Modern Principles of Economics: Taxes and Subsidies

Modern Principles of Economics: Taxes and Subsidies

Introduction

  • This chapter discusses taxes and subsidies through the lens of supply, demand, and elasticity.
  • Key Points:
    • Who pays a tax is not determined by who writes the check to the government but rather by the relative elasticities of supply and demand.
    • Commodity taxation generates revenue and results in deadweight loss, which is the reduction in gains from trade.

Commodity Taxes

  • Definition: Taxes applied to goods, such as fuel, cigarettes, and liquor.
Collection Methods
  • The government can collect a tax in two ways:
    • Tax on Sellers: levied for every unit sold.
    • Tax on Buyers: levied for every unit bought.
  • The effect of a tax remains the same regardless of whether it is imposed on sellers or buyers.
  • The determination of who pays the tax depends on the relative elasticities of supply and demand.
Who Ultimately Pays the Tax
Tax Wedge Concept
  • A tax creates a tax wedge, defined as:
    • Tax Wedge: ( ext{Tax} = ext{Price paid by buyers} - ext{Price received by sellers} )
  • For instance, if the tax is $1:
    • The buyer's price increases by $1 compared to the seller’s price.
  • In the example diagram:
    • New equilibrium quantity traded = 500 baskets of apples.
    • Price paid by buyers = $2.65.
    • Price received by sellers = $1.65.
Elasticity Implications
  • Elasticity Definition: Measures how responsive the quantity demanded or supplied is to price changes.
  • Tax incidence is influenced by elasticity:
    • If demand is more elastic than supply, buyers bear less of the tax burden.
    • If supply is more elastic than demand, sellers bear less of the tax burden.

Examples in Real Life

Health Insurance Mandate
  • 2010 Patient Protection and Affordable Care Act:
    • Mandates large employers to provide health insurance for employees.
    • The elasticity of demand versus supply determines who bears the burden of this mandate:
    • Firms are more adaptable, while workers face higher costs leaving the labor force.
    • Thus, most of the tax burden is absorbed by workers.
Cigarette Taxes
  • Cigarette taxes vary significantly by state, e.g., $3.20 in New Jersey vs. $0.86 in South Carolina.
  • Demand for cigarettes is inelastic due to addiction:
    • As supply is more elastic than demand, buyers ultimately bear more of the tax burden.

Effects of Commodity Taxes

  • Without tax, consumer and producer surplus is maximized.
  • With tax:
    • Consumer and producer surplus decline while tax revenues increase.
    • However, tax revenues increase less than the decline in surplus, resulting in a deadweight loss:
    • Deadweight Loss: Represents the loss from trades that do not occur due to taxation.
Visual Representation of Taxes
  • The diagrams illustrate how consumer surplus, producer surplus, and tax revenue are affected by the presence of a tax.

Elasticity and Deadweight Loss

Elasticity of Demand
  • Deadweight loss from taxation decreases if demand becomes less elastic:
    • Elastic Demand: A tax deters many trades leading to higher deadweight loss.
    • Inelastic Demand: A tax deters fewer trades, leading to a smaller deadweight loss.
Elasticity of Supply
  • Similar to demand:
    • Elastic Supply: Higher deadweight loss due to lost trades from taxation.
    • Inelastic Supply: Lower deadweight loss for the same reason.

Subsidies

Definition
  • Subsidy: A payment from the government to consumers or producers, effectively functioning as a reverse tax.
Effects of Subsidies
  • Similar to taxes, the allocation of subsidies does not depend on who receives the check from the government but on the relative elasticities of supply and demand.
  • Subsidies are funded by taxpayers and may lead to inefficient increases in trade and deadweight loss:
    • Deadweight Loss from Subsidies: Arises from trades that do not provide beneficial returns.
Visual Effects of Subsidies
  • Price changes for buyers and sellers are represented, showing subsidy impacts on market equilibrium.

Comparative Analysis of Taxes and Subsidies

  • When demand is more elastic than supply, suppliers face a higher tax burden and gain more from subsidies.

Case Studies in Subsidization

Cotton Subsidy Example
  • In California, agricultural water subsidies significantly reduce costs for farmers:
    • Farmers pay $20-$30 for water costing $200-$500.
    • Demand for cotton is highly elastic, while supply is inelastic, resulting in farmers benefiting most from subsidies.
Wage Subsidy Proposal
  • Edmund Phelps proposed wage subsidies to enhance low-wage employment:
    • Potential benefits include reduced welfare payments, crime, drug dependency, and the culture of defeatism.

Key Takeaways

  1. Use of supply and demand principles helps analyze taxes and subsidies.
  2. The implications of taxes and subsidies depend on the relative elasticities of demand and supply.
  3. Markets become less efficient due to taxes and subsidies, creating deadweight loss.
  4. More elastic market sides tend to escape a larger portion of tax while benefitting more from subsidies.