Ch 29. Public Choice Theory
& the Economics of
Taxation
A.
Public choice theory – economic
analysis of gov’t decision making,
politics, & elections.
-- How/when/how much should gov’t intervene w/ externalities?
-- Candidates offer alternative packages and voters choose.
Public Choice Theory
Inefficient Voting Outcomes
Inefficient
Majority “Yes” Vote
Benefit; Tax
Benefit; Tax
-- Majority
voting can
produce
inefficient
decisions.
-- (a) Majority
voting leads
to rejection$300
of a public
good that
produce a
greater public 0
benefit than cost.
-- (b) Results in
accepting a public
good with a higher
cost than benefit.
Inefficient
Majority “No” Vote
$700
Adams
$250
Benson
$350
$350
Benson
Conrad
“YES”
“YES”
$300
$200
$100
Conrad
Adams
“YES”
“NO”
“NO”
“NO”
0
“NO” Wins!
Inefficient Since
MSB > MSC
$1,150 > $900
“YES” Wins!
Inefficient Since
MSB < MSC
$800 < $900
B.
Gov’t failure
1. Special
interest effect
2. Rent seeking
3. Limited & bundled choice
4. Bureaucracy
-- Failure due to inefficiency from certain characteristics of the public sector.
-- Special interests: small group trying to get specific outcomes.
-- Rent: payment beyond what’s necessary to keep a resource supplied; securing
favorable gov’t policies that result in rent (higher profit or income) than normal.
-- Bundled choice deals with Congress passing an Appropriations Bill that has
many amendments (many w/ nothing to do with the bill); vote yea or nay.
C.
The tax burden
1. Benefits-received principle
2. Ability-to-pay
principle
-- Benefits-received of taxation asserts businesses & households should purchase
the goods & services of gov’t in same way as other commodities like a gas tax
for road repairs. But, could the unemployed pay a tax for job training?
-- Ability-to-pay taxation asserts that taxes are based on income & wealth.
-- No scientific way to determine how much a person is able to pay in taxes.
16th Amendment
(Congress to levy the Income Tax, 1913)
• Applied to mostly
the rich when ratified
in 1913.
• Extended to nearly
everyone to finance
WWII.
• 1943, withholding
system adopted to
ensure collections.
D.
Taxes:
1. Progressive –  rate w/  income.
2. Proportional – rate stays same.
3. Regressive -  rate w/  income.
-- The Federal tax system is Progressive.
-- Overall U.S. tax system is only slightly Progressive (small redistribution of wealth).
-- Many state & local tax systems are Regressive.
-- In 1999, the lowest 20% of households paid an average of 4.6% Federal taxes.
-- 1999, the top 10 % paid 30.6%.
“…nothing can be said to be certain
except death and taxes.”
-- Ben Franklin
Types of Taxes:
-- Personal income tax
-- Corporate income tax
-- Payroll tax
-- Property tax
-- Sales tax
-- Excise tax (sin tax on
alcohol or
cigarettes)
-- California’s ‘Proposition 13’ passed in 1978 capped the amount of property tax.
Tax Incidence
Incidence of an Excise Tax
P
S’
Price (Per Bottle)
-- An excise tax of
a specified amount,
here $2 per unit,
shifts the supply
curve upward by
the amount of the
tax per unit: the
vertical distance
between S & St.
-- This results in a
higher price ($9) to
consumers and a lower
after-tax price ($7) to
producers.
-- Thus, consumers &
producers share the tax
burden (equally @ $1).
14
S
12
Tax $2
10
8
6
4
D
2
0
5
10
15
20
Quantity
25
(Millions of Bottles Per Month)
Q
Tax Incidence
Demand Elasticity and the Incidence
of an Excise Tax
-- (a) if demandP
is elastic in
the relevant
price range,
price rises
Pe
modestly
P1
(P1 to Pe) with
an excise tax. Pa
-- Producer
bears most
of burden.
-- (b) If demand 0
is inelastic, the
price to the buyer
rises drastically
(P1 to Pi), most of
tax on consumer.
P
St
Tax
St
Tax
S
S
a
Pi
a
b
P1
Pb
De
c
b
c
Dt
Q2
Q1
Tax Incidence and
Elastic Demand
Q
0
Q2Q1
Tax Incidence and
Inelastic Demand
Elastic demand: product or resource demand whose price
elasticity is greater than 1.
 Inelastic demand: coefficient is less than 1.
Q
Tax Incidence
Supply Elasticity and the Incidence
of an Excise Tax
-- With elastic P
supply, an
excise tax
results in a
large price
Pe
increase
P1
(P1 to Pe),
Pa
tax paid
mostly by
consumers.
-- (b) If supply 0
is inelastic, the
price rise is
small (P1 to Pi),
and seller bears
most of tax.
P
Tax
St S
Tax
St
a
S
Pi
P1
b
a
b
c
Pb
c
D
Q2
Q1
Tax Incidence and
Elastic Supply
D
Q
0
Q2Q1
Tax Incidence and
Inelastic Supply
Elastic supply: product or resource supply whose price
elasticity is greater than 1.
 Inelastic supply: coefficient is less than 1.
Q
Tax Incidence
Efficiency Loss of a Tax
P
S’
14
Tax Paid by
Consumers
12
Price (Per Bottle)
-- The levy of a $2 tax
per bottle of wine
increases the price
per bottle from
$8 to $9 and reduces
the equilibrium
quantity from
15 to 12.5 million.
-- Tax revenue to
the gov’t is $25
million (area efac).
-- The efficiency loss
of the tax arises from
the 2.5 million decline
in output, the amount
of that loss is shown
as triangle abc.
S
Tax $2
10
8
6
4
2
0
Efficiency
Loss (or
Tax Paid by Deadweight
Loss)
Producers
5
10
15
20
Quantity
D
25
(Millions of Bottles Per Month)
Q
Incidence of U.S. Taxes
Taxes on Goods and Services as a
Percentage of Total Tax Revenues
GLOBAL PERSPECTIVE
-- A number of
industrialized nations
rely on a goods &
0
5
10
15
20
25
30
35
services tax
United Kingdom
32.7
– sales tax,
30.8
value-added taxes, Netherlands
and specific excise
Germany
29.2
taxes – than the
Italy
26.9
U.S. does.
Sweden
26.4
-- A value-added tax only
26.3
applies to the difference Canada
France
between the value of a
25.4
firm’s sales and the
Japan
20.1
value of its
United States
17.6
purchases from
other firms.
Source: Organization for Economic Cooperation and Development, 2002
Facts About Income Inequality
• Lorenz Curve and Gini Ratio
e
100
Lorenz Curve
Percentage of Income
The
Lorenz
Curve
80
(Actual Distribution)
Perfect Equality
60
d
A
B
40
c
20
Complete
Inequality
b
0
a
20
40
60
80
Percentage of Households
Gini Ratio =
f
100
Area A
Area A + Area B
Facts About Income Inequality
• Effect of Gov’t Redistribution
100
Percentage of Income
80
60
Lorenz Curve
After Taxes and
Transfers
40
20
0
Lorenz Curve
Before Taxes and
Transfers
20
40
60
80
100
Percentage of Households
Impact of Government Taxes and Transfers