Taxes are necessary: all governments need money to function.

Efficiency: taxes should be designed to distort incentives as little as possible.

Excise tax- a tax charged on each unit of a good or service that is sold.

- A tax on sales of a good or service

- An excise tax drives a wedge between the price paid by consumers and that received
by producers, leading to a fall in the quantity transacted. It creates inefficiency by
distorting incentives and creating missed opportunities.

The incentives of hotel owners pre-tax (before the tax is levied) to their incentives post-tax
(after the tax is levied).

In fact, it doesn’t matter who officially pays the tax—the equilibrium outcome is the same.

The incidence of a tax—who really bears the burden of the tax—is typically not a question
you can answer by asking who writes the check to the government.

The incidence of an excise tax doesn’t depend on who the tax is officially levied on. Rather,
It depends on the price elasticities of demand and of supply.

More specifically, the incidence of an excise tax depends on the price elasticity of supply
and the price elasticity of demand.

When the price elasticity of demand is low and the price elasticity of supply is high, the
burden of an excise tax falls mainly on consumers.

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.

When the price elasticity of demand is higher than the price elasticity of supply, an excise
tax falls mainly on producers. When the price elasticity of supply is higher than the price
elasticity of demand, an excise tax falls mainly on consumers. So elasticity—not who
officially pays the tax—determines the incidence of an excise tax.

The tax revenue collected is:

Tax revenue = $40 per room × 5,000 rooms = $200,000

The area of the shaded rectangle is: Area = Height × Width = $40 per room × 5,000 rooms =
$200,000 or, Tax revenue = Area of shaded rectangle

A tax rate is the amount of tax levied per unit of whatever is being taxed.

A tax rate is the amount of tax people are required to pay per unit of whatever is being
taxed.
One way to think about the revenue effect of increasing an excise tax is that the tax increase
affects tax revenue in two ways. On one side, the tax increase means that the government
raises more revenue for each unit of the good sold, which other things equal would lead to a
rise in tax revenue. On the other side, the tax increase reduces the quantity of sales, which
other things equal would lead to a fall in tax revenue. The end result depends both on the
price elasticities of supply and demand and on the initial level of the tax. If the price
elasticities of both supply and demand are low, the tax increase won’t reduce the quantity
of the good sold very much, so that tax revenue will definitely rise. If the price elasticities
are high, the result is less certain; if they are high enough, the tax reduces the quantity sold
so much that tax revenue falls. Also, if the initial tax rate is low, the government doesn’t lose
much revenue from the decline in the quantity of the good sold, so the tax increase will
definitely increase tax revenue. If the initial tax rate is high, the result is again less certain.
Tax revenue is likely to fall or rise very little from a tax increase only in cases where the price
elasticities are high and there is already a high tax rate.

The possibility that a higher tax rate can reduce tax revenue, and the corresponding
possibility that cutting taxes can increase tax revenue, is a basic principle of taxation that
policy makers take into account when setting tax rates. That is, when considering a tax
created for the purpose of raising revenue (in contrast to taxes created to discourage
undesirable behaviour, known as “sin taxes”), a well-informed policy maker won’t impose a
tax rate so high that cutting the tax would increase revenue. In the real world, policy makers
aren’t always well informed, but they usually aren’t complete fools either. That’s why it’s
very hard to find real-world examples in which raising a tax reduced revenue or cutting a tax
increased revenue. Nonetheless, the theoretical possibility that a tax reduction increases tax
revenue has played an important role in the folklore of American politics. As explained in
For Inquiring Minds, an economist who, in the 1970s, sketched on a napkin the figure of a
revenue increasing income tax reduction had a significant impact on the economic policies
adopted in the United States in the 1980s.

The administrative costs of a tax are the resources used by government to collect the tax,
and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it.

These lost resources are called the administrative costs of the tax.

A tax has little effect on behavior because behavior is relatively unresponsive to changes in
the price. In the extreme case in which demand is perfectly inelastic (a vertical demand
curve), the quantity demanded is unchanged by the imposition of the tax. As a result, the
tax imposes no deadweight loss. Similarly, if supply is perfectly inelastic (a vertical supply
curve), the quantity supplied is unchanged by the tax and there is also no deadweight loss.

An excise tax generates tax revenue equal to the tax rate times the number of units of the
good or service transacted but reduces consumer and producer surplus.
The government tax revenue collected is less than the loss in total surplus because the tax
creates inefficiency by discouraging some mutually beneficial transactions.

The difference between the tax revenue from an excise tax and the reduction in total
surplus is the deadweight loss from the tax. The total amount of inefficiency resulting from a
tax is equal to the deadweight loss plus the administrative costs of the tax.

The larger the number of transactions prevented by a tax, the larger the deadweight loss. As
a result, taxes on goods with a greater price elasticity of supply or demand, or both,
generate higher deadweight losses. There is no deadweight loss when the number of
transactions is unchanged by the tax.

According to the benefits principle of tax fairness, those who benefit from public spending
should bear the burden of the tax that pays for that spending.

According to the ability-to-pay principle of tax fairness, those with greater ability to pay a
tax should pay more tax.

A lump-sum tax is the same for everyone, regardless of any actions people take.

In a well-designed tax system, there is a trade-off between equity and efficiency: the
system can be made more efficient only by making it less fair, and vice versa.

Other things equal, government tax policy aims for tax efficiency. But it also tries to achieve
tax fairness, or tax equity.

There are two important principles of tax fairness: the benefits principle and the ability-to-
pay principle.

A lump-sum tax is efficient because it does not distort incentives, but it is generally
considered unfair. In any well-designed tax system, there is a trade-off between equity and
efficiency in devising tax policy.

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

The tax structure specifies how the tax depends on the tax base.

An income tax is a tax on an individual’s or family’s income.

A payroll tax is a tax on the earnings an employer pays to an employee.

A sales tax is a tax on the value of goods sold.

A profits tax is a tax on a firm’s profits.

A property tax is a tax on the value of property, such as the value of a home.
A wealth tax is a tax on an individual’s wealth.

A proportional tax is the same percentage of the tax base regardless of the taxpayer’s
income or wealth.

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

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

The marginal tax rate is the percentage of an increase in income that is taxed away.

Gross domestic product—the total value of goods and services produced in a country. By
this measure, as you can see in the accompanying figure, U.S. taxes are near the bottom of
the scale.

Every tax consists of a tax base and a tax structure.

Among the types of taxes are income taxes, payroll taxes, sales taxes, profits taxes,
property taxes, and wealth taxes.

Tax systems are classified as being proportional, progressive, or regressive.

Progressive taxes are often justified by the ability-to-pay principle. But strongly progressive
taxes lead to high marginal tax rates, which create major incentive problems.

The United States has a mixture of progressive and regressive taxes.

However, the overall structure of taxes is progressive.