Taxation and Government

Intervention
Mark Jayson C. Agarin
Dyrick Marl M. Mata
Sherwin N. BeltranQTY
 Taxation and Government

• For government to provide goods and services

such as national defense, social security,
national parks, etc. it must have money.
• The Government raises money several ways
including user fees and taxes.
• User Fees are fees paid by those that use the
good or service: it is a price.
• Taxes may be paid by everyone or only those
that use a good or service: who pays depends
on the type of tax.
 Types of Taxes

• There are many types of taxes:

– Personal Income taxes
– Corporate Income taxes
– Excise Taxes
– Value Added Taxes (VAT)
– Property Taxes
– Social Security Taxes
– Sales Taxes
 Tax Burden or Incidence
• Who seems to pay the tax and who actually pays the
tax may not be the same person!
• For example, suppose the federal government
institutes a 10% excise tax on luxury boats.
• Suppose the consumer pays the tax up front: on the
purchase of a $100,000 luxury boat the consumer pays
sales taxes of 5% and a luxury tax of 10% for a total
price of $115,000 (there is no tax on tax).
• But what if the boat builder had to lower the price
from $110,000 to $100,000 to sell the boat?
• In this case, the buyer appears to pay the luxury tax
but in reality the boat builder pays the taxes.
• The entire burden of the tax falls on the boat builder.
 What is the Role of Government?
• The level of taxes is determined by the amount of
government services and goods provided.
• The Government’s roles include:

– Providing a stable set of institutions, laws and rules.

– Promoting effective and workable competition.
– Correcting for externalities.
– Creating an environment that fosters economic
stability and growth.
– Providing public goods.
– Adjusting for undesirable market results.
The How Much Should Government Tax?

• The government must raise revenues

equal to the cost of providing the amount
of goods and services that its citizens
demand.
 The Costs of Taxation

• The costs of taxation include:

– The direct cost of the revenue paid to
government
– The loss of consumer and producer surplus
caused by the tax
– The cost of administering the tax codes.
 The Costs of Taxation

• When government institutes taxes,

there is a loss of consumer and producer
surplus that is not gained by government.

• This is known as deadweight loss.

 The Costs of Taxation

• Graphically the deadweight loss is shown

on a supply-demand curve as the welfare
loss triangle.

• The welfare loss triangle – a

geometric representation of the
welfare loss in terms of misallocated
resources caused by a deviation from
a supply-demand equilibrium.
 Consumer Surplus
Producer Surplus
• Consumer Surplus – the amount of consumers
would be willing to pay (with perfect price
discrimination) minus what they have to pay (at
the market price) is the excess benefit
consumers enjoy and is called consumer
surplus.
• Producer Surplus – the amount producers
receive for the total units sold (at the market
price) minus what they would have received if
they charged their cost for each unit.
• See pages 97-99 and page 158 for more info
(in hardback Economics text). End of Chapter
4 in Microeconomics book.
 The Costs of Taxation

• There are other costs of taxation.

• Resources must be devoted by the

government to administer the tax
codes and by citizens and businesses
to comply with it.
 The Costs of Taxation

• Payroll accounting has become so

onerous, businesses large and small often
pay payroll-accounting firms to keep up
with changing federal and state payroll
rules and actually issue paychecks for
their clients’ employees.
 The Benefits of Taxation

• The benefits of taxation are the goods

and services that government provides.
 The Benefits of Taxation

• Some of these benefits are the part of

the basic institutional structure of a
market economy that allows it to work
efficiently.

– The basic legal system is an example.

 The Benefits of Taxation

• Still others benefits take on the

qualities of a public good – national
defense, for example.
 The Benefits of Taxation

• Others benefits are provided for

reasons of equity or because they
provide positive externalities.
 The Benefits of Taxation

• The policy debate about the benefits of

taxation generally focuses on goods that
could be supplied by the market but are
publicly supplied.

– Education and health care are examples.

 The Benefits of Taxation

• Measuring the benefits of these goods is

difficult since they are not provided in a
market setting.
 The Two Principles of Taxation

• There are two principles of taxation

widely recognized by tax experts as
desirable features of a tax system.

1. The Benefit Principle

2. The Ability to Pay Principle
 Two Principles of Taxation

• The benefit principle states that the

individuals who receive the benefit of
the good or service should pay the tax
necessary to supply the good.

– Examples are gasoline taxes and airport

taxes, both paid by travelers.
 Two Principles of Taxation

• The ability-to-pay principle states that

individuals who are most able to bear the
burden of the tax should pay the tax.

– The best example of this is a

progressive tax, such as the U.S. income
tax.
 Difficulty of Applying the
Principles of Taxation

• The elasticity concept helps us to

understand the tradeoffs as well as who
is likely to bear the burden of a tax.
Burden Depends on Relative Elasticity

• Elasticity is a measure of how easy it is

for the supplier and consumer to change
their behavior and substitute other
goods.
• Consequently, the more one group
(consumers or suppliers) is able or willing
to change its behavior relative to the
other group the more likely it is to avoid
the tax burden.
Burden Depends on Relative Elasticity

• The relative burden of the tax dictates

that the more relatively inelastic the
behavior of one’s group (supply or
demand), the larger the tax burden one
will bear.
Burden Depends on Relative Elasticity

• If demand is more inelastic than supply,

consumers will pay the higher share. If
supply is more inelastic than demand,
suppliers will pay the higher share.
Burden Depends on Relative Elasticity

• Who pays a tax is not necessarily who

bears the burden.

• The person who actually pays the tax

does not matter, and the person who
bears the burden can differ from the
person who pays.
 Difficulty of Applying the
Principles of Taxation
• Since the free market system is very
efficient, Governments with free market
economies desire to change the behavior of
suppliers and demander as little as possible.
• Hence, Governments should tax inelastic goods
or services.
• In the language of consumer and producer
surplus, if the government seeks to minimize
welfare loss, it should tax goods with inelastic
supplies and demands.
 Tax Incidence and Current Policy
Debates
• The analysis of tax incidence is helpful
when discussing current policy debates.
 Social Security Taxes

• Social Security taxes are payroll taxes

for a government-run retirement
program.
• Both employer and employee contribute
the same percentage of before-tax
wages to the Social Security fund.
 Social Security Taxes

• The fact that both the employer and

employee contribute the same
percentage does not mean they share
the burden equally.
 Social Security Taxes

• On average, labor supply tends to be less

elastic than labor demand, so the Social
Security tax burden is primarily on
employees.
 Sales Taxes

• Sales taxes are those paid by retailers

on the basis of their sales revenue.
• Since sales taxes are broadly defined,
consumers find it hard to substitute.
• Demand is inelastic so consumers bear
the greater burden of the tax.
 Sales Taxes

• Consumers can now buy on the internet

where sales are not taxed so that retail
stores will bear a greater burden of the
tax levied on their sales.
 Government Intervention

• Taxation is but one way in which

government affects our lives.
• Other forms of government intervention
include price controls.
 Government Intervention as
Implicit Taxation

• Government intervention can be seen as

a combination tax and subsidy.
 Price Ceilings

• A price ceiling is a government-set price

below market equilibrium price.
• It is an implicit tax on producers and an
implicit subsidy to consumers.
• This causes a loss in producer and
consumer surpluses that is identical to
the welfare loss from taxation.
 Price Floors

• A price floor is a government-set price

above equilibrium price.
• It is a tax on consumers and a subsidy to
producers.
• Price floors transfer consumer surplus
to producers.
The Difference Between Taxes and Price Controls

• The effects of taxation and price

controls are similar.
• They are different in that price ceilings
create shortages and taxes do not.
• Shortages also create black markets.
• Both taxes and price controls create
deadweight loss.
Rent Seeking, Politics, and Elasticities

• Price controls exist because of political

power.

– If farmers have political power, they

want crop subsidies or price supports.
– If renters have it, they want rent
controls.
Rent Seeking, Politics, and Elasticities

• An enormous amount of time and money

is spent in the political arena to increase
one’s surplus at the expense of another
group.
• This activity is called rent seeking
behavior – the effort to transfer
surplus from one group to another.
Rent Seeking, Politics, and Elasticities

• Public choice economists integrate an

economic analysis of politics with their
analysis of the economy.

• They argue that often when all the

rent seeking and tax consequences
are netted out, there is no net gain to
the public.
 Inelastic Demand and Incentives to
Restrict Supply
• When demand is inelastic, producers
have incentives to restrict supply.
• Farming is an example.
 Inelastic Demand and Incentives to
Restrict Supply
• Advances in farming productivity
increases supply but lowers prices.

• Since food has few substitutes, its

demand is inelastic.
• Inelastic demand means that prices
fall faster than a rise in quantity sold.
• Revenues fall, and farmers are worse
off.
 Inelastic Demand and Incentives to
Restrict Supply

• There is an enormous incentive for

farmers to seek a price floor from
government or through a producer
cooperative.