumer surplus and 3. Producer surplus—is maximized.

  11. 8.1 TAXES ON BUYERS AND SELLERS Figure 8.2(b) shows how taxes create inefficiency. A $10 tax shifts the supply curve to S + tax. 1. Marginal benefit exceeds 2. Marginal cost. 3. Consumer surplus and4. Producer surplus shrink. 5. The government collects its tax revenue. 6. A deadweight loss arises.

  12. 8.1 TAXES ON BUYERS AND SELLERS The loss of consumer surplus and producer surplus is the burden of the tax. The burden of the tax equals the tax revenue plus the deadweight loss.

  13. 8.1 TAXES ON BUYERS AND SELLERS • Excess burden is the deadweight loss from a tax. • The excess burden is (3,000  $10  2), which equals $15,000. • Excess burden is the amount by which the burden of a tax exceeds the tax revenue received by the government.

  14. 8.1 TAXES ON BUYERS AND SELLERS • Incidence, Inefficiency, and Elasticity • The incidence of a tax and its excess burden depend on the elasticites of demand and supply: • For a given elasticity of supply, the buyer pays a larger share of the tax, the more inelastic is the demand for the good. • For a given elasticity of demand, the seller pays a larger share of the tax, the more inelastic is the supply of the good. • Excess burden is smaller, the more inelastic is demand or supply.

  15. 8.1 TAXES ON BUYERS AND SELLERS • Incidence, Inefficiency, and Elasticity of Demand • Perfectly Inelastic Demand: Buyer Pays and Efficient • Perfectly Elastic Demand: Seller Pays and Inefficient • Figures 8.3(a) and 8.3(b) illustrate these two extreme cases.

  16. 8.1 TAXES ON BUYERS AND SELLERS • Figure 8.3(a) shows tax incidence in a market with perfectly inelastic demand—the market for insulin. • A tax of 20¢ a dose raises the price by 20¢, and the buyer pays all the tax. • Marginal benefit equals marginal cost, so the outcome is efficient.

  17. 8.1 TAXES ON BUYERS AND SELLERS • Figure 8.3(b) shows tax incidence in a market with perfectly elastic demand—the market for pink pens. • A tax of 10¢ a pink pen lowers the price received by the seller by 10¢, and the seller pays all the tax. • A deadweight loss arises, so the outcome is inefficient.

  18. 8.1 TAXES ON BUYERS AND SELLERS • Incidence, Inefficiency, and Elasticity of Supply • Perfectly Inelastic Supply: Seller Pays and Efficient • Perfectly Elastic Supply: Buyer Pays and Inefficient • Figures 8.4(a) and 8.4(b) illustrate these two extreme cases.

  19. 8.1 TAXES ON BUYERS AND SELLERS • Figure 8.4(a) shows tax incidence in a market with perfectly inelastic supply—the market for spring water. • A tax of 5¢ a bottle does not change the price paid by the buyer but lowers the price received by the seller by 5¢. • Marginal benefit equals marginal cost, so the outcome is efficient. • The seller pays the entire tax.

  20. 8.1 TAXES ON BUYERS AND SELLERS • Figure 8.4(b) shows tax incidence in a market with perfectly elastic supply—the market for sand. • A tax of 1¢ a pound increases the price by 1¢ a pound, and the buyer pays all the tax. • A deadweight loss arises, so the outcome is inefficient.

  21. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • In 2009, the personal income tax raised: • $1.25 trillion for the federal government • About $300 billion for state and local governments • The amount of income tax that a person pays depends on her or his taxable income and on the tax rates. • Taxable incomeis total income minus a personal exemption and a standard deduction (or other allowable deductions). • The Personal Income Tax

  22. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • Marginal tax rateis the percentage of an additional dollar of income that is paid in tax. • Average tax rateis the percentage of income that is paid in tax.

  23. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • A tax can be progressive, proportional, or regressive. • Aprogressive taxis a tax whose average rate increases as income increases. • Aproportional taxis a tax whose average rate is constant at all income levels. • A regressive tax is a tax whose average rate decreases as income increases.

  24. 8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.5 shows U.S. tax rates in 2011. 1.Marginal tax rate increases with income. 2.Average tax rate increases with income. The personal income tax is a progressive tax.

  25. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • Tax on Labor Income • Firms can substitute machines for labor, so the demand for labor is elastic. • Most people must work for their income, so the supply of labor is inelastic. • With elastic demand and inelastic supply, the worker bears the greater burden of the income tax. • The Effects of the Income Tax

  26. 8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.6 shows the effects of a tax on labor income. 1. Workers pay a 20 percent marginal income tax rate. The supply of labor decreases. The wage rate rises, and the after-tax wage rate falls. 2.The employer pays some of the tax. 3.The worker pays most of the tax. 4.A deadweight loss arises.

  27. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • Taxes on Capital Income • Taxing the income from capital works like taxing the income from labor. • One crucial difference: capital is internationally mobile and so the supply of capital is highly elastic—perhaps perfectly elastic.

  28. 8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.7 shows the effect of a tax on capital income. 1.The supply of capital is perfectly elastic. 2. With a 40 percent tax on capital income, the interest rate rises. 3. The firm pays the entire tax. 4.A large deadweight loss arises.

  29. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • Taxes on Income from Land and Unique Resources • Works in the same way as taxing the income from other sources except for one crucial difference. • The supply of land is highly inelastic. • The tax on land income is fully borne by the landowners and the quantity of land is unaffected by the tax. • With no change in the quantity of land, the tax on land income creates no deadweight loss or excess burden and is efficient.

  30. 8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.8(a) shows a tax on income from land. 1. Supply is perfectly inelastic. 2. With a 40 percent tax, the supply of land is unchanged and the market rent is unchanged. 3. The landowner pays the entire tax. No deadweight loss arises—the tax is efficient.

  31. 8.2 INCOME TAX AND SOCIAL SECURITY TAX Figure 8.8(b) shows a high tax rate on Angelina’s income. 1. Supply is perfectly inelastic. 2. With a 40 percent tax, the supply curve is unchanged and the market price is unchanged. 3. Angelina pays the entire tax. No deadweight loss arises and the tax is efficient.

  32. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • The Social Security Tax The Social Security tax law says that the tax is to be shared equally by workers and employers. But the principles that determine the incidence of other taxes you’ve studied in this chapter also apply to the Social Security tax. We look at two extreme Social Security taxes: one on workers only and one on employers only.

  33. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • A Social Security Tax on Workers • With no taxes, the wage rate is $12.00 an hour and 4,000 people are employed. • 1.A 20 percent Social Security tax on workers shifts the supply curve to LS + tax.

  34. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • 2.The wage rate paid by employers rises to $12.50 an hour—an increase of 50¢ an hour. • 3.The number of people employed decreases to 3,000. • 4.Workers receive $10.00 an hour—a decrease of $2 an hour.

  35. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • 5.The government collects tax revenue shown by the purple rectangle. • Workers pay most of the tax because the supply of labor is more inelastic than the demand for labor.

  36. 8.2 INCOME AND SOCIAL SECURITY TAX • A Social Security Tax on Employers • Payroll taxis a tax on employers based on the wages they pay their workers. • Figure 8.10 on the next slide shows the effects of a payroll tax.

  37. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • A Social Security Tax on Employers With no tax, the wage rate is $12.00 an hour and 4,000 people are employed. • 1.A tax on employers of $2.50 an hour shifts the demand curve to LD – tax.

  38. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • 2.The wage rate falls to $10.00 an hour—a decrease of $2.00 an hour. • 3.The number of workers employed decreases to 3,000.

  39. 8.2 INCOME TAX AND SOCIAL SECURITY TAX • 4.Employers’ total cost of labor rises to $12.50 an hour—the $10.00 wage rate plus the $2.50 tax. • 5.The government collects tax revenue shown by the purple rectangle.

  40. 8.3 FAIRNESS AND THE BIG TRADEOFF • Whenever political leaders debate tax issues, it is fairness, not efficiency, that looms above all other considerations. • There are two conflicting principles of fairness of taxes: • The benefits principle • The ability-to-pay principle

  41. 8.3 FAIRNESS AND THE BIG TRADEOFF • The Benefits Principle • Thebenefits principleis the proposition that people should pay taxes equal to the benefits they receive from public goods and services. • This arrangement is fair because it means that those who benefit most pay the most. • But to implement it, we would need an objective way of measuring each person’s marginal benefit from public goods and services.

  42. 8.3 FAIRNESS AND THE BIG TRADEOFF • The Ability-to-Pay Principle • Theability-to-pay principleis the proposition that people should pay taxes according to how easily they can bear the burden. • A rich person can more easily bear the burden of providing public goods than a poor person can, so the rich should pay higher taxes than the poor. • This principle compares people according to • Horizontal equity • Vertical equity

  43. 8.3 FAIRNESS AND THE BIG TRADEOFF Horizontal equityis the requirement that taxpayers with the same ability to pay should pay the same taxes. Vertical equityis the requirement that taxpayers with a greater ability to pay bear a greater share of the taxes.

  44. 8.3 FAIRNESS AND THE BIG TRADEOFF • The Marriage Tax Problem • In the U.S. tax code, a married couple is considered a single taxpayer. • This arrangement means that if they each earn the same income as before a marriage, the married couple might pay more tax than they did before marriage.

  45. 8.3 FAIRNESS AND THE BIG TRADEOFF • The Big Tradeoff • Questions about the fairness of taxes conflict with efficiency questions and create the big tradeoff. • Taxes on capital incomes create the greatest deadweight loss—are the most inefficient. • But most of the capital is owned by a small number of rich people, so (most people believe) taxes on capital are the fairest. • Our tax system is an evolving attempt to juggle the two goals of efficiency and fairness.

  46. Does Congress Decide Who Pays the Taxes? • Congress says that employers and workers pay the same Social Security tax contributions (7.65 percent each in 2011). • But because the elasticity of demand for labor is much greater than the elasticity of supply of labor, workers end up paying most of the Social Security tax. • But there is one thing that Congress can do to influence who pays a tax. • It can pass a tax law (or tax rebate law) that doesn’t impact the margin on which decisions turn. • Recently, Congress passed such a law.

  47. Does Congress Decide Who Pays the Taxes? • On February 17, 2009, the President signed the American Recovery and Reinvestment Act. • Among the Act’s many provisions is a “Making Work Pay” tax credit of $400 for a single worker and $800 for a couple. • A tax credit is a fixed reduction in the amount paid in personal income tax (in the current case, $400). • For most people, a tax credit has no effect on their supply of labor. • The tax credit doesn’t influence the work-hours choice.

  48. Does Congress Decide Who Pays the Taxes? • A 20% income tax rate shifts the labor supply curve from LS to LS + tax. • The pre-tax wage rises by $1 to $20 per hour, • the after-tax wage falls by $3 to $16 per hour, and • the workweek fall from 40 hours to 35 hours. • Workers pay 75% of the tax and employers pay 25%.

  49. Does Congress Decide Who Pays the Taxes? • Suppose that Congress now passes an Act that gives workers a tax rebate of $30 a week. • Tax paid by worker falls. • Marginal tax rate remains at 20%, but now workers pay only 68% of the tax and employers pay 32%. • Congress has worked around the elasticities!

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