Mankiw Chapter 8

Principle of Microeconomics

Chapter 8 Cost of taxation Selected materials from chapter 10 and 12

Tax places a wedge between the price paid by buyers and the price received by sellers. The quantity traded falls.
Price Price buyers pay Supply

Price without tax

Size of tax

Price sellers receive Demand 0 Quantity with tax Quantity without tax Quantity

Principle of Microeconomics Zhao

Mankiw Chapter 8

Main purpose of tax is revenue

Government tax revenue = tax times quantity sold or bought
Price Size of tax (T) Price buyers pay
Tax revenue TQ

Supply

Price sellers receive

Quantity sold or bought (Q) 0 Quantity with tax Quantity without tax

Demand Quantity

Welfare analysis on tax

Price Price Consumer buyers A surplus pay =Pb B Government Loss of tax revenue total surplus D Price =Ps sellers receive F Producer surplus 0 Q2

Supply

Demand

Quantity

Deadweight loss (DWL) of taxation Due to some mutually beneficial trade are not carried out.

Principle of Microeconomics Zhao

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1. Fill in the blanks

The consumer surplus without tax 1a The producer surplus is 450. without tax is 360. 1b The size of tax is 7 1c . Quantity traded on the market is reduced by 15 1d units. The consumer surplus with tax is 247.5 . The producer surplus with 1e tax is 202.5. 1f The tax revenue is 315 1g . The dead weight loss is 52.5 1h .
30

19 15 12

3 45 60

The size of deadweight loss depends on price elasticity the case of supply
(a) Inelastic Supply (b) Elastic Supply

Price Supply

Price

Supply tax tax Demand Demand

Quantity

Quantity

Principle of Microeconomics Zhao

Mankiw Chapter 8

The size of deadweight loss depends on price elasticity the case of demand
(c) Inelastic Demand (d) Elastic Demand

Price Supply

Price Supply

tax

tax

Demand Demand 0 Quantity 0 Quantity

Elasticity of demand and supply both determine the size of DWL

Price Supply

Price

Supply

tax

tax

Demand Demand 0 Quantity 0 Quantity

Principle of Microeconomics Zhao

Mankiw Chapter 8

Relative elasticity of demand and supply determines who shoulders a bigger share of the tax burden has a larger reduction of surplus, which goes to government as revenue.
elasticity of demand > elasticity of supply
Price Supply Price Supply

elasticity of supply > elasticity of demand

Buyers tax burden Sellers tax burden

Demand

Buyers tax burden Sellers tax burden

Demand

Quantity

Quantity

International Comparison: Taxes as a Percentage of GDP, 1993

Size of government
United States Total taxes 29.7 OECD average 38.7 Japan 29.1 United Kingdom 33.6 Canada 35.6 Germany 39 Sweden 49.9

Income taxes Personal Corporate Consumption Tax Value added Sales

12.6 10.2 2.3

14.1 11.3 2.6

11.8 7.5 4.3

11.8 9.3 2.4

15.7 13.5 2

12 10.6 1.4

20.6 18.4 2.2

2.3

6.1 0.4

1.5

6.6

2.6 2.7

6.8

8.5

Social insurance taxes 8.7 Other taxes

source: OECD

10.2 3.4

9.8 3.8

6 4.5

5.9 5.3

15.1 1.5

13.8 2.3

3.9

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Deadweight Loss and Tax Revenue Vary with the Size of a Tax
(a) Small tax
Price Supply Pb Ps Tax revenue
DWL

(b) Medium tax

Price Supply Tax DWL revenue Demand Ps Demand Ps Price Pb Tax revenue

(c) Large tax

Pb

Supply
DWL

Demand

Q2 Q1 Quantity

Q2

Q1

0 Q2

Q1 Quantity

Quantity

Size of the tax

As the tax increases deadweight loss increases
Trade occur when willingness to pay > reservation price + tax Tax block more and more mutually beneficial trade

As the tax increases tax revenue may or may not increase

Tax revenue = tax * quantity sold or bought As the tax increases, government receives more for each unit of traded goods As the tax increases, the less and less amount of goods will be traded. As result, tax increase initially increases revenue. Then revenue decreases as higher tax drastically reduces the size of the market.

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Supply-side economists and the Laffer curve

Tax Revenue

Tax size

The biggest free lunch in economics: cutting tax without a cut of revenue

Progressive v. regressive tax

Regressive
income tax % of income

Proportional
tax % of income

Progressive
tax % of income

$50,000 $15,000 30% 100,000 200,000 25,000 25 40,000 20

$12,500 25% 25,000 25 50,000 25

$10,000 20% 25,000 25 60,000 30

Principle of Microeconomics Zhao

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2011 Federal income tax brackets

Marginal Tax Rate Single Married Filing Jointly or Qualified Widow(er) Married Filing Separately Head of Household

10% 15%

$0 $8,500 $8,501 $34,500

$0 $17,000 $17,001 $69,000

$0 $8,500 $8,501 $34,500

$0 $12,150 $12,150 $46,250

25%

$34,501 $83,600

$69,001 $139,350

$34,501 $69,675

$46,250 $119,400

28%

$83,601 $174,400

$139,351 $212,300

$69,675 $106,150

$119,401 $193,350

33% 35%

$174,401 $379,150 $379,151+

$212,301 $379,150 $379,651+

$106,151 $189,575 $189,576+

$193,350 - $379,150 $379,151+

Historical marginal tax rate

Year 1913 1918 1928 1932 1942 1966 1980 1986 1988 1994 2004 2010 $10,001 1% 16% 6% 10% 38% 22% 18% 14% 15% 15% 10% 10% $20,001 2% 21% 10% 16% 55% 32% 24% 18% 15% 15% 15% 15% $60,001 3% 41% 21% 36% 75% 53% 54% 38% 28% 28% 25% 15% $100,001 5% 64% 25% 56% 85% 62% 59% 45% 28% 31% 25% 25% $250,001 6% 72% 25% 58% 88% 70% 70% 50% 28% 39.60% 33% 33% 17,710 24,897 26,061 32,264 44,334 49,445 Median income

Principle of Microeconomics Zhao

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Piketty and Saez (2006) The evolution of top income: a historical and international perspective AER 96(2) 200-205

Who are the richest persons ?

Top executive (the working rich) replace top capital owners (the rentiers.

Principle of Microeconomics Zhao

Mankiw Chapter 8

Dollar weighted average marginal tax rate on wage income

35

30

Carter (D)
25

Reagan (R) Clinton (D) Bush (R) Bush (R)

Ford (R) Nixon (R)

20

Johnson (D)

15

10
19 66 19 68 19 70 19 72 19 74 19 76 19 78 19 80 19 82 19 84 19 86 19 88 19 90 19 92 19 94 19 96 19 98 20 00 20 02 20 04

Tax collected at various level of US government

Federal and state personal income tax
Tax on income Tax on consumption

Payroll tax and other social security levies Federal and state corporate income tax Sales tax (value-added tax) Excise tax (tax on gasoline, tobacco, alcohol, luxury goods) Custom duties (import tariffs) Property tax Federal estate and gift tax

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Best goods and services to tax most efficient tax Efficiency is measured by DWL per unit of revenue
(c) Inelastic Demand (d) Elastic Demand

Price Supply

Price Supply

Demand Demand 0 Quantity 0 Quantity

An extreme case without DWL

Price Supply

Price Perfect inelastic supply

Pb

Pb

Ps
Perfect inelastic demand 0 Quantity

Ps

Demand

Quantity

All tax burden is on buyers

All tax burden is on sellers

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Two goods that government can tax on have similar elasticity

Plan A: no tax on goods One
Price Supply Pb =Ps Demand Ps

Medium tax on goods Two

Price Supply Tax DWL revenue Demand

Pb

Q1 Quantity

Q2

Q1

Quantity

No DWL and no revenue

Two goods that government can tax on have similar elasticity

Plan A: no tax on goods One Medium tax on goods Two
Price Supply Tax DWL revenue Ps Demand Pb Tax Ps revenue
DWL

Plan B: Uniform small tax on both

Price Supply

Pb

Demand

Q2

Q1

Q2 Q1 Quantity

Quantity

Conclusion: the broader the tax base, more efficient is the tax

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Examples of Negative Externalities

Governments can sometimes improve market outcomes.

Air pollution from a factory Late-night stereo blasting from the dorm room next to yours Noise pollution from construction projects Health risk to others from second-hand smoke Talking on cell phone while driving makes the roads less safe for others

Tax levied to correct behavior (Pigouvian tax)

Externality: individual choice fails to take into account of the impact of his/her behavior on others, smoking for example.

Price Supply

Pigouvian tax
Demand

Personal benefit

Social optimal

Quantity traded in a competitive equilibrium

Personal willingness-to-pay minus cost to others due to negative externality

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How effective is Pigouvian tax Effectiveness is measured by impact on quantity sold and bought
(c) Inelastic Demand (d) Elastic Demand

Price Supply

Price Supply

tax

tax

Demand Demand 0 Quantity 0 Quantity

Tax on cigarettes
Since 2002, 47 states has increased their tax on cigarettes. Some state more that once. As of August, 2011 the tax rates
All states average: $1.46 per pack Major tobacco producing state average: $0.485 per pack Other state average: $1.59 per pack The highest New York State: $4.35 The lowest Missouri: $0.17 Georgia (the 4th lowest) $0.37

Estimate price elasticity of demand (Gallet and List 2003)

Adult Young adult Teen 0.32 0.76 1.43

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Principle of Microeconomics Zhao

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US beverage consumption
per capita consumption (gallons)

60.0 50.0 40.0 30.0 20.0 10.0 0.0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

milk

softdrink

selectedfruitjuices

alcoholic beverages

Data source: USDA

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Principle of Microeconomics Zhao

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Profiling US food consumption by USDA

Examples of Positive Externalities

Being vaccinated against contagious diseases protects not only you, but people who are around you. R&D creates knowledge others can use. People going to college raise the populations education level, which reduces crime and improves government.

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Tax levied to correct behavior (Pigouvian tax)

Externality: individual choice fails to take into account of the impact of his/her behavior on others, smoking for example.

Price Supply

subsidy

Personal willingness-to-pay plus benefits to others due to positive externality

Demand 0

Personal benefit

Quantity traded in a competitive equilibrium

Social optimal

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