Basics of Taxation: Theory & Practice for Efficiency in Income Distribution

1. Taxation, income distribution, and efficiency Today: Some basic tax theory

2. Begin Unit 4 • Today • Chapters 14 and 15 • An introduction to some basic theories related to taxation

3. Taxation • Taxes are typically used to finance public projects • Deadweight loss comes with most forms of taxation

4. Taxation and income distribution • The US federal tax system has been set up so that people with high incomes have higher average tax rates • Do people consume more leisure with high marginal tax rates? • To be answered later • Public project financing • People with high tax rates probably have high willingness to pay for many public projects • See Table 14.3, p. 327

5. Some terminology • Statutory incidence • Who legally has to pay for the tax • Economic incidence • How much does real income change to all parties due to a tax?

6. Some terminology • Lump sum tax • A tax that has to be paid no matter how a person behaves • Proportional tax • Average tax rate is independent of income • Progressive tax • Average tax rate increases with income • Regressive tax • Average tax rate decreases with income

7. Some terminology • Unit tax • A tax that is paid per unit of a good • Ad valorem tax • A tax that is a percentage of the purchase price

8. Partial equilibrium models • With partial equilibrium models, only one market is examined at any one time • Ignores possible spillover effects • Usually easier to analyze than general equilibrium models • Two types of taxes analyzed • Unit tax • Ad valorem tax

9. Unit tax • You have likely seen unit taxes before • Econ 1 (or equivalent) • Econ 100A/B (or equivalent) • Either the buyer or seller pays a given dollar amount for each unit sold or purchased

10. $ 0 Partial Equilibrium Models $1.20 $1.40 $1.00 $1.20 S1 S0 D1 D0 Quantity

11. Ad valorem taxes • Assume that the consumer pays an ad valorem tax • Example: 6% sales tax • The ad valorem tax shifts the demand curve by the same percentage (relative to the horizontal axis) • See Figure 14.7, p. 315

12. Other types of taxes • Taxes from working • Income tax • Social Security tax • Hospital insurance tax (Medicare) • Capital taxes • Taxes on profits • Accounting profits • Economic profits

13. Tax incidence and capitalization • Suppose that we value land as the net present value of the yearly income from the land • Assume that the land has value for T years • T could be infinity • Then the value of the land will be PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T

14. Tax incidence and capitalization • Suppose that a new tax is implemented on each piece of land • Yearly income falls by the amount of the tax • New value of the land • PR’ = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)T • Value of the land drops by u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T

15. Tax incidence and capitalization • Capitalization process • When a new tax is implemented, the new price falls by the net present value of the total taxes that will have to be paid

16. General equilibrium models • When a tax affects a large portion of the economy, partial equilibrium models may not accurately predict the overall effects to the economy • General equilibrium models are needed to analyze situations that affect more than one market

17. Changes in consumption due to taxes • Recall that people typically consume less of a good or service once it is taxed • Example: Yacht tax in the early 1990s • Tax on yachts over $100,000 purchased in the US • People bought yachts in other countries • Net economic impact • $16.6 million in taxes collected (less than the $31 million predicted) • Less income tax paid by workers (7,600 jobs lost in the US)

18. Study of taxation graphically • Individual behavior • See Figure 15.2, p. 333 • Excess burden in a market with horizontal supply • See Figure 15.5, p. 340 • Taxes on labor • See Figure 15.7, p. 343, and Figure 15.9, p. 347 • Subsidies • See Figure 15.6, p. 342 • Pigouvian taxes • See Figure 5.4, p. 83

19. Recall double dividend hypothesis • Industry with negative externality • Pigouvian tax  Reduces excess burden • If tax proceeds are used to reduce other taxes, excess burden from these taxes are lowered • Criticism: An environmental tax could lead to an increase in the excess burden in the labor market

20. An economist’s analysis • Given an amount of revenue that is generated, taxes should be imposed such that one of the following goals is achieved • Excess burden is minimized • Social welfare is maximized

21. The real world • Taxes are often imposed that have the lowest amount of political resistance • Excess burden seems less important than revenue generation • Sometimes efficiency is completely ignored

22. How does personal income get taxed? • The personal tax system used by the federal government requires many steps to understand • Chapter 17 • Highlight the basic structure, marginal tax rates, and other aspects of the federal tax structure • For next lecture: Read p. 380-406

23. Today vs. tomorrow • With a tax system currently in place, we should ask how changes in tax policy affect current and future behavior • Chapter 16 has more on this • Marginal excess burden • Tax avoidance versus tax evasion • Focus reading on p. 353-362 and 370-376 for next lecture

24. Summary • Taxation of efficient markets typically leads to excess burden • Unit tax • Ad valorem tax • Taxes on land lower the income potential for the land, lowering its value • Subsidies usually lead to excess burden also