The economics terms that we learnt in this course

This course on public finance has given us insight on the tough choices the government faces in
formulating an effective policy. One of the critical areas of public policy is the tax rate set by the
government. Related to the issue of setting tax rates we have learnt about the Laffer Curve and 3 rules
of tax incidence.
Laffer Curve
Income tax is one of the major sources of tax revenue so it is very important for the government to set
income taxes at the optimal rate and minimize deadweight loss. Always increasing the tax rate is not a
good strategy for increasing tax revenue. Suppose income taxes are raised. Now after tax wage rates will
fall. The substitution effect in labor market will discourage people from working as leisure is
comparatively cheaper but income effect will motivate people to work. If the tax rate is beyond optimal
rate, the substitution effect dominates income effect so labor supply falls leading to a fall in tax revenue.
Basically the size of the pie reduces as tax on labor rises beyond optimal. This phenomenon is
represented by the Laffer Curve. In the figure below we see that beyond the optimal rate t* the tax
revenue falls as the substitution effect dominates the income effect.


3 rules of tax incidence
We analysed the three rules using the example of sellers and buyers of cigarettes.
The first rule states that the statutory burden of a tax does not describe who bears the burden of tax. So
if sellers of cigarettes are the statutory party it does not imply that the tax is paid out of their pockets.
The second rule states that the side of the market on which the tax is imposed, is irrelevant for the
economic burden of the tax. So it does not make a difference whether tax is imposed on buyers or
sellers of cigarettes, the consumer burden and producer burden of the tax remains unchanged.
The third rule states that the inelastic side of the market bears burden of tax. Cigarettes have inelastic
demand. So any tax imposed either on buyers or sellers of cigarettes will ultimately lead to a very high
proportion of the tax being borne by consumer. The reason behind this is that an inelastic demand
indicates that the consumers cannot substitute easily for lower taxed alternatives. If the demand for
cigarettes was elastic then the consumers could avoid paying the tax by switching to substitutes that are
taxed less.