Microeconomics: Taxes

The Government

• In a competitive market, the main participants are:
  • Buyers/Consumers
  • Sellers/Producers
• The Government is introduced as a new participant.
  • The Government does not buy or sell products in the market.
  • The Government ensures the market functions well by:
    • Enforcing property rights.
    • Regulating economic relationships.
    • Providing utilities and public works.

Taxation

• Governments require money from the public to perform tasks.
• Taxation is one method to collect money.
• Taxes vary based on:
  • Assessment method
  • Taxable basis
  • Taxpayer
• The focus will be on sales taxes and their consequences:
  • How they affect supply and demand.
  • Welfare effects of sales taxation.
  • Factors determining who bears the tax burden.

Sales Taxes

• A sales tax is a compulsory financial charge on taxpayers for sales of certain goods and services.
• Analysis requires distinguishing between taxpayers:
  • Tax levied on sellers.
  • Tax levied on buyers.
• Sales taxes are distinguished according to their assessment method:
  • Per-unit tax (or specific tax): Fixed amount of money for each unit of a good or service.
  • Ad valorem tax: Fixed percentage of product value.
  • Specific and ad valorem taxes have the same equilibrium effects, so the focus will be on specific taxes.

A Specific Tax Imposed on the Buyers

• Consider an initial situation: individuals trade apples at the competitive price $P^* = \text{€}4$.
• At $P^* = \text{€}4$, consumers are willing to buy 3 kilos of apples.
• Suppose the Government imposes a tax $\tau = \text{€}2$ per kilo.
• When the price is $P^* = \text{€}4$, the consumer needs to pay $P^* + \tau = \text{€}6$ per kilo.
• But then at €6, consumers are only willing to buy 1 kilo.
• The tax reduces the willingness to buy of consumers:
  • When the price is $P^* = \text{€}4$ consumers are only willing to buy $Q = 1$ kilo.
• When the price is $P^* = \text{€}3$, the consumer needs to pay $P^* + \tau = \text{€}5$ per kilo.
• But then at €5, consumers are only willing to buy 2 kilos.
• The tax reduces the willingness to buy of consumers:
  • When the price is $P^* = \text{€}3$ consumers are only willing to buy $Q = 2$ kilos.
• Repeating this reasoning for all possible prices yields the after-tax consumers’ willingness to buy.
• A new demand curve, arising from a leftward shift of the original demand curve, characterizes the after-tax willingness to buy.
• Consumption decisions are made on the basis of the after-tax willingness to buy.
• A new equilibrium is reached:
  • The new competitive price is $\hat{P} = \text{€}3$.
  • The new competitive quantity is $\hat{Q} = 2$.
• Because the shifted demand already “discounts” the tax from the willingness to buy, consumers are billed $\hat{P} + \tau = \text{€}5$.
• Farmers are paid $\hat{P} + \tau = \text{€}5$ (per kg.) and then transfer $\tau = \text{€}2$ (per kg.) to the government.
  • The final payment actually received by farmers is $\hat{P} = \text{€}3$.
• Consumers bear some, but not all the burden of the tax, since the price they pay raised from $P^* = \text{€}4$ to $\hat{P} + \tau = \text{€}5$.
• Farmers also bear part of the burden as the price they receive dropped from $P^* = \text{€}4$ to $\hat{P} = \text{€}3$.
• The tax $\tau = \text{€}2$ is shared between buyers and sellers:
  • Consumers pay €1.
  • Producers pay €1.

Price Elasticities and Tax Incidence

• Although buyers and sellers share the burden of the tax, it’s not necessarily an equal burden.
• The tax incidence will depend on the sensitivity of demand and supply to changes in the price.
• In the previous story both supply and demand curves had the same elasticity.
  • Therefore, consumers and farmers shared equally the burden of the tax.
• When the price elasticity of demand is relatively low compared to the price elasticity of supply, the burden of a specific tax falls mainly on consumers.
• When the price elasticity of demand is relatively high compared to the price elasticity of supply, the burden of a specific tax falls mainly on producers.

Learn by Doing: Practice Question 1

• Junk food has been criticized for being too cheap, enticing the poor to adopt unhealthful lifestyles. Suppose that the Government imposes a tax on junk food.
  1. What has to be true for the tax to reduce the consumption of junk food?
     • a) Demand should be inelastic and supply elastic?
     • b) Demand should be elastic and supply inelastic?
     • c) Both (a) and (b) are true. (correct answer)
  2. What has to be true for the tax to deter most people from eating junk food?
     • a) Demand should be inelastic
     • b) Demand should be elastic (correct answer)
     • c) Both (a) and (b) are true.

After Tax Consumer Surplus

• Consumer surplus:
  • Difference between what consumers pay and their willingness to pay.
• Consumers’ willingness to pay:
  • Willingness to pay is described by the original demand curve.
  • The tax creates a discrepancy between the willingness to buy and the willingness to pay.
• Price actually paid by consumers:
  • We already know what consumers pay: $\hat{P} + \tau = \text{€}5$.
• The consumer surplus is the area below the original demand curve and the price consumers pay after the tax.

After Tax Producer Surplus

• Producer surplus:
  • Area above the supply curve but below the price received by the farmers.

Fiscal Revenue from a Specific Tax

• The fiscal revenue to the government is $\tau \times Q$.

Welfare Loss from a Specific Tax

• A sales tax deters consumption, which reduces sales and, therefore, decreases the gains from trade.
  • Potentially beneficial transactions go unexploited, thus generating a welfare loss.

Increasing the Tax Rate Does Not Necessarily Increase Fiscal Revenue

• There are two countervailing effects when increasing the tax rate:
  • Higher tax rate means more revenue for each unit sold.
  • Higher tax rate reduces the quantity of sales.
• Which effect prevails will depend on the price-elasticities.
  • The more elastic the demand curve, the easier it is for consumers to reduce quantity instead of paying the tax.
  • The more elastic the supply curve, the easier it is for sellers to reduce the quantity sold, instead of taking lower prices.

Elasticities and Deadweight Loss

• The greater the price-elasticity of demand, the greater the tax-induced deadweight loss.
• The greater the price-elasticity of supply, the greater the tax-induced deadweight loss.
• What goods should be taxed?
  • If the goal in tax policy is efficiency (i.e., minimizing deadweight loss), then policy makers should choose the goods with the lowest price elasticities.
  • A tax on insulin would be efficient—but not necessarily fair.

Tax Fairness and Tax Efficiency

• Two principles of tax fairness:
  • The benefits principle: Those who benefit from public spending should bear the burden of the tax that pays for that spending.
    • Example: Those who use a road should pay for that road’s upkeep.
  • The ability-to-pay principle: Those with greater ability to pay a tax should pay more.
• There is usually a trade-off between equity and efficiency:
  • The tax system can be made more efficient only by making it less fair, and vice versa.

The Costs of Taxation

• One may also consider in our story administrative costs not included in the deadweight loss:
  • Resources used for its collection.
  • Resources used for avoiding attempts to evade the tax.
  • Higher transaction fees.
• Total inefficiency of tax = Deadweight loss + Administrative costs

A Specific Tax Imposed on the Sellers

• Suppose now that the tax $\tau = \text{€}2$ is levied on sellers.
• When the price is $P^* = \text{€}4$, the farmers only receive $P^* - \tau = \text{€}2$ per kilo.
• But then at €2, farmers are only willing to sell 1 kilo.
• The tax reduces the willingness to sell of producers:
  • When the price is $P^* = \text{€}4$ farmers are only willing to sell $Q = 1$ kilo.
• A new supply curve, arising from a leftward shift of the original supply curve, describes the after-tax willingness to sell.
• Production decisions are made on the basis of the after-tax willingness to sell.
• A new equilibrium is reached:
  • The new competitive price is $\tilde{P} = \text{€}5$.
  • The new competitive quantity is $\tilde{Q} = 2$.
• Because the shifted supply already “incorporates” the tax into the willingness to sell, producers only receive $\tilde{P} - \tau = \text{€}3$.
• Consumers are billed $\tilde{P} = \text{€}5$.
• As for a sales tax levied on consumers, both producers and consumers share the burden of a sales tax levied on producers.
  • In this story, the tax $\tau = \text{€}2$ is equally shared between buyers and sellers.

Neutrality of the Sales Taxes

• The equilibrium and the incidence of the tax are the same regardless of whether the government collects the tax from consumers or producers.
• This equivalence is called neutrality of sales tax.

After Tax Producer Surplus

• Producer surplus:
  • Difference between what producers receive and their willingness to accept.
• What is the producers’ willingness to accept?
  • Willingness to accept is described by the marginal cost.
  • The tax creates a discrepancy between the willingness to sell and the willingness to accept.
• Price received by producers:
  • We already know what producers receive $\tilde{P} - \tau = \text{€}3$.
• The producer surplus is the area above the original supply curve and the price producers receive after transferring the tax to the government.

After Tax Welfare

• The consumer surplus is the area below the demand curve but above the price they pay.
• The fiscal revenues of the government are given by the green area.
• A deadweight loss results from the all the beneficial unexploited transactions.

After Tax Welfare

• The neutrality of sales taxes also reflects in the welfare distribution.
• The allocation of surpluses and losses is the same regardless of whether the government collects the tax from consumers or producers.