Public Finance MPA 405 Dr Khurrum S Mughal
Public Finance (MPA 405) Dr. Khurrum S. Mughal
Lecture 24: Taxation, Prices Efficiency, and the Distribution of Income Public Finance
Incidence of a Tax • The Legal Incidence is the burden of a tax as determined by who is legally obligated to pay the tax. • The Economic Incidence is the burden of a tax as determined by how much the parties are affected in terms of paying higher prices, or receiving lower prices.
Shifting of Taxes • Forward Shifting is the transfer of the burden of the tax from the seller, who is legally obligated to pay it, to the buyer. – Gasoline example • Backward Shifting is the transfer of the burden of the tax from the buyer, who is legally obligated to pay it, to the seller. – Payroll tax if income decreases
Ad-Valorem Taxes • Ad-Valorem Taxes add a fixed percentage to the price of a good. • The primary example is sales taxes. • Higher the price of the good, greater is the tax per unit • T=t. P • The tax increases automatically with increase in the price of the good
Incidence of an Ad-valorem tax DWL = 1/2 T Q T = t. PG = 1/2 t 2 PG 2(Q*/P*) × (ESED)/(ES – ED) if t is very small, then P*=PG, = 1/2 t 2 P*Q*(ESED)/(ES – ED)
Wages (Dollars) Impact of an Ad Valorem Tax on Labor Excess S Burden A WG = 5. 20 5. 00 WN = 4. 16 E E' Tax Revenue D = Gross Wage Net Wage = WG (I – t) 0 Q 1 Q* Labor Hours per Year
Independence of Legal and Economic Incidence • It does not matter whether the buyer or seller is legally liable for a tax. • The economic incidence of the tax is determined by supply and demand elasticities, the amount of the tax, and the original equilibrium price and quantity.
Incidence of a Tax Collected From Buyers S = MSC C Price (Dollars) PG + T =1. 15 1. 00 PG = 0. 90 A B D = MSB D' = MSB – T 0 Q 1 Q* Price per Year (Gallons)
Implication • The result is exactly the same distribution of tax burden that prevailed when tax was collected from sellers.
The More Inelastic the Demand, the Greater the Portion of a Tax Borne by Buyers Price (Dollars) S = MC + $0. 25 C 1. 20 1. 15 1. 00 . 95 . 90 S = MC E B A Q’ D’ Q’ 0 D Q 1 Q 2 Q* Gasoline per Year (Gallons)
Price (Cents) Impact of a Tax on a Good with a Perfectly Elastic Supply 60 50 E' E MC + T = S' MC = S' D 0 Q 1 Q* Housing per Month Square Feet
Impact of a Tax on a Good with a Perfectly Elastic Supply • Generally the supply of goods and services is more elastic in the long run than in the short run. • Therefore, buyers are more likely to pay the taxes in the long run. • Industries where resources can be easily shifted for other use have elastic supply curves in long run.
Tax Incidence When Market Supply is Perfectly Inelastic Wages (Dollars) S E W*G tw*G WN= W*G (1– t ) F D=W WN= WG (1– t) 0 Q* Labor Hours per Year
Shifting Under Imperfect Competition • Monopolists can shift less of a given tax forward to consumers than competitive industry.
Shifting Under Monopoly Price MC + T MC PMT PM PM P*T P* P* D QM Q* MR QMT QM Q*T Q* Output per Year
General Equilibrium Analysis and Shifting • When one good is taxed another good is not taxed, the impact of the tax is not confined to the taxed good. • Because a tax on one good lowers the profit that can be made to firms producing it, they may shift their productive resources to the other good so as to maximize their after-tax rate-of-return in both markets. • This has the effect of equalizing the after-tax rate -of-return.
General Equilibrium Analysis and Shifting • Complex inter-related markets – Tax in one markets affects other • Tax on electricity consumption – Electrical appliances – Natural Gas – Products whose production needs electricity as an input
Multimarket Analysis of Excess Burden (Minimizing the excess burden) Price A B E 2 E 1 PF(1 + t) PF A QF S' S E 2 PC(1 + t) E 1 PC B S' S DC QC DF QF 2 QF 1 0 QC 2 QC 1 Clothing per Year
Implication • Efficiency loss can be minimized – Goods are taxed at rates that decrease with elasticity of demand • More inelastic demand needs higher tax • Efficient system of taxes will have to face political opposition
Multimarket Analysis Incidence A S' = MC + T Price S S E 2 PG P* PN B S' E 1 P P'F E 1 E 2 D Q' Q* 0 Clothing per Year D 0 QF Q'F Food per Year
Implication • Price of clothing to increase but that of food to decrease • Effect on specialized capital and labor of clothing industry
The Lorenz Curve • The Lorenz Curve maps the cumulative percentage of households against their cumulative percentage of income.
Figure 11. 12 A Lorenz Curve Percentage of Real Income 100 E Line of Equal Distribution 75 y 60 50 25 20 10 5 3 0 Area A Area B x 10 25 50 75 Percentage of Households D 100
The Gini Coefficient • The Gini Coefficient is the ratio of the area between the Lorenz curve and the perfect equality line (Area A in the previous slide) to the area under the perfect equality line (Areas A and B). • Closer to zero represents equality in distribution
Budget Balance and Government Debt Public Finance
Budget Terms • A Budget Surplus exists when Tax Revenues are greater than Expenditures and is the difference between the two. • A Budget Deficit exists when Expenditures are greater than Tax Revenues and is the difference between the two. • The National Debt is the sum of deficits minus the sum of all surpluses
Controversies Over What To Do With the Current Surpluses Options • Pay off portions of the national debt • Cut taxes • Increase spending on programs • Set surpluses aside to make Social Security and Medicare more solvent
High-Employment Deficit or Surplus • The budget balance is altered significantly by the state of the economy. – Size of budget deficit or surplus varies with business cycles • If GDP is rising quickly, then fewer people are drawing on the welfare state and more are paying taxes. • Deficits and Surpluses can be attributed to – current year economic activity – Structural imbalances between revenue and expenditure
High-Employment Deficit or Surplus • The high-employment deficit or surplus is what the surplus would be if unemployment were low. – usually estimated at 5 -6% – Deficits receipts and expenditure if 95 -96 were employed • Economists often prefer this measure to the actual level of the deficit or surplus when advocating policy.
Unified Budget • The Unified Budget is the sum of the on- and off-budget deficits and surpluses. • If this is a net deficit, then the government must borrow new money from the public. • If it is a net surplus, then it is a net provider of capital to the private sector.
Real Surpluses and Deficits • Real Surpluses and Real Deficits are expressed in inflation-adjusted terms.
Economic Effects of Federal Budget Deficits • Deficits can be financed by taxes or issuing bonds – Borrowing rather than taxing can improve votes for a politician – Borrowing postpones the burden of taxation
Government Demand for Loanable Funds and the Market Rate of Interest Rate S E' i 2 E i 1 D 1 + DG D 1 0 L 1 L 2 Loanable Funds per Year
Ricardian Equivalence • Ricardian Equivalence is the view that deficits do not alter interest rates because citizens today see that deficits today will be financed with higher taxes tomorrow and citizens save in order to have the funds to pay those higher taxes.
Ricardian Equivalence: Deficits Do Not Affect Interest Rates S Interest Rate S' i 2 i 1 E' E E'' D 1 + DG L 0 D 1 L 2 L 3 Loanable Funds per Year
Economic Effects of Federal Budget Surpluses • Unified budget surpluses allow government to provide capital to the loanable funds market.
Impact of a Budget Surplus on Credit Markets Interest Rate S S' = S 1 + L E I 1 E' I 2 D 0 L L 1 L 2 Loanable Funds per Year
Budget Balance, National Saving, and Economic Growth • An increase in the deficit contributes to a decrease in national savings while an increase in a surplus contributes to a increase in national savings. • Increases in national savings increases the potential for the economy to grow.
Incidence of Deficit Finance • Lower growth rates imply lower incomes for future generations. • If Ricardian Equivalence holds, then this is not the case. • Deficits may also change political equilibrium so that there are increases in government infrastructure that could lean to increased future growth.
The Government Debt • Mid-2000 – Federal Debt $5. 66 trillion – State and Local Debt $1 trillion
Figure 12. 6 Federal Debt Held by the Public as a Share of GDP (By fiscal year) Percentage of GDP 120 100 80 60 40 20 0 1940 1950 1960 1970 1980 1990 2000
Net Federal Debt • The Net Federal Debt is the portion of the debt not held by the federal government.
Gross public Debt of the US Treasury by Holder July 31, 2000 Holder Amount of Debt (Billions of Dollars) Percent of Total U. S. Govt. Agencies Trust Funds and Federal Reserve 2, 229. 5 39. 4 Private Investors 3, 429. 3 60. 6 Total 5, 658. 8 100. 0
Net Public Debt of the U. S. Treasury by Holder (Percent Distribution) December 1999 Holder Depositors and Institutions Mutual Funds Insurance Companies Pension Funds State and Local Governments Percentage of Total 7. 6 10. 9 4. 2 13. 8 6. 6 Foreign and International 39. 2 Other Investors 17. 7 Total 100
Internal and External Debt • The Internal Debt is the portion of the debt owed to our own citizens. • The External Debt is the portion of the debt owed to people other than U. S. citizens.
State and Local Borrowing • Bonds are issued by state and local governments to fund large projects. • They are rated by financial companies for their riskiness. • Similar to federal debt, much of it is held externally.
General Obligation vs Revenue Bonds • General Obligation Bonds are backed by the state or local government’s ability to tax. • Revenue Bonds are backed by the revenue that a state or local enterprise would generate.
Social Security and the Deficit • Social Security Surpluses are used to purchase federal government debt. • This will happen until benefits exceed revenues (estimated to be 2023). • Thereafter it will run deficits and will be forced to sell off those bonds. • Whether Social Security is on- or off-budget and whether or not there is a trust fund has no effect on the net national debt.
Burden of the Debt • Impact on future generations: – People have to pay increased taxes to pay interest on that debt. – Some may inherit the original bonds. – Growth rates are reduced because of higher interest rates. • These impacts can be offset by the increased private savings of the generation that does the borrowing, or by returns that come from programs that were funded by the borrowing.
European Union • Entry into the EU required that members have – inflation rates no more than 1. 5 percentage point more than that of the three lowest inflation countries. – interest rates on government debt be no more than 3 points higher than that of the three lowest interest countries. – government deficit as a percentage of GDP be no greater than 3% and debt no more than 60% of GDP.
EU Deficit and Debt Figures Nation Belgium Surplus/Deficit as a Debt as a percentage of GDP percentage of 1998 GDP 1998 – 0. 9 118. 2 Germany – 2. 0 61. 1 France – 2. 9 58. 8 Italy – 2. 7 118. 7 Sweden 1. 9 74. 2 United Kingdom 0. 5 48. 7
What Should be Done With Surpluses? • • Social Security and Medicare solvency Tax Cuts Other Spending Programs Reduce National Debt
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