PF05-Efficiency - Chapter 15

Public Finance
- Efficiency of taxation -
Sun Go
Chung-Ang University
Overview Excess burden Topics and examples Summary
Review
Tax incidence
I Economic incidence
I A partial Equilibrium model
I A general equilibrium model
I Progressiveness
Sun Go Efficiency of taxation 2/54

Overview
Efficiency of taxation
I Excess burden
I Indifference curve analysis
I Compensated demand curve analysis
I Discussion topics
I The theory of the second best
I Excess burden in general
I Housing service subsidy
I Income tax
I Differential taxation of inputs
Textbook
I Ch. 15


Excess burden: Introduction

Key questions
Previous questions
I What is the fair distribution of tax burden?
Now
I What is the most efficient way to raise tax?

Definition
Excess Burden
I Deadweight loss
I The cost imposed by taxation, over and above the revenue
actually collected


Excess burden: Indifference curve

analysis

An example of excise tax
Suppose Ruth, having income I, buys corn and barley

I She spends on only two commodities: corn and barley
I Government levies a tax at a percentage rate of tb on barley
I Pb0 = (1 + tb )Pb : Steeper budget constraint (gross price)
I A new consumption bundle by the new indifference curve and
new budget constraint
Assume corn and barley are produced at constant MC

I Perfectly elastic supply
I Tax borne completely by consumers

Excise tax on barley

Equivalent variation: EV
I How much worse off is the consumer due to this tax?

I The amount of income that could be taken away from the
consumer and reduce utility by as much as the tax does
I Measures the decrease in the consumer’s welfare (i to ii) by
money (corn)
I Assuming no price change


Excess burden
EV - T = EB
I EV: measures of harm from the tax
I T: Tax revenue actually paid
I EB: the welfare loss to the consumer (measured as EV) over
and above the tax revenue that would be collected by the tax


Income and substitution effects

Income effect: E1 ⇒ E3
I Equivalent to lump-sum tax (no price change)
I Causes zero excess burden b/c no price change
I MRS does not change
I No distortion in the incentive to buy barley
Substitution effect: E3 ⇒ E2
I Impact of increase in the price of barley, holding real income
constant
I This is where the inefficiency arises
I The “tax wedge” causes the inefficiency
I Consumers: MRSbc = (1+tPbc )Pb
I Firms:MRTbc = PPbc
I Inefficiency: MRSbc > MRTbc

Lump sum tax
Why don’t we use the lumpsum tax?

I The lumpsum tax does not entail an excess burden
I EV = T, thus EB = 0
I People think it unfair
I The example of Margaret Thatcher implementing a poll tax

Perfectly inelastic demand
Still EB = EV - T
I The uncompensated demand curve diagram cannot show this
burden

Perfectly inelastic demand


Compensated demand curve

Compensated demand curve
Compensated demand curve shows responses to price increase if

you are given enough extra revenue to compensate you so that your
utility does not fall
I All the points on the Hicksian demand curves give the same
utility
I Assuming income varies so as to keep utility fixed
Note: Marshallian demand curves

I Walrasian demand curves
I Income effect + substitution effect
I Assumes income fixed

Ex: Tax on barley

Hicksian vs. Marshallian

Ex: a normal good

Ex: a normal good

Ex: an inferior good

Ex: an inferior good

Ex: perfectly inelastic demand

Ex: perfectly inelastic demand


Excess burden: Demand curve analysis

Measuring EB
Excess burden = 12 ηPQt 2

I When MC is flat
I η = elasticity of demand (along the compensated demand
curve)

Measuring EB

Measuring EB

Measuring EB
More elastic demand leads to more excess burden

Measuring EB
Doubling the tax rate quadruples the excess burden
I Excess burden = 12 ηPQt 2

Measuring EB
Upward sloping S curve leads to more excess burden

I Excess burden = 12 ( 1PQ
+1
)t 2
η
I η: elasticity of demand
I : elasticity of supply

Measuring EB


Topics and examples

Efficiency consideration
I It is better to tax many commodities at a lower rate than to

tax a few commodities at a higher rate
I In the presence of existing distortions, policies that in isolation
would increase efficiency can decrease it and vice versa

The theory of the second best
Example: Gin and Rum

I Gin and Rum are substitutes for each other
I Suppose initially there is a tax on rum
I EB = triangle abc
I If new tax on gin
I New additional EB = triangble def
I But it will increase demand for rum, as gin is now more
expensive
I A social gain = area cbhg: new tax revenue
I If cbhg is sufficiently large, the tax can actually reduce overall
excess burden

Measuring EB

EB in general
In general, the excess burden of a set of taxes depends on
I The whole set of tax rates and the degree of substitutability
and complementarity among the various commodities
Suppose n commodities are subject to taxation

I Pi : the before-tax price of i
I ti : the ad valorem tax on i
∂X C
I Sij = ∂Pij : the compensated response in the demand of i wrt
a change in Pj
Pn Pn
The overall Excess Burden = − 12 i=1 j=1 ti Pi tj Pj Sij
I For example, if n=2 (r & g), assuming Srg = Sgr ,
I EB = − 21 (tr2 Pr2 Srr + tg2 Pg2 Sgg + 2tr Pr tg Pg Srg )

EB of a subsidy
Consider subsidy for housing services

I After-subsidy consumer surplus = triangle mqu
I The cost of subsidy = rectangle nvuq
I EB = triangle ovu

EB of a subsidy

EB of income taxation
I Workers = the supplier of labor (producer)

I Worker’s surplus changes from triangle adf to triangle ahg
I Income tax revenue = rectangle fihg
I EB = triangle idh = 12 εωL1 t 2
I ε = the compensated elasticity of hours of work wrt the wage

EB of income taxation

Differential taxation of inputs
Hours at home vs. hours at market

I Home production is not taxed, but working outside is taxed
I VMP: the value of marginal product
I Pre-tax equilibrium: H ∗
I After-tax equilibrium: H1
I EB = triangle abe = 12 ∆Htw2
The greater the excess burden if

I The greater the change in the allocation of labor (∆H)
I The greater the tax wedge (tw2 )

Differential taxation of inputs


Summary

Summary
Re-cap: Efficiency of taxation

I Excess burden
I Indifference curve analysis
I Compensated demand curve analysis
I Discussion topics
I Excess burden in general
I Housing service subsidy
I Income tax
I Differential taxation of inputs
Next class:
I Optimal taxation (Ch. 16)

PF05-Efficiency - Chapter 15

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Public Finance

Sun Go Efficiency of taxation 2/54

Sun Go Efficiency of taxation 3/54

Sun Go Efficiency of taxation 4/54

Excess burden: Introduction

Sun Go Efficiency of taxation 5/54

Sun Go Efficiency of taxation 6/54

Sun Go Efficiency of taxation 7/54

Sun Go Efficiency of taxation 8/54

Excess burden: Indifference curve

Sun Go Efficiency of taxation 9/54

An example of excise tax

Suppose Ruth, having income I, buys corn and barley

Assume corn and barley are produced at constant MC

Sun Go Efficiency of taxation 10/54

Excise tax on barley

Sun Go Efficiency of taxation 11/54

I How much worse off is the consumer due to this tax?

Sun Go Efficiency of taxation 12/54

Excise tax on barley

Sun Go Efficiency of taxation 13/54

Sun Go Efficiency of taxation 14/54

Excise tax on barley

Sun Go Efficiency of taxation 15/54

Income and substitution effects

Sun Go Efficiency of taxation 16/54

Lump sum tax

Why don’t we use the lumpsum tax?

Sun Go Efficiency of taxation 17/54

Perfectly inelastic demand

Sun Go Efficiency of taxation 18/54

Perfectly inelastic demand

Sun Go Efficiency of taxation 19/54

Sun Go Efficiency of taxation 20/54

Compensated demand curve

Sun Go Efficiency of taxation 21/54

Compensated demand curve

Compensated demand curve shows responses to price increase if

Note: Marshallian demand curves

Sun Go Efficiency of taxation 22/54

Ex: Tax on barley

Sun Go Efficiency of taxation 23/54

Hicksian vs. Marshallian

Sun Go Efficiency of taxation 24/54

Ex: a normal good

Sun Go Efficiency of taxation 25/54

Ex: a normal good

Sun Go Efficiency of taxation 26/54

Ex: an inferior good

Sun Go Efficiency of taxation 27/54

Ex: an inferior good

Sun Go Efficiency of taxation 28/54

Ex: perfectly inelastic demand

Sun Go Efficiency of taxation 29/54

Ex: perfectly inelastic demand

Sun Go Efficiency of taxation 30/54

Sun Go Efficiency of taxation 31/54

Excess burden: Demand curve analysis

Sun Go Efficiency of taxation 32/54

Excess burden = 12 ηPQt 2

Sun Go Efficiency of taxation 33/54

Sun Go Efficiency of taxation 34/54

Sun Go Efficiency of taxation 35/54