CHAPTER
6
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Taxes and Subsidies
CHAPTER OUTLINE
Commodity Taxes
Subsidies
For applications, click here
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questions
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Video
Policy Shapes Incentives and Behavior
Not only are more children born in late December than in
Unless you’re a cynic, or an
early January, but also the extra births appear to be
economist,
realize
you
clustered among
those who Ihave
the most
to gain from a
tax deduction
might have trouble believing
that the intricacies of the
nation’s tax code would
impinge on something as
sacred as the birth of a
child. But it appears that you
would be wrong.
- David Leonhardt The New York Times
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Taxes
"In this world nothing can be said to be certain,
except death and taxes."
- Benjamin Franklin
“The difference between death and taxes is death
doesn't get worse every time Congress meets.”
- Will Rogers Will Rogers
“No nation has ever taxed itself into prosperity”
- Ronald Reagan
“No Nation ever borrowed itself into prosperity”
- Unknown
“It’s as if people think that if the government imposed
a tax on cows, the tax would be paid by the cows.”
- Hebert Stein
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Taxes
“The power to tax is the power to destroy.”
- John Marshall, American Jurist, Statesman
“The Income Tax has made more liars out of the
American people than golf has.”
– Will Rogers
Rich bachelors should be heavily taxed. It is not
fair that some men should be happier than
others.”
– Oscar Wilde
“Oh my God, what happened to my paycheck?”
- Mike Mace, on receiving his first full-time
paycheck in December 1977
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Taxes
Milton Friedman on taxes:
“Inflation is taxation without legislation”
“I am favor of cutting taxes under any
circumstances and for any excuse, for any
reason, whenever it's possible.”
“We have a system that increasingly taxes
work and subsidizes non-work.”
“The real cost of government is measured
by what government spends, not by
receipts labeled taxes.”
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Taxes
A Commodity Tax is a tax on goods.
Some truths about commodity taxation:
1. Who pays the tax does not depend on
who writes the check to the government;
2. Who pays the tax does depend on the
relative elasticities of demand and
supply;
3. Commodity taxation raises revenue and
creates lost gains from trade (deadweight loss).
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Who Pays the Tax?
A Tax on Sellers Shifts the Supply Curve Up by the Tax
Buyers pay
more than
before…
Price
And sellers
receive less
than before
Supply With Tax
tax
Supply No Tax
Price Paid by
Buyers
Price (No Tax)
b (new equilibrium)
tax
a
Price Received
by Sellers
Demand
Quantity
Qwith tax Qno tax
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A Tax on Apple Sellers
A $1 Tax on Sellers Shifts the Supply
Curve Up by $1
Price rises by less than the tax
($1)
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A Tax on Apple Buyers
A $1 Tax on Buyers Shifts the Demand
Curve Down by $1
Result? Same as if tax were
levied on Sellers… Price rises by
less than the tax B($1)
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The Tax “Wedge”
Since it doesn’t matter whether buyers or sellers are taxed, we can graph
the tax as a simple “wedge”
Supply
Price
Price Paid by
Buyers: $2.65
b
The $1
tax
wedge
a
d
Price Sellers
Receive: $1.65
Demand
Quantity
QDemanded with $1 tax
If the tax is $1, the price buyers pay must be $1 more than the price sellers receive.
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Who Pays the Tax? Depends.
Who pays the tax? It depends on
the relative elasticities of supply and
demand.
The less elastic side of the market
will pay the greater share of a tax
(bear more of the burden of a
tax).
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The Burden of a Tax
When Demand is More Elastic than Supply Sellers Pay More of the Tax
Price
Supply
Price Paid
by Buyers
b
a
Price (No Tax)
tax
Price Received
by Sellers
Demand
d
Qwith tax
Qno tax
Quantity
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The Burden of a Tax
When Supply is More Elastic than Demand Buyers Pay More of the Tax
Price
Price Paid
by Buyers
b
tax
a
Supply
Price (No Tax)
d
Price Received
by Sellers
Demand
Quantity
Qwith tax
Qno tax
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Try it!
In a long-distance relationship, who will do more of the
driving?
Does the “tax” fall more heavily to the more committed
partner?
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Try it!
SEE THE INVISIBLE HAND
This pleasure boat seems like a good thing to tax…
Or not: The Omnibus Budget Reconciliation Act of 1990
applied a 10% federal luxury tax to the retail sale of luxury
goods like pleasure boats with a sales price above $100,000.
Expected tax revenue? $9 billion. Reality?
•Sales of boats down 52.7%;
• Net loss of 30,000 jobs;
• The federal government paid out > $7 million
more in unemployment benefits to those workers
than it collected in luxury tax revenues.
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The Burden of a Tax
The Omnibus Budget Reconciliation Act of 1990
applied a 10% federal luxury tax to the first retail
sale of luxury goods such as pleasure boats with a
sales price above $100,000.
The tax was originally projected to generate
revenues of $9 billion over five years after passage.
The tax was widely popular among policy makers
as a way to shift the burden of deficit reduction to
those who can best afford it (i.e. the Rich).
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The Burden of a Tax
The results were not what was expected by
policy makers:
Sales of boats down 52.7%;
Net loss of 30,000 jobs;
The federal government paid out over $7 million
more in unemployment benefits to those workers
than it collected in luxury tax revenues.
BACK TO
The Burden of a Tax
The elasticity of supply for boats was
evidently less elastic than the elasticity of
demand for boats.
The federal luxury tax was quickly (and
quietly) repealed in 1993
BACK TO
The Burden of a Tax
You had to be an ignoramus to believe the luxury
tax was only going to soak the rich. The only
people it hurt was working people like myself,”
-Judy Ott, an assembly worker at the Viking
Yacht Company’s plant in New Jersey.
“All these people suffered needlessly because
the politicians in Washington needed a symbol to
sell the American people a new tax increase,”
- Viking’s co-founder Robert T. Healey.
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The Burden of a Tax
So the next time you vote for politicians who are
going to “stick it” to the rich or corporations via
taxes, remember the “little guys” who will lose their
jobs as a result.
Why could the current efforts in the U.S. and
California (no less than THREE ballot initiatives to
raise taxes on the rich) cause more harm than
good?
“Democracy is two wolves and a sheep voting on
what’s for dinner”
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The Burden of a Tax
Other applications:
Health Insurance Mandates and Tax Analysis
Mandates requiring employers to provide
health insurance to their workers may reduce
wages if labor supply is less elastic than
demand for workers.
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The Burden of a Tax
Health Insurance Mandates and Tax Analysis
Many people believe that healthcare benefits
are paid by their employer
Most don’t realize that their wages are lower as a
result
Healthcare tax mandate on employers raises the
cost of labor supply
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The Burden of a Tax
Which side of the market is more inelastic, the
demand for labor or the supply of labor?
Firms can substitute capital (machines) for labor,
move overseas to avoid the tax, or simply close down
Employees are unlikely to be able to quite working (if
taxed) or less likely move overseas than their
employers
For most workers, the elasticity of their supply of labor
is lower than their employers’ elasticity of demand for
labor
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The Burden of a Tax
Health Insurance Mandates and Tax Analysis
It is likely that workers will bear most of the cost of
mandated health insurance via lower wages
This is not to say that the law is a bad idea
What is a bad idea is voters believing that somehow
healthcare has been made “free.”
They are being duped by less-than-forthcoming
politicians, i.e. they are depending on your
economic ignorance
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The Burden of a Tax
Same argument applies to FICA and similar
payroll taxes
Workers bear most of the tax burden even though
employers “pay half the tax” via wages lower than
without FICA
Why? The labor supply curve is more inelastic than the
labor demand curve
There is no free lunch (the politician’s weapon of
choice)
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The Burden of a Tax
Other applications:
Who Pays the Cigarette
tax?
If manufacturers of
cigarettes can easily dodge
state taxes (via smuggling),
then it’s possible the tax will
not discourage smoking.
National cigarette taxes are
more effective in deterring
smoking: no interstate taxdodging occurs.
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The Burden of a Tax
Who Pays the Cigarette Tax?
Smokers have an inelastic demand for cigarettes
of about .5
Cigarette companies have a very high elasticity
of supply to any one state since they can easily
ship their products to other states with relatively
lower taxes
Buyers bear nearly all of the tax
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The Burden of a Tax
Real world example:
Taxes range from $.07 in S. Carolina to $2.57/pack in
New Jersey
Cigarettes sell for $3.35/pack in S. Carolina, while
cigarettes in New Jersey are priced at $6.45
After-tax price received by sellers is $3.28 in SC
compared to $3.88 in NJ
Prices vary probably due to differences in related
costs
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In 2010, New York contemplated a $1/pack cigarette
tax. This video highlights the costs of the tax. Click
on the picture. (1:22 minutes)
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The Effects of a Tax
A Tax Generates Revenue and Creates a Deadweight Loss
Price
Price Buyer
Pays =
$2.65
Deadweight
Loss- No one
gets this
Tax
Revenue
= $500
Supply
tax
Pno tax
Consumer Surplusconsumers get this
Price Seller
Receives =
$1.65
Tax Revenue- the
government gets
this
Producer Surplusproducers get this
500 = Qtax
Demand
Quantity
700 = Qno tax
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The Deadweight Loss of a Tax
Another example of DWL:
Imagine that you want to go to New York on a
trip. You value the trip at $50 and a bus ticket costs
$40. Do you take the trip?
A. Yes. The value ($50) of the trip exceeds the cost
of the ticket ($40) so you travel to New York.
How much consumer surplus (net value) do you get
from the trip?
A. $10=$50-$40.
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The Deadweight Loss of a Tax
The government taxes bus tickets which raises the
price of a bus ticket to $60. Do you take the trip?
A. No. The value of the trip is now less than the price
of the ticket.
What happened to the $10 consumer surplus which
you used to get when there was no tax?
A. It's gone since no trip takes place.
Did the government get any tax revenue from you?
A. No.
Key idea: Consumers lose but the government does
not gain from trips that are not taken.
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Try it!
What is the tax revenue that the
government collects from the tax on
gadgets?
a) $350
b) $450
c) $100
d) $550
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Deadweight Loss and Elasticity
Deadweight Losses are Larger the More Elastic the Demand Curve:
If the demand is inelastic, a tax will not deter many trades.
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Subsidies
A subsidy is a reverse tax where the government
gives money to consumers (or producers).
Subsidy = Price Received by Sellers – Price Paid by
Buyers
Some facts about subsidies:
1. Who gets the subsidy does not depend on
who receives the check from the
government;
2. Who benefits from the subsidy does depend
on the relative elasticities of demand and
supply;
3. Subsidies must be paid for by taxpayers and
they create inefficient increases in trade
(deadweight loss).
BACK TO
The Subsidy “Wedge”
A subsidy drives a wedge between the price received by sellers and the
price paid by the buyers.
Supply
Price
Price received
by Sellers: $2.40
b
The $1
subsidy
wedge
a
d
Price paid by
Buyers: $1.40
Demand
QDemanded with $1 subsidy
Quantity
If the subsidy is $1, the price buyers pay must be $1 less than the price sellers receive.
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Subsidies
When demand is more elastic than supply, suppliers bear
more of the burden of a tax and receive more of the benefit
of a subsidy.
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Try it!
Who benefits most from the large
agricultural water subsidy?
Farmers in California’s Central Valley typically pay $20-$30 an
acre-foot for water that costs $200-$500 an acre-foot
Hint: which is more elastic: demand or supply for cotton?
a) California cotton suppliers
b) California cotton buyers
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Subsidies
King Cotton and the Deadweight Loss of
Water Subsidies
In the Central Valley of California, farmers pay
$20-$30 an acre-foot for water that costs $200$500 an acre-foot
The difference represents the government subsidy
Rice, cotton, alfalfa are grown in a “Cadillac
Desert”
Other subsidies abound
Ex) crop subsidies for cotton
Ex) Subsidized water used to grow subsidized corn
to feeds cows producing subsidized milk
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Subsidies
All of these subsidies represent “deadweight
loss” since such crops can be grown more
cheaply elsewhere
Who benefits from the water subsidy?
Cotton suppliers or cotton buyers?
Remember that the benefit of a subsidy falls on
the more inelastic side of the market
Elasticity of demand for California cotton is much
higher than the elasticity of supply. Why?
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Subsidies
Demand elasticity is very high since cotton grown
outside of California is a perfect substitute (i.e.
many substitutes)
Supply elasticity is lower as a result, hence
subsidy flows to producers
Without the subsidies, there would be much
less water intensive farming
Would definitely affect the debate on
environmental issues in Central Valley
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Subsidies
Should Los Angeles subsidize the Cirque du Soleil?
• In 2009 the Los Angeles City Council approved a $30m loan for a
10-year Production of Cirque du Soleil in Hollywood
• What are the costs? Benefits?
Should the government be in the entertainment business?
See Alex Tabarrok’s post here
B
A CK
T O
Wage Subsidies
The minimum wage is the clearest example of a
price floor in the United States.
Such a policy, however, can hurt low-skilled
workers by reducing employment.
Some economists believe that a better
approach would be to subsidize employers
(demanders of labor).
This approach leads to a higher wage and a
higher level of employment.
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Some Subsidies have Serious Benefits:
Wage Subsidies Increase Employment
A wage subsidy costs the government money but increases employment
from Qm to Qs (and reduces welfare payments)
Supply of Labor
Wage
Wage received
by Workers: $12
b
Market Wage:
$10.50
a
The $4
subsidy
wedge
d
Wage paid by
Firms: $8
Demand for Labor
Qd
Qm
Qs
Quantity
of Labor
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Wage Subsidies
Suggested by Edmund Phelps. Nobel Prize
winner in Economics
It would be expensive, paid by taxpayers
Would result in more low skilled workers being
employed
Costs could be offset by social benefits: less
crime, less dependency, etc
Similar to EITC program
BACK TO
Try it!
Which of the following statements are true?
I.
A $0.50 tax on each fishing lure sold
raises the price per lure by $0.50.
II.
A tax on sellers is equivalent to a tax
on buyers.
III. A tax on buyers is analyzed by
shifting the demand curve up by the amount of
the tax.
a)
b)
c)
d)
I and II
II and III
II only
I, II, and III
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If demand of some good is more elastic than
supply and a tax is imposed on the consumption
of the good, who will bear more of the burden of
the tax?
a) Producers, because consumers have a greater
ability to change their behavior in response to
the tax.
b) Both parties will share the burden equally.
c) Consumers, because they pay the tax out of
pocket.
d) The government, because the tax will cause
less of the good to be produced and
consumed.
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Try it!
Junk food has been criticized for being
unhealthy and too cheap, enticing the poor to
adopt unhealthy lifestyles. Suppose that the
state of Oklakansas imposes a tax on junk food.
What needs to be true for the tax to actually
deter the most people from eating junk food:
Should junk food demand be elastic or should it
be inelastic?
a) Demand should be perfectly inelastic.
b) Demand should be elastic.
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