Chapter 7: Taxes

Why is the progressive taxation system inefficient?

- A progressive tax system is more fair because it focuses on the ability-to-pay principle, however it decreases the incentive for people to invest time and effort to raise their earnings.

What is a profits tax?

- A tax on an incorporated firms profits

What is a wealth tax?

- A tax on an individual's wealth

Explain why there is often a trade-off between equity and efficiency in tax systems?

- A tax system can be made more fair by moving it in the direction of the benefits principle or the ability to pay principle. - However, this comes at a cost of reduced efficiency, because the tax people pay is now more heavily based on their actions. - This increases deadweight loss -> inefficiency.

How should a tax system be designed in terms of efficiency?

- A tax system should be designed to minimize the total inefficiency it imposes on society.

What is payroll tax?

- A tax that depends on the earnings an employer pays to an employee

What is an income tax?

- A tax that depends on the income of an individual or family from wages and investments

What is a sales tax?

- A tax that depends on the value of the goods sold

What is a property tax?

- A tax that depends on the value of the property, such as the value of a home

What is a lump-sum tax?

- A tax that is the same for every person, regardless of any actions people take.

What is a sin tax?

- A tax that is used to discourage undesirable behaviour.

What is a progressive tax?

- A tax that takes a larger share of the income of high-income taxpayers than of low-income tax-payers.

What is a regressive tax?

- A tax that takes a smaller share of the income of high income taxpayers than of low-income tax payers.

If the price elasticity of demand and supply are high, how will an increase in the tax rate affect tax revenue?

- Less certain - If the elasticities are high enough, the tax increase will reduce the quantity bought and sold. - Tax revenue will decrease.

Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax. b) A local tax of 20% on hotel rooms that finances local government expenditures.

- Ability to pay principle, because the payers are nonresidents of the local area, but the beneficiaries are local residents who will enjoy greater government services. - People who stay in hotels have higher income compared to those who don't. - It will distort the action of staying in a hotel room in this area, resulting in fewer nights of hotel room stays.

What is an administrative cost?

- An administrative cost is the resources used by government to collect the tax, and by taxpayers to pay it, over an above the amount of the tax - Resources used to evade the tax, legally and illegally - Example: money spent on accountants, time spent filling out tax forms

What is an excise tax?

- An excise tax is a per unit tax on sales of a good or service.

Explain how an excise tax causes deadweight loss?

- An excise tax means that the price of the good increases for consumers, and the price received by producers decreases. - An increase in price causes a loss in consumer surplus - A decrease in price causes a loss in producer surplus. - Some of the surplus that is lost is transferred to the government in the form of tax revenue. - There is still a portion of lost consumer and producer surplus that is not transferred to the government, this is the deadweight loss that is generated by the excise tax.

What is the effect of an excise tax, in terms of the quantity of goods and services bought and sold?

- An excise tax reduces the quantity of goods bought and sold. - Some people will no longer purchase the good due to increased prices. - Some producers will no longer supply the good due to decreased prices.

Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax. a) A federal tax of $500 for each new car purchased that finances highway safety programs.

- Benefits principle, because drivers are the beneficiaries of highway safety programs. - The level of the tax does not depend on ability to pay the tax - A $500-per-car tax will cause people to buy fewer new cars.

Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax. d) A 1% sales tax on food that pays for government food safety regulation and inspection programs

- Benefits principle, because food consumers are the beneficiaries of government food safety programs. - It does not perform well according to the ability-to-pay principle because food is a necessity, and lower-income people will pay approximately as much as higher-income people. - This tax will distort the action of buying food, leading people to purchase cheaper varieties of food.

Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax. c) A local tax of 1% on the assessed value of homes that finances local schools

- Benefits principle, because local homeowners are the users of the schools AND - Ability to pay principle, because it as assessed a percentage of the home value. It will distort the action of buying a house in this area versus another area with a lower property tax rate. - It could also distort the action of making improvements to a house that would increase its assessed value.

When either demand, supply or both are elastic, describe the value of the deadweight loss due to an imposed excise tax?

- Elastic: the quantity demanded or supplied is relatively responsive to changes in price - A tax imposed on a good with elastic demand, supply OR both will cause a relatively large decrease in the quantity transacted. - This results in a relatively large deadweight loss.

What determines the incidence of an excise tax?

- Elasticity, not the government!

True or False? Payroll taxes do not affect a person's incentive to take a job because they are paid by employers.

- False. Recall that a seller always bears some burden of a tax as long as his or her supply of the good is not perfectly elastic. Since the supply of labour a worker offers is not perfectly elastic, some of the payroll tax will be borne by the worker, and therefore the tax will affect the person's incentive to take a job.

True or False? A lump-sum tax is a proportional tax because it is the same amount for each person.

- False. Under a proportional tax, the percentage of the tax base is the same for everyone. Under a lump-sum tax, the total tax paid is the same for everyone, regardless of their income. A lump-sum tax is regressive.

What is the relationship between tax rate and tax revenue?

- In general, it is not a one-to-one relationship, i.e. doubling the tax rate WILL NOT double tax revenue, because the tax increase will reduce the quantity of the good or service that is transacted. - Also, increasing tax rates does not always increase tax revenue. Increasing the tax rate can decrease the amount of tax revenue that is generated.

What is incidence?

- Incidence is a measure of who really pays the tax.

When both demand and supply are inelastic, describe the value of the deadweight loss due to an imposed excise tax?

- Inelastic: the quantity demanded or supplied is relatively unresponsive to changes in price - A tax imposed on a good with inelastic demand and supply will cause a relatively small decrease in the quantity transacted. - This results in a relatively small deadweight loss.

What is the effect on the equilibrium price/quantity when an excise tax is imposed on producers? What is the effect on the equilibrium price/quantity when an excise tax is imposed on consumers?

- It doesn't matter if the tax is levied on producers or consumers, the equilibrium outcome will be the same.

Why is the benefits principle useful?

- It makes sense to charge each person in proportion to the benefits he or she gets from those goods, specifically public goods. - Example: road maintenance

If the initial tax rate is high, how will an increase in the tax rate affect tax revenue?

- Less certain. - Tax revenue is likely to fall or rise very little from a tax increase only in cases where elasticities are high and there is already a high tax rate.

Does the incidence of a tax usually fall evenly between consumers and producers?

- No, usually one group will bear more burden than the other.

If the initial tax rate is low, how will an increase in the tax rate affect tax revenue?

- Not much revenue is lost from the decline of the quantity bought and sold. - The tax increase will definitely increase tax revenue.

If you want to minimize the efficiency costs of taxation, which goods should be taxed?

- Only goods that have an inelastic demand and supply should be taxed.

In what cases will a tax imposed to decrease harmful activity be effective?

- Only when either demand OR supply OR both are elastic

What is a tax structure?

- Specifies how the tax depends on the tax base. - Usually expressed in percentage terms

How is the total inefficiency caused by a tax calculated?

- Sum of the deadweight loss and and administrative costs

If the quantity transacted decreases, other things equal, what is the effect on tax revenue?

- Tax revenue decreases, because the tax increase reduces the quantity of sales.

If tax rates increase, other things equal, what is the effect on tax revenue?

- Tax revenue will increase, because the government receives more for each unit of the good or service sold.

What is a tax rate?

- The amount of tax people are required to pay per unit of whatever is being taxed.

How is the value of the deadweight loss calculated when an excise tax has been imposed?

- The area of the triangle whose base is the size of the wedge between the price paid by consumers and the price received by producers and the height is equal to the reduction in the quantity bought and sold.

What is the incidence of a tax when price elasticity of demand is low, and the price elasticity of supply is high?

- The burden of an excise tax falls mainly on consumers. - A low price elasticity of demand means that consumers have few substitutes, and are less responsive to changes in price. - A high price elasticity of supply means that producers have many production substitutes, and are more responsive to changes in price. - When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers.

What is the incidence of a tax when when the price elasticity of demand is high, and the price elasticity of supply is low?

- The burden of an excise tax falls mainly on producers. - A high price elasticity of demand means that consumers have many substitutes, and are more responsive to changes in price. - A low price elasticity of supply means that producers have few production substitutes, and are less responsive to changes in price. - When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers.

The demand for economics textbooks is very inelastic, but the supply is somewhat elastic. What does this imply about the incidence of an excise tax?

- The consumers bear more of the burden of the excise tax.

If the quantity bought and sold after imposing an excise tax is the same as before the tax was imposed, what can be said about the value of the deadweight loss?

- The deadweight loss will be zero, because the excise tax does not prevent mutually beneficial transactions from occurring. - The excise tax simply shifts consumer and producer surplus to the government.

What is the effect on the demand curve when an excise tax has been imposed on the consumer?

- The demand curve will shift downwards by the amount of the tax. - In order for consumers to be willing to purchase the same quantity post-tax as they would pre-tax they must decrease the amount paid by an amount equal to the amount of the tax. - However, from the point of view of the consumer, they are still operating at the original demand curve, because they do not receive a lower price for the good.

What determines how the burden of an excise tax is allocated between consumers and producers?

- The incidence of an excise tax depends on the price elasticity of supply and the price elasticity of demand.

What is a tax base?

- The measure or value, such as income or property value, that determines how much tax an individual or firm pays.

What is a marginal tax rate?

- The percentage of an increase in income that is taxed away.

What is the benefits principle?

- The principle of tax fairness that those who benefit from public spending should bear the burden of the tax that pays for that spending.

What is the ability-to-pay principle?

- The principle of tax fairness that those with greater ability to pay more tax should pay more tax. - Example: high-income individuals should pay more than low-income individuals

The supply of bottled spring water is very inelastic, but the demand for it is somewhat elastic. What does this imply about the incidence of a tax?

- The producers bear more of the burden of the excise tax.

What is proportional tax?

- The simplest tax structure - A tax that is the same percentage of the tax base regardless of the taxpayer's income or wealth

How is the revenue generated by an excise tax calculated?

- The size of the wedge that the tax drives between the supply price and the demand price multiplied by the quantity bought and sold.

What is the effect on the supply curve when an excise tax has been imposed on the producer?

- The supply will shift upwards by the amount of the tax. - In order for producers to be willing to supply the same quantity post-tax as they would pre-tax they must receive an additional amount, equal to the amount of the tax. - However, from the point of view of the producer, they are still operating at the original supply curve, because they do not receive a higher price for the good.

If price elasticity of demand and supply are low, how will an increase in tax rates affect tax revenue?

- The tax increase won't reduce the quantity bought and sold very much. - Tax revenue will increase.

Why is it impossible to base the entire tax system on the benefits principle?

- Too difficult to have a specific tax for each of the distinct programs that the government offers.

True or false? Other things equal, consumers would prefer to face a less elastic supply curve for a good or service when an excise tax is imposed.

- True, because if supply is inelastic, more of the burden of the tax falls on producers, not consumers.

Why doesn't a lump-sum distort incentives?

- Under a lump-sum tax, people have to pay the same amount of tax regardless of their actions, meaning that it does not lead them to change their actions. - Therefore, a lump-sum tax causes no deadweight loss. - This is more efficient, but less fair. ** There is normally a tradeoff between equity and efficiency.**

What is the effect of an excise tax, in terms of the price at which goods and services are bought and sold?

- When an excise tax is imposed it produces a wedge between the price paid by consumers and the price received by producers. - Consumers pay more for a good or service than the amount received by producers.

What is the tax system in Canada?

Progressive (mostly)

True or false? When a substitute for a good is readily available to consumers, but it is difficult for producers to adjust the quantity of the good produced, then the burden of a tax on the good falls more heavily on producers.

True, because demand is elastic and supply is inelastic.

If demand is perfectly inelastic, what is the value of the deadweight loss after an excise tax has been imposed?

ZERO

If supply is perfectly inelastic, what is the value of the deadweight loss after an excise tax has been imposed?

ZERO

What is the cost of taxation?

i) Cost of the paid tax, in other words, the tax revenue collected by the government. ii) The value of the forgone mutually beneficial transactions, or deadweight loss! iii) Resources used by the government to collect the tax iv) Resources used by taxpayers to pay the tax.

What are the two principles of tax fairness?

i) The benefits principle ii) The ability-to-pay principle