Ch 29. Public Choice Theory & the Economics of Taxation

1. Ch 29. Public Choice Theory & the Economics of Taxation

2. A. Public choice theory – economic analysis of gov’t decision making, politics, & elections. -- How/when/how much should gov’t intervene w/ externalities? -- Candidates offer alternative packages and voters choose.

3. Benefit; Tax Benefit; Tax 0 0 Public Choice Theory Inefficient Voting Outcomes Inefficient Majority “No” Vote Inefficient Majority “Yes” Vote -- Majority voting can produce inefficient decisions. -- (a) Majority voting leads to rejection of a public good that produce a greater public benefit than cost. -- (b) Results in accepting a public good with a higher cost than benefit. $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

4. B. Gov’t failure 1. Special interest effect 2. Rent seeking 3. Limited & bundled choice 4. Bureaucracy -- Failure due to inefficiency from certain characteristics of the public sector. -- Special interests: small group trying to get specific outcomes. -- Rent: payment beyond what’s necessary to keep a resource supplied; securing favorable gov’t policies that result in rent (higher profit or income) than normal. -- Bundled choice deals with Congress passing an Appropriations Bill that has many amendments (many w/ nothing to do with the bill); vote yea or nay.

5. C . The tax burden 1. Benefits-received principle 2. Ability-to-pay principle -- Benefits-received of taxation asserts businesses & households should purchase the goods & services of gov’t in same way as other commodities like a gas tax for road repairs. But, could the unemployed pay a tax for job training? -- Ability-to-pay taxation asserts that taxes are based on income & wealth. -- No scientific way to determine how much a person is able to pay in taxes.

6. 16th Amendment(Congress to levy the Income Tax, 1913) • Applied to mostly the rich when ratified in 1913. • Extended to nearly everyone to finance WWII. • 1943, withholding system adopted to ensure collections.

7. D. Taxes: 1. Progressive –  rate w/  income. 2. Proportional – rate stays same. 3. Regressive -  rate w/  income. -- The Federal tax system is Progressive. -- Overall U.S. tax system is only slightly Progressive (small redistribution of wealth). -- Many state & local tax systems are Regressive. -- In 1999, the lowest 20% of households paid an average of 4.6% Federal taxes. -- 1999, the top 10 % paid 30.6%.

8. “…nothing can be said to be certain except death and taxes.” -- Ben Franklin Types of Taxes: -- Personal income tax -- Corporate income tax -- Payroll tax -- Property tax -- Sales tax -- Excise tax (sin tax on alcohol or cigarettes) -- California’s ‘Proposition 13’ passed in 1978 capped the amount of property tax.

9. 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’ -- An excise tax of a specified amount, here $2 per unit, shifts the supply curve upward by the amount of the tax per unit: the vertical distance between S & St. -- This results in a higher price ($9) to consumers and a lower after-tax price ($7) to producers. -- Thus, consumers & producers share the tax burden (equally @ $1). S Tax $2 D

10. P P 0 0 Q Q Tax Incidence Demand Elasticity and the Incidence of an Excise Tax -- (a) if demand is elastic in the relevant price range, price rises modestly (P1 to Pe) with an excise tax. -- Producer bears most of burden. -- (b) If demand is inelastic, the price to the buyer rises drastically (P1 to Pi), most of tax on consumer. 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 • Elastic demand: product or resource demand whose price elasticity is greater than 1.  Inelastic demand: coefficient is less than 1.

11. P P 0 0 Q Q Tax Incidence Supply Elasticity and the Incidence of an Excise Tax -- With elastic supply, an excise tax results in a large price increase (P1 to Pe), tax paid mostly by consumers. -- (b) If supply is inelastic, the price rise is small (P1 to Pi), and seller bears most of 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 • Elastic supply: product or resource supply whose price elasticity is greater than 1.  Inelastic supply: coefficient is less than 1.

12. 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 -- The levy of a $2 tax per bottle of wine increases the price per bottle from $8 to $9 and reduces the equilibrium quantity from 15 to 12.5 million. -- Tax revenue to the gov’t is $25 million (area efac). -- The efficiency loss of the tax arises from the 2.5 million decline in output, the amount of that loss is shown as triangle abc. S’ Tax Paid by Consumers S Tax $2 Efficiency Loss (or Deadweight Loss) Tax Paid by Producers D

13. GLOBAL PERSPECTIVE Incidence of U.S. Taxes Taxes on Goods and Services as a Percentage of Total Tax Revenues -- A number of industrialized nations rely on a goods & services tax – sales tax, value-added taxes, and specific excise taxes – than the U.S. does. -- A value-added tax only applies to the difference between the value of a firm’s sales and the value of its purchases from other firms. 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

14. 100 80 60 Percentage of Income 40 20 0 20 40 60 80 100 Percentage of Households Area A Gini Ratio = Area A + Area B Facts About Income Inequality • Lorenz Curve and Gini Ratio e Lorenz Curve (Actual Distribution) The Lorenz Curve Perfect Equality d A B c Complete Inequality b a f

15. 100 80 60 Percentage of Income 40 20 0 20 40 60 80 100 Percentage of Households Facts About Income Inequality • Effect of Gov’t Redistribution Lorenz Curve After Taxes and Transfers Lorenz Curve Before Taxes and Transfers Impact of Government Taxes and Transfers