Taxation and Efficiency Chapter 15

Contents 1. Questions and answers 2. Excess burden measurement with demand curves 3. Differential taxation of inputs www.themegallery.com Company Name

Taxation and Efficiency 1.Excess burden(welfare cost , deadweight loss)—Because a tax distorts economic decisions , it creates an excess burden—a loss of welfare above and beyond the tax revenues collected. Two commodities (Barley and corn) Fixed income Pb and Pc are prices of goods No distortions such as externalities, imperfect competition, public goods, etc. www.themegallery.com Company Name

Figure 15.1 shows the budget constraint (AD), with utility maximized at bundle E1. Ad-valorem tax levied on barley at rate tb raises the price to (1+tb)Pb and rotates the budget constraint along the x-axis. The new budget constraint is AF. www.themegallery.com Company Name

www.themegallery.com Company Name

Vertical distance between old and new budget constraints is GE2, the “tax bill.” www.themegallery.com Company Name

Equivalent variation is the amount of income we would have to take away (before any tax was imposed) to induce a move to the lower indifference curve. www.themegallery.com Company Name

Note that ME3=GN>GE2, but both give the consumer the same utility. Thus, the difference E2N is the excess burden of the barley tax. The barley tax makes the person worse off by an amount that exceeds the revenue it generates. Lump sum tax is a tax that must be paid regardless of the taxpayer’s behavior. Budget constraint HI satisfies this. Revenue yield exactly equals the equivalent variation. Conclusion: Lump sum tax has no excess burden. www.themegallery.com Company Name

Questions and answers 1.If lump sum taxes are so efficient, why aren’t they widely used? Because the loss of the same amount hurts a poor family than a rich family. It is unfair. Thus, individual lump sum taxes are best viewed as standards of efficiency,not as major policy options in a modern economy. 2.Are there any result from welfare economics that would help us understand why excess burdens arise? www.themegallery.com Company Name

3,Does an income tax entail an burden? Questions and answers 3,Does an income tax entail an burden? The answer is generally yes . In fact, if income were fixed, an income tax would be a lump sum tax.if a third commodity, leisure, exists. 4. If demand for a commodity is perfectly inelastic, is there excess burden? Even though Naomi’s barley consumption is unchanged by the barley tax, it still creates an excess burden of E2S(Figure 15.4) www.themegallery.com Company Name

Questions and answers 5, The compensated response is the important one for calculating excess burden. The movement from E1 to E2 is the uncompensated response. Now,we can imagine decomposing the move from E1 to E2 into a move from E1 to E3, and then from E3 to E2. The move from E1 to E3 shows the effect on consumption of a lump sum tax. This change, called the income effect , is due to solely to the loss of income because relative prices are unaffected. The movement from E3 to E2 is called the compensated response, also sometimes referred to as the substitution effect. The compensated response is the important one for calculating excess burden. Because it is only in moving from E3 to E2 that the marginal rate of substitution is affected. As shown earlier, this change violates the necessary conditions for a Pareto efficient allocation of commodities. www.themegallery.com Company Name

Conclusion 1,An ordinary demand curve depicts the uncompensated change in the quantity of a commodity demanded when price changes. 2,A compensated demand curve shows how the quantity demanded changes when price changes and simultaneously income is compensated so that the individual’s commodity bundle stays on the same indifference curve. A way of summarizing this discussion is to say that excess burden depends on movements along the compensated rather than the ordinary demand curve. www.themegallery.com Company Name

Figure 13.5 Excess burden equal to triangle fid. Through some mathematical manipulation, this can be expressed as: www.themegallery.com Company Name

www.themegallery.com Company Name

Implications of formula: Higher (compensated) elasticities lead to larger excess burden. Excess burden increases with the square of the tax rate. The greater the initial expenditure on the taxed commodity, the larger the excess burden. www.themegallery.com Company Name

Excess burden measurement with demand curves EBM With DC The excess burden of a subsidy Preexisting distortions www.themegallery.com Company Name

Preexisting distortions 1.In reality, when a new tax is introduced, there are already other distortions:monopolies, externalities, and preexisting taxes. 2. The excess burden of a subsidy (figure 15.6) 3.The excess burden of income taxation(figure 15.7) www.themegallery.com Company Name

Differential taxation of inputs 1. Excess burden of differential taxation of inputs:(Figure 15.9) In general, whenever a factor is taxed differently in different uses, it leads to a misallocation of factors between sector and hence an excess burden. The tax thus creates a situation in which there is “too much ” housework and “not enough ” work in the market .The resulting decrease in real income is the excess burden of the tax. Excess burden equal to abe. www.themegallery.com Company Name

www.themegallery.com Company Name

The end