Chapter 17 Public Choice Theory and the Economics of Taxation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Conveying economic preferences through majority voting Government failure Tax philosophies and the tax burden Tax shifting, tax incidence, and efficiency losses from taxes 17-2

Majority Voting Can result in inefficiency Interest groups Logrolling Over or underproduction of a public good Individuals think only of themselves Strength of preferences ignored Interest groups Logrolling 17-3

Majority Voting Inefficient Majority “No” Vote Inefficient Majority “Yes” Vote Benefit; Tax $700 Adams $350 $350 Benson Conrad $300 $300 $250 $200 Benson $100 Conrad Adams “YES” “NO” “NO” “NO” “YES” “YES” “NO” Wins! “YES” Wins! Inefficient Since Inefficient Since MSB > MSC MSB < MSC $1,150 > $900 $800 < $900 17-4

Majority Voting Paradox of voting Median voter model Paired choice majority voting Flawed procedure Outcome depends on vote order Median voter model Politicians appeal to the middle Extremes pick the middle Implications 17-5

Government Failure Special-interest effect Rent-seeking behavior Pork-barrel politics Rent-seeking behavior Clear benefits, hidden costs Limited and bundled choice Bureaucracy and inefficiency Imperfect institutions 17-6

The Tax Burden How should the tax burden be apportioned? Benefits-received principle Ability-to-pay principle Progressive tax Regressive tax Proportional tax 17-7

Types of Taxes Personal income tax Sales tax Corporate income tax Payroll tax Property tax 17-8

Tax Incidence Who really pays the tax? Excise tax Tax burden depends on elasticity Inelastic vs. elastic Efficiency loss of an excise tax Deadweight loss Depends on elasticity Transfer of surplus to govt. 17-9

Tax Incidence of an Excise Tax 2 4 6 8 10 12 14 5 15 20 25 Q P St S Price (Per Bottle) Quantity (Millions of Bottles Per Month) Tax $2 D 17-10

Tax Incidence Why impose an excise tax? Burden of the excise tax? Discourage consumption Redistributive goals Reduce negative externality Burden of the excise tax? Depends on elasticity Availability of substitutes 17-11

Tax Incidence and Elasticity Smaller efficiency loss with inelastic demand Q P P Q St St Tax Tax S S a Pi a Pe b P1 P1 b De Pb Pa c c Di Q2 Q1 Q2 Q1 Tax Incidence and Elastic Demand Tax Incidence and Inelastic Demand 17-12

Tax Incidence and Elasticity Smaller efficiency loss with inelastic supply Q P P Q St S Tax Tax St a Pe S a Pi b P1 P1 b Pa c Pb c D D Q2 Q1 Q2 Q1 Tax Incidence and Elastic Supply Tax Incidence and Inelastic Supply 17-13

Efficiency Loss of a Tax 2 4 6 8 10 12 14 5 15 20 25 Q P S’ Tax Paid by Consumers S Price (Per Bottle) Quantity (Millions of Bottles Per Month) Tax $2 Efficiency Loss (or Deadweight Loss) Tax Paid by Producers D 17-14

Incidence of U.S. Taxes Workers bear full burden of: Social security tax Medicare tax Income tax Burden of corporate income tax: Stockholders (short run) Workers (long run) 17-15

U.S. Tax Structure Federal tax system progressive State and local system is regressive Overall tax structure slightly progressive 17-16

Taxes on General Consumption Sales tax, excise tax, value-added tax Percentage of GDP, 2005 0 2 4 6 8 10 12 14 Iceland Denmark Sweden New Zealand France Germany Italy Canada Japan United States Source: Organization for Economic Cooperation and Development 17-17

Government Failure Examples of pork barrel politics Chicago “wilderness” program Bison meat, cauliflower, and pumpkin supports Catfish as livestock spending 9,300 special projects in 2003 Waste and fraud in Katrina relief spending 17-18

Key Terms public choice theory logrolling paradox of voting median-voter model government failure special-interest effect earmarks rent seeking benefits-received principle ability-to-pay principle progressive tax regressive tax proportional tax tax incidence efficiency loss of a tax 17-19

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