Taxes, Efficiency and Equity

1. Taxes, Efficiency and Equity

2. What is the impact of taxes? • On market equilibriums? • On efficiency? • On distribution? (i.e. who pays them?)

3. Economic Burden • The reduction in total economic surplus that results from the adoption of a policy • Also known as ‘deadweight loss’

4. S 3 D Review of economic surplus: the market for potatoes 6 Consumer surplus Economic surplus = consumer surplus + producers surplus 5 4 Price ($/pound) Producer surplus 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

5. Without a tax P = $3/lb and Q = 3 million lbs/month S + tax S • With a tax of $1/lb • MC increases by $1/lb • Supply shifts up by $1 • P = $3.50; Q = 2.5 million • Consumers and producers share the burden of the tax equally • Producers receive $2.50/lb • Consumers pay $3.50/lb 3.50 3 2.50 D 2.5 The Effect of a Tax on the Equilibrium Quantity and Price of Potatoes 6 5 4 Price ($/pound) 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

6. S Total economic surplus = $9 million/month How a tax collected for a seller affects economic surplus D The Market for Potatoes Without Taxes 6 5 4 Price ($/pound) 3 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

7. S + tax Deadweight loss caused by tax 3.50 2.50 2.5 The Deadweight Loss Caused by a Tax S 6 5 4 Price ($/pound) 3 Transfer NOTE: An ad valorem tax would rotate the supply curve upwards 2 1 D 1 2 3 4 5 Quantity (millions of pounds/month)

8. Taxes and Efficiency • How would you determine the impact of a tax on efficiency?

9. Review of elasticity • Elasticity • A measure of the extent to which quantity demanded and quantity supplied respond to variations in price, income, and other factors. • What is the elasticity of demand for food? • What is the elasticity of supply for milk? • Short run vs. long run • What is the elasticity of demand for tropical vacations? • For Exxon gasoline? • What is the elasticity of supply for land?

10. Deadweight loss Deadweight loss S + T S + T 2.60 S S 2.40 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 Elasticity of Demand and the Deadweight Loss from a Tax Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The greater the elasticity of demand, the greater the deadweight loss from a tax

11. BUT… • The less elastic the demand, the greater share of the tax paid by the consumer. • How effective are cigarette taxes at reducing smoking? • How effective are cigarette taxes for earning revenue? • What are the distributional implications of taxes on necessities?

12. Differential taxes on inputs • E.g. tax on labor vs. tax on capital • Makes labor more expensive, capital is used as substitute • What happens if we tax capital? • The problem of capital flight

13. Income tax and efficiency • Income taxes theoretically change our consumption of work and leisure • Theoretically produce an excess burden

14. Taxes, Externalities and Efficiency • Externalities are a cost imposed on society by producers • Efficiency requires that producers/consumers pay the full cost of production/consumption

15. S= MC D Externalities in the Potato market: pesticide applications MC + MEC 6 5 4 Price ($/pound) 3 2 1 1 2 3 4 5 Quantity (pounds/acre/year)

16. S= MC D Externalities in the Potato market: pesticide applications S+Tax 6 5 4 Price ($/pound) 3 2 1 1 2 3 4 5 Quantity (millions of pounds/month)

17. Double-dividend • Taxes on negative externalities are efficient • Pollution • Loss of ecosystem services from resource depletion • Tax bads and use revenue to reduce inefficient taxes on goods

18. Land Taxes and efficiency What is the elasticity of supply for land?

19. How do property taxes currently work? • Tax on combined value of buildings and land. • What is the impact on economic efficiency and distribution?

20. Demand for Land • What makes land valuable? • Price is determined by demand • What determines demand? • Basic needs • Factor of production • Speculation • Rent is major expenditure for poor

21. Supply and demand of buildings P S1 CS p1 PS D q1 Q

22. TAX ON BUILDINGS - production cost S2 P S1 CS p2 Deadweight loss p1 PS tax tax D q2 q1 Q What happens to rent when the supply of buildings shifts?

23. TAX ON LAND - no production cost S “Buy land, they ain’t making any more.” -Will Rogers P P* tax? P1 tax tax D Q* Q1 Q What’s the deadweight loss? What’s the impact on speculation?

24. Impact of shift in land tax • Reduces speculative demand • Land prices fall • Capitalization theory • Increases supply of buildings on most valuable land • Where is the most valuable land? • Rents fall • Reduces urban sprawl • Bank of America Study • No deadweight loss

25. Subsidies • Same basic concept as a tax • Distort production incentives • Must be paid for, so a subsidy in one place implies a tax in another

26. What do you think? • What are the efficiency implications of federal subsidies for logging, mining, grazing and oil extraction? • Requires higher taxes elsewhere, and increases negative externalities • Are natural resources capital assets? • What would be the impact on output of a tax on excess profits (i.e. profits above and beyond a fair return to the factors of production, also known as economic rent?) • Why aren’t taxes being shifted to economic rent?

27. Taxes and equity • Who Pays a Tax? • Tax incidence • Statutory incidence • Who is legally responsible for paying? • Economic incidence • Who actually pays?

28. S + tax Deadweight loss caused by tax 3.50 2.50 2.5 Tax on producers S 6 5 4 Price ($/pound) 3 Transfer 2 1 D 1 2 3 4 5 Quantity (millions of pounds/month)

29. A tax on consumers S 6 5 Transfer 4 Deadweight loss 3.5 Price ($/pound) 3 It makes no difference if tax is placed on producers or consumers 2.5 2 D 1 D after tax 1 2 3 4 5 2.5 Quantity (millions of pounds/month)

30. Taxes and equity • Who Pays a Tax? • The more inelastic the demand, the more the consumer pays • The more elastic the supply, the more the consumer pays • When supply is perfectly inelastic, the tax falls entirely on the producer

31. Deadweight loss Deadweight loss S + T S + T 2.60 S S 2.40 2.00 2.00 1.60 1.40 D1 D2 19 24 21 24 Elasticity of Demand and the Deadweight Loss from a Tax Price ($/unit) Price ($/unit) Quantity (units/day) Quantity (units/day) The lower the elasticity of demand, the greater the share of a tax paid by the consumer

32. What do you think? • Who pays the social security tax, employees or employers? • If the demand for food is inelastic, why is it not taxed in most states? • What would be the impact of a gasoline tax on gasoline on equity?

33. Tax progressivity • What is progressivity? • Higher marginal taxes? • Paying for more than what you get? • Are sales taxes progressive? • Is the US income tax progressive? • "Society is responsible for a very significant percentage of what I've earned," Warren Buffet • It takes a village to raise a millionaire • What can be said for and against progressive taxes?

34. Taxes and stability • High taxes slow down economic growth • Stabilization policy • Lower taxes when economy is bad • Increase taxes when economy is good