ECN Chapter 7 - Taxes

ECN Chapter 7 - Taxes

Excise Tax

  • Definition: An excise tax is a per unit tax levied on the sale of specific goods or services.
  • Examples:
      - Gasoline: federal excise tax of $0.10 per liter.
      - Fuel-inefficient automobiles: excise tax of $4,000 for cars consuming 16 liters or more per 100 km.

Effects of Excise Taxes on Prices and Quantities

  • Excise taxes lead to:
      - An increase in the price paid by buyers.
      - A decrease in the price received by sellers.
      - The creation of a wedge between the price buyers pay and the price sellers receive.
      - A reduction in the equilibrium quantity supplied and demanded.

Supply and Demand Graph

  • Understand the concept through a supply and demand graph:
      - S = Supply Curve
        - S₁: Original supply curve before the tax indicates the quantity producers are willing to supply at various prices.
        - S₂: New supply curve after tax, shifted upward, requiring a higher price to supply the same quantity due to the tax per unit.
      - D = Demand Curve
        - D₁: Original demand curve before tax indicates the quantity consumers are willing to buy at various prices.
        - D₂: New demand curve after tax, shifted downward, as consumers effectively face a higher price due to the tax.

Tax Incidence

  • Definition: Tax incidence measures who ultimately bears the burden of the tax.
  • Principles of Taxation:
      - The incidence depends inherently on the shapes of the supply and demand curves, specifically their elasticities, rather than who officially pays the tax.
      - When the price elasticity of demand is higher than the price elasticity of supply, consumers bear more of the burden.
      - Conversely, when the price elasticity of supply is higher than the price elasticity of demand, producers bear more of the burden.

Payroll Taxes in Canada

  • Payroll taxes are deducted from employee paychecks for social programs like the Canada Pension Plan (CPP) and Employment Insurance (EI).
  • Employers also contribute equal amounts to employee CPP and 1.4 times the amount contributed to EI.
  • The burden of payroll taxes typically falls on workers, leading to lower wages, rather than increasing employer profits.

Revenue from Excise Tax

  • The general principle states that total revenue from an excise tax equals the area of the rectangle formed by the tax wedge (height) multiplied by the quantity sold (width).
  • Question: Does doubling the excise tax rate double revenue?
      - Conclusion: Usually no, because an increase in tax raises prices and reduces the quantity sold, potentially lowering overall revenue.

The Laffer Curve

  • Theoretical Proposition: Initially, increasing tax rates raises revenue, but beyond a certain point, additional increases can lead to a decline in revenue due to reduced transaction volume.
  • As tax rates rise excessively, the reduction in transactions will diminish tax revenue.
  • Effects on Surplus: Higher prices decrease consumer surplus, while lower prices increase it—taxation decreases both consumer and producer surpluses, leading to a net loss in total surplus.

Deadweight Loss and Efficiency Costs of Taxes

  • Taxes create deadweight loss, representing the loss in total surplus within society that arises from reduced transactions, as some trades that would have occurred in a tax-free environment do not take place.
  • Administrative Costs: The costs associated with collecting taxes are incurred both by the government and taxpayers, exceeding the net amount collected.
  • Total Inefficiency: Calculated as the sum of deadweight loss and administrative costs. Tax systems should aim to minimize these inefficiencies.

Minimization of Efficiency Costs

  • Minimize inefficiencies by targeting taxes towards goods with relatively inelastic demand or supply.
      - Extreme Cases:
        - A perfectly inelastic demand curve results in no deadweight loss.
        - A perfectly inelastic supply also avoids deadweight loss.
  • Principles of Tax Fairness:
      - Benefit Principle: Those who benefit from public spending should also bear the tax burden corresponding to that benefit (e.g., gas taxes for infrastructure improvements).
      - Ability to Pay Principle: Taxpayers should contribute according to their ability to pay.
      - Lump-sum taxes are considered efficient but unfair as they are uniform irrespective of individuals' circumstances.
  • A well-designed tax system represents a trade-off between equity and efficiency.

Federal Tax Philosophy

  • The income tax constitutes approximately half of federal revenue, with government transfer payments functioning similarly to a negative tax rate (e.g., old age security, child benefits).

Structure of Tax Systems

  • Components:
      - Tax Base: The value of assets over which a tax can be applied.
      - Tax Structure: Defines how tax rates are computed based on the tax base.
  • Major types of taxes:
      - Income Tax: Based on individual or family income.
      - Payroll Tax: Based on wages paid by employers to employees.
      - Sales Tax: Based on the value of goods sold.
      - Profits Tax (Corporate Income Tax): Based on firm profits.
      - Property Tax: Based on the value of owned property.

Tax Rate Types

  • Proportional Tax: Fixed tax rate.
  • Progressive Tax: Increases with income, taking a larger share from high-income earners.
  • Regressive Tax: Decreases with income, resulting in low-income earners paying a larger share.
  • Marginal Tax Rate: The percentage of an increase in income that will be taxed.