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ECON 441: Public Economics

Dan Silverman
ASU Economics

Fall 2016

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Other Justications for Government Action

E ciency concerns are, as we know, just one potential justication for


government intervention.
In many circumstances, e ciency justications for policy are hard to nd.
This may or may not indicate that government intervention lacks
rigorous/legitimate motivation.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Fairness/Equity

By emphasizing e ciency, we have largely avoided discussion of equity or


fairness.
Public assistance accounts for at least 15% of US government expenditures
The preferred method of obtaining money to pay for these programs is
taxation.
There are large transfers of money from rich to the poor and the percentage
has grown over time.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Measuring Inequality

Silverman (ASU Economics)

ECON 441 Chapter 5

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Measuring Inequality

Country
USA
Japan
India
Canada
Germany
Norway
Sweden
South Africa
Brazil
Mexico
China

Silverman (ASU Economics)

Gini Coe cient


45
37.6
36.8
32.1
27
25
23
63.1
51.9
48.3
47.4

ECON 441 Chapter 5

Fall 2016

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Measuring Inequality
International Income Distributions
Country
Norway
Sweden
Australia
Canada
Netherlands

poorest 10%
3.9
3.6
2
2.5
2.8

Share of income
Gini
poorest 20% richest 20% richest 10%
9.6
37.2
23.4
25.8
9.1
36.6
22.2
25
5.9
41.3
25.4
35.2
7
40.4
25
33.1
7.3
40.1
25.1
32.6

USA
UK
Mexico
Brazil
South Africa

1.9
2.1
1
0.5
0.7

5.4
6.1
3.1
2
2

45.8
44
59.1
64.4
66.5

29.9
28.5
43.1
46.7
46.9

40.8
36
54.6
59.1
59.3

Russia
India
China

1.8
3.9
1.8

4.9
8.9
4.7

51.3
41.6
50

36
27.4
33.1

45.6
32.5
44.7

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Issues with Correcting Inequality

Important policy debate about the desirability of varying degrees of


inequality, and policies aimed at achieving them.
Remember and Joe the Plumber and spreading the wealth around?
Concerns about fairness and justice
Concerns that eorts to divide the pie will importantly shrink it.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Distortionary eects of taxing proportional to income

An extreme logic: With tax rates at 100% no one would bother to work and
so tax revenue would become zero.
Simple example: Worker earns $20 per hour
Disutility of working h hours given by h2
Worker solves
max (1

) 20h

h2

Optimal hours h then solves

(1

) 20

(1

= 0,
) 10 = h
2h

Obviously declining in the tax rate

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Distortionary eects of taxing proportional to income

What does tax revenue look like in this example?


Revenue is given by

= (1

= 10

) 10
10 2

We can then think of the tax rate that will maximize tax revenue. Such a
solves
max 10

10 2

20

10

Silverman (ASU Economics)

ECON 441 Chapter 5

0,
1
2

Fall 2016

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Distortionary eects of taxing proportional to income


This example motivates the Laer Curve, (after Arthur Laer), representing
tax revenues as a function of the income tax rate.
Laer argued that, as income taxes rise from low levels, tax revenue received
by the government would also increase.
However, as taxes continue to rise, there would come a point where people
would stop working so hard and tax revenue would fall.
Tax revenue

T*

Tax rate

T is the tax rate that gives rise to the maximum amount of tax revenue.
Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Laer (Plus)

Previous example focuses on labor earnings.


Popular idea for reducing inequality involves taxing capital income and then
making transfers to workers.
Rich people hold more capital, so this seems like a sensible method for
making things more equal.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Laer (Plus)
Laers theoretical response:
Suppose the economys output y is described by the production function
f (L, K ) = y
Where labor (L) and capital (K ) are combined to make productive outputs.
Optimality in a competitive market implies marginal product equals marginal
cost

= w
fK (L, K ) = r
fL (L, K )

Assume that labor is immobile and inelastically supplied


Assume capital is mobile

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ECON 441 Chapter 5

Fall 2016

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Laer (Plus)

Equilibrium in this economy without taxes: L , K , w , r such that.


fL ( L , K )
fK (L , K )

= w
= r =r

where r is the global rate of return to capital.


Now impose a tax on labor income.
fL (L, K ) = w , unchanged, since labor is inelastically supplied.
Net wage is w (1

), incidence of tax falls on workers only.

Tax revenue is Lw .

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Laer (Plus)

Suppose you, instead, impose a tax on capital income.


Local rate of return on capital r must now compensate for taxes
fK ( L , K )

= r (1

) = r ,
r
r =
(1 )

fK ( L , K )

(1)

At prior levels of capital and labor, equation 1 will not hold


Capital level must adjust.
Which way? Up or down?

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Laer (Plus)

If capital ies the country (to avoid taxes) what happens to wages?
Depends on whether labor and capital are substitutes
f 2
?0?
LK
2

We usually assume they are complements ( LfK > 0). (Does that make
sense?)
If so, wages will fall as capital ees and the marginal product of labor goes
down.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Laer (Plus)

OK, but have we really hurt the workers if the transfers are going to them?
Tax revenues
K r K + L w L
Suppose (pretty reasonably)
K r =

L w
2

And suppose L = 15% and K = 20%. Then tax revenues could go down
by increasing the tax on capital.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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Central Question of Taxation

Laer and other supply-side economists argued that taxes were to the right
of T and that increasing taxes on captial income would decrease tax
revenues.
Therefore, Laer argued, reducing the tax rate would bring about an increase
in tax revenue.
This was exactly what many wanted to hear to justify his tax cuts.
Unfortunately reality has proved to be at odds with Laers prediction by
and large tax cuts have caused a shortfalls in tax revenue.
Most professional economists agree that we are to the left of T for labor
income.
More debate about the right level of capital income taxation.

Silverman (ASU Economics)

ECON 441 Chapter 5

Fall 2016

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