Introduction Thinking Like an Economist CHAPTER 7 Taxation

Introduction: Thinking Like an Economist CHAPTER 7 Taxation and Government Intervention © 2017 Mc. Graw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education. 1

Chapter Goals Ø Show equilibrium maximizes consumer and producer surplus Ø Demonstrate the burden of taxation to consumers and producers Ø Explain how government intervention is a type of implicit taxation Ø Define rent seeking and show it is related to elasticity © 2017 Mc. Graw-Hill Education. All Rights Reserved. 2

Producer and Consumer Surplus Ø Consumer surplus is the value the consumer gets from buying a product, less its price • It is the area below the demand curve and above the price Ø Producer surplus is the price the producer sells a product for less the cost of producing it • It is the area above the supply curve but below the price the producer receives © 2017 Mc. Graw-Hill Education. All Rights Reserved. 3

Consumer and Producer Surplus P $10 9 8 7 6 5 4 3 2 1 Consumer surplus = area of red triangle = ½($5)(5) = $12. 5 S Producer surplus = area of green triangle = ½($5)(5) = $12. 5 CS PS D 0 1 2 3 4 5 6 7 8 Q The combination of producer and consumer surplus is maximized at market equilibrium © 2017 Mc. Graw-Hill Education. All Rights Reserved. 4

Producer and Consumer Surplus P $10 9 8 7 6 5 4 3 2 1 Lost surplus or “Deadweight Loss” or “Welfare Loss” When price deviates from its equilibrium, combined consumer and producer surplus falls. There is a loss of total surplus when price is $1 higher than equilibrium price. S CS PS D 0 1 2 3 4 5 6 7 8 Q © 2017 Mc. Graw-Hill Education. All Rights Reserved. 5

The Burden of Taxation P S If there is no tax, market equilibrium is reached and consumer and producer surplus is maximized P D Q Q © 2017 Mc. Graw-Hill Education. All Rights Reserved. 6

The Burden of Taxation A tax paid by the supplier shifts the supply curve up by the amount of the tax (t) Consumer surplus is represented by areas A, B, and C before the tax and area A after the tax. Producer surplus is represented by areas D, E, and F before the tax and area F after the tax. Government collects tax shown by areas B and D. P Deadweight Loss of area C and E S 0 A P 1 P 0 P 1 -t S 1 t B D C E F D Q 1 © 2017 Mc. Graw-Hill Education. All Rights Reserved. Q 0 Q 7

The Burden of Taxation The costs of taxation include: Ø Direct cost of the tax to consumers and producers Ø The deadweight loss, or welfare loss of CS and PS that is NOT gained by gov’t Ø The administrative costs of compliance, resources used by the government to administer and others to comply © 2017 Mc. Graw-Hill Education. All Rights Reserved. 8

The Burden of Taxation Who bears the burden of tax? Ø One who physically pays it is not necessarily the one who bears burden Ø The more inelastic one’s relative D or S, the larger the tax burden one will bear • If Dis more inelastic than S, consumers will pay higher share • If Sis more inelastic than D, suppliers will pay higher share © 2017 Mc. Graw-Hill Education. All Rights Reserved. 9

What Goods Should Be Taxed? Goal of Government Most effective when Raise revenue, limit deadweight loss D or S is inelastic Change behavior D or S is elastic Elasticity Who bears the burden? D inelastic and S elastic Consumers S inelastic and D elastic Producers Both S and D elastic Shared, but one whose S or D is more inelastic pays more © 2017 Mc. Graw-Hill Education. All Rights Reserved. 10

The Burden of Taxation D is relatively elastic D is relatively inelastic P P S 1 Producers pay more t S 0 Consumers pay more t P 1 S 1 S 0 P 0 P 1 -t D Q 1 Q 0 Q © 2017 Mc. Graw-Hill Education. All Rights Reserved. D Q 1 Q 0 Q 11

The Burden of Taxation How to calculate the fraction of the tax borne: Fraction of tax borne by demander Fraction of tax borne by supplier © 2017 Mc. Graw-Hill Education. All Rights Reserved. 12

The Burden of Taxation The tax burden is independent of who pays the tax P P Supplier pays the tax, S shifts Consumer pays the tax, D shifts S 1 t S 0 S P 1+t P 0 P 1 -t P 1 D Q 0 Q 1 Q t D 0 D 1 Q 0 © 2017 Mc. Graw-Hill Education. All Rights Reserved. Q 13

Tax Incidence and Current Policy Debates Social Security Taxes • Both employer and employee contribute the same percentage of wages to the Social Security fund, but don’t share burden equally • Labor S tends to be less elastic than labor D, so the Social Security tax burden is primarily on employees © 2017 Mc. Graw-Hill Education. All Rights Reserved. 14

Tax Incidence and Current Policy Debates Sales Taxes Ø Sales taxes are paid by retailers on basis of sales revenue Ø Since sales taxes include most goods and services, consumers find it hard to substitute to avoid the tax Ø D is inelastic so consumers bear the greater burden of the tax Ø As consumers increase purchases on the Internet where sales are not taxed, retail stores will bear greater burden of sales tax © 2017 Mc. Graw-Hill Education. All Rights Reserved. 15

Government Intervention as Implicit Taxation Ø An effective price ceiling is a gov’t set price below the mkt equil. price • Acts as implicit tax on producers and an implicit subsidy to consumers, causes welfare loss identical to loss from tax Ø An effective price floor is a gov’t set price above mkt equil. • Acts as tax on consumers and subsidy for producers, transfers consumer surplus to producers © 2017 Mc. Graw-Hill Education. All Rights Reserved. 16

Application: The Effect of a Price Ceiling An effective price ceiling is set below market equilibrium price P S A P 0 P 1 B C D F A price ceiling P 1 transfers surplus D from producers to consumers, generates deadweight loss, and reduces equilibrium quantity Price ceiling F Shortage Q 1 Q 0 D Q © 2017 Mc. Graw-Hill Education. All Rights Reserved. 17

Application: The Effect of a Price Floor An effective price floor is set above market equilibrium price P Surplus P 1 A P 0 S Price floor B C D E F D Q 1 Q 0 A price floor P 1 transfers surplus B from consumers to producers, generates deadweight loss, and reduces equilibrium quantity Q © 2017 Mc. Graw-Hill Education. All Rights Reserved. 18

The Difference Between Taxes and Price Controls Ø Price ceilings create shortages; taxes do not Ø Taxes leave people free to choose how much they want to supply and consume as long as they pay the tax Ø Shortages may also create black markets © 2017 Mc. Graw-Hill Education. All Rights Reserved. 19

Rent Seeking, Politics, and Elasticities Ø Rent-seeking activities: designed to transfer surplus from one group to another Ø Ex: Lobbying for price controls Ø Individuals spend money and use resources to lobby governments to institute policies that increase their own surplus Ø Public choice economists argue that the taxes and the benefits of government programs offset each other and do not help society significantly, but they do cost resources © 2017 Mc. Graw-Hill Education. All Rights Reserved. 20

Inelastic Demand Incentives to Restrict Supply Ø When D is inelastic, increases in productivity (shifts S right) results in lower revenue for suppliers Ø Suppliers have incentive to get gov’t to restrict S or create a price floor to raise supplier revenue Ø General rule of political economy: small groups significantly affected by a gov’t policy will lobby more effectively than large groups affected by that policy © 2017 Mc. Graw-Hill Education. All Rights Reserved. 21

Inelastic Demand Incentives to Restrict Supply When D is inelastic, increases in productivity cause suppliers to gain area B, but they lose the much larger area A. Suppliers have an incentive to restrict S when D is inelastic so they can increase revenues. P S 0 S 1 P 0 A B Q 1 Q 0 D Q © 2017 Mc. Graw-Hill Education. All Rights Reserved. 22

Inelastic Supplies and Incentives to Restrict Prices Ø When S is inelastic, consumers have incentives to restrict prices Ø When S is inelastic and D increases, prices increase causing consumers to lobby for price controls Ø Ex: Rent control in NYC © 2017 Mc. Graw-Hill Education. All Rights Reserved. 23

Application: Price Floors and Elasticity With elastic curves, a large surplus is created by price controls; with inelastic curves, a small surplus is created. P P Surplus S P 1 P 0 Price floor D D Q 1 Q 0 Q Q 1 Q 0 © 2017 Mc. Graw-Hill Education. All Rights Reserved. Q 24

Chapter Summary Ø Consumer surplus is the net benefit a consumer gets from purchasing a good, while producer surplus is the net benefit a producer gets from selling a good Ø Equilibrium maximizes the combination of consumer and producer surplus Ø Taxes create a loss of consumer and producer surplus known as deadweight loss, which is graphically represented by the welfare loss triangle Ø The cost of taxation to consumers and producers includes the actual tax paid, the deadweight loss, and the costs of administering the tax © 2017 Mc. Graw-Hill Education. All Rights Reserved. 25

Chapter Summary Ø Relative elasticities determine who bears the burden of the tax. The more inelastic one’s demand or supply, the larger the burden of the tax. Ø Price ceilings and floors, like taxes, result in loss of consumer and producer surplus Ø Price ceilings transfer producer surplus to consumers; they are a tax on producers and a subsidy to consumers. Price floors have the opposite effect. Ø The more elastic supply and/or demand is, the greater the surplus with an effective price floor and the greater the shortage is with an effective price ceiling © 2017 Mc. Graw-Hill Education. All Rights Reserved. 26