Taxation, income distribution,
and efficiency
Today: Some basic tax theory
Begin Unit 4
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Today
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Chapters 14 and 15
An introduction to some basic theories related to
taxation
Taxation
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Taxes are typically used to finance public
projects
Deadweight loss comes with most forms of
taxation
Taxation and income distribution
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The US federal tax system has been set up
so that people with high incomes have higher
average tax rates
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Do people consume more leisure with high
marginal tax rates?
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Public project financing
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To be answered later
People with high tax rates probably have high
willingness to pay for many public projects
See Table 14.3, p. 327
Some terminology
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Statutory incidence
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Who legally has to pay for the tax
Economic incidence
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How much does real income change to all parties
due to a tax?
Some terminology
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Lump sum tax
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Proportional tax
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Average tax rate is independent of income
Progressive tax
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A tax that has to be paid no matter how a person
behaves
Average tax rate increases with income
Regressive tax
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Average tax rate decreases with income
Some terminology
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Unit tax
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A tax that is paid per unit of a good
Ad valorem tax
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A tax that is a percentage of the purchase price
Partial equilibrium models
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With partial equilibrium models, only one
market is examined at any one time
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Ignores possible spillover effects
Usually easier to analyze than general equilibrium
models
Two types of taxes analyzed
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Unit tax
Ad valorem tax
Unit tax
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You have likely seen unit taxes before
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Econ 1 (or equivalent)
Econ 100A/B (or equivalent)
Either the buyer or seller pays a given dollar
amount for each unit sold or purchased
$
2.60
Before Tax
After Tax
Partial
Equilibrium
Models
2.40
Consumers Pay
$1.20
$1.40
2.20
Suppliers Receive
$1.20
$1.00
S1
2.00
S0
1.80
1.60
1.40
1.20
1.00
0.80
D1
D0
0.60
0
1
2
3
4
5
6
7
Quantity 8
Ad valorem taxes
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Assume that the consumer pays an ad
valorem tax
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Example: 6% sales tax
The ad valorem tax shifts the demand curve
by the same percentage (relative to the
horizontal axis)
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See Figure 14.7, p. 315
Other types of taxes
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Taxes from working
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Income tax
Social Security tax
Hospital insurance tax (Medicare)
Capital taxes
Taxes on profits
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Accounting profits
Economic profits
Tax incidence and capitalization
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Suppose that we value land as the net
present value of the yearly income from the
land
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Assume that the land has value for T years
T could be infinity
Then the value of the land will be
PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … +
$RT/(1 + r)T
Tax incidence and capitalization
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Suppose that a new tax is implemented on
each piece of land
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New value of the land
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Yearly income falls by the amount of the tax
PR’ = $(R0 – u0) + $(R1 – u1)/(1 + r) +
$(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)T
Value of the land drops by
u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T
Tax incidence and capitalization
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Capitalization process
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When a new tax is implemented, the new price
falls by the net present value of the total taxes
that will have to be paid
General equilibrium models
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When a tax affects a large portion of the
economy, partial equilibrium models may not
accurately predict the overall effects to the
economy
General equilibrium models are needed to
analyze situations that affect more than one
market
Changes in consumption due to taxes
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Recall that people typically consume less of a
good or service once it is taxed
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Example: Yacht tax in the early 1990s
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Tax on yachts over $100,000 purchased in the US
People bought yachts in other countries
Net economic impact
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$16.6 million in taxes collected (less than the $31 million
predicted)
Less income tax paid by workers (7,600 jobs lost in the US)
Study of taxation graphically
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Individual behavior
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Excess burden in a market with horizontal supply
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See Figure 15.7, p. 343, and Figure 15.9, p. 347
Subsidies
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See Figure 15.5, p. 340
Taxes on labor
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See Figure 15.2, p. 333
See Figure 15.6, p. 342
Pigouvian taxes
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See Figure 5.4, p. 83
Recall double dividend hypothesis
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Industry with negative externality
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Pigouvian tax  Reduces excess burden
If tax proceeds are used to reduce other
taxes, excess burden from these taxes are
lowered
Criticism: An environmental tax could lead to
an increase in the excess burden in the labor
market
An economist’s analysis
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Given an amount of revenue that is
generated, taxes should be imposed such
that one of the following goals is achieved
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Excess burden is minimized
Social welfare is maximized
The real world
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Taxes are often imposed that have the lowest
amount of political resistance
Excess burden seems less important than
revenue generation
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Sometimes efficiency is completely ignored
How does personal income get taxed?
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The personal tax system used by the federal
government requires many steps to
understand
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Chapter 17
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Highlight the basic structure, marginal tax rates, and
other aspects of the federal tax structure
For next lecture: Read p. 380-406
Today vs. tomorrow
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With a tax system currently in place, we
should ask how changes in tax policy affect
current and future behavior
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Chapter 16 has more on this
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Marginal excess burden
Tax avoidance versus tax evasion
Focus reading on p. 353-362 and 370-376 for
next lecture
Summary
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Taxation of efficient markets typically leads to
excess burden
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Unit tax
Ad valorem tax
Taxes on land lower the income potential for
the land, lowering its value
Subsidies usually lead to excess burden also