Public Finance MPA 405 Dr Khurrum S Mughal

Public Finance (MPA 405) Dr. Khurrum S. Mughal

Lecture 23: Taxation, Prices Efficiency, and the Distribution of Income Public Finance

Lump-Sum Taxes – A Lump-sum tax is a fixed tax that is owed by everyone and is not subject to something taxpayers can change. – It is independent of income, consumption, or wealth. – An example is a Head Tax, which is constant for everyone.

Inefficiency in Taxation and the Lump-Sum Tax • Inefficiency in taxation results from the ability to avoid taxes by avoiding a taxed activity. • Because lump-sum taxes are unavoidable, they serve as the benchmark by which other taxes are measured. • They only have income effects

Inefficiency in Taxation and the Lump-Sum Tax • No price distortion – Reduce buying power without affecting “MSB=MSC” – Doesn’t affect the attainment of efficient outcomes – Efficient allocation of resources with the pattern of demand originating from new demand due to new income distribution

Price Distorting Taxes • A price distorting tax is a tax that alters the relative price of goods. • Example: Tax on Gasoline – The budget line pivots on the y-axis shifts on x -axis – The purchase price increased for consumers – Also shows a scenario if a Lump-sum tax was applied instead

Price Distorting Tax Versus A Lump-Sum Tax Expenditure on Other Goods per Year (Dollars) A T L Y* T YT Y 1 E' E'' U 1 0 E U 2 B' L' QT QL Q 1 Gasoline per Year (Gallons) U 3 B

Implication • Individuals utility level declines in case of price distorting subsidy • Individual is much better off in case of lump-sum tax – There is no substitution effect since the product is not expensive relative to other goods

Unit Taxes • A unit tax adds to the price by a fixed amount. Examples include the 32 cents per pack of cigarettes and 24 cents per gallon of gasoline in federal taxes.

Tax Terms • The Gross Price (PG) is the price paid by consumers. • The Net Price (PN) is the price received by producers after the tax is paid. • PN = PG – T

Impact of A Unit Tax on Market Equilibrium • Example: Unit tax on Gasoline – The supply curve would shift left showing increased price at existing demand curve – The marginal social cost now includes tax. – Excess burden is created

Impact of A Unit Tax on Market Equilibrium ST = MSC +$0. 25 Price (Dollars) S = MSC Tax Revenue 1. 15 = PG 1. 00 0. 90 = PN C A Excess Burden B T = $0. 25 Q 0 D = MSB Q 1 Q* Gasoline per Year (Gallons)

Excess Burden of a Unit Tax DWL = 1/2 T Q =1/2 ×T 2 × (Q*/P*) × (ESED)/(ES – ED)

Implication of the DWL Calculation • A doubling of the per unit tax quadruples the Deadweight Loss. • Even if the revenue collected is returned to supplier and the seller, deadweight loss cannot be removed.

Excess Burden is Zero When Demand or Supply is Perfectly Inelastic A Demand Supply B after Tax Supply Price Supply Demand Net Price after Tax 0 q Quantity per Month

Efficiency Loss Ratio of a Tax • The Efficiency Loss Ratio is the deadweight loss per dollar of revenue raised DWL/R.