McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 15 TAXATION AND EFFICIENCY

15-2 Excess Burden Defined  A loss of welfare above and beyond taxes collected.  Same as Deadweight Loss  $20 Tax on Candy Bars?  Consider white board example.

15-3 Excess Burden Defined  Consider a Tax on Barley P b t = (1+t b ) P b Note: Different Axes from last chapter.

15-4 Excess Burden Defined Pounds of corn per year Pounds of barley per year E1E1 B1B1 C1C1 D F A CbCb CaCa B0B0 Government levies tax on barley i

15-5 Effect of Tax on Consumption Bundle Pounds of corn per year Pounds of barley per year E1E1 B1B1 C1C1 D F A CbCb CaCa B0B0 E2E2 i ii G

15-6 Excess Burden of the Barley Tax Pounds of corn per year Pounds of barley per year E1E1 B1B1 C1C1 D F A CbCb CaCa B0B0 E2E2 i ii G H B3B3 M I Tax Revenues Equivalent variation Excess Burden Note: No Excess Burden from Lump Sum Taxes

15-7 Compensated vs. Uncompensated  Uncompensated Response Consumption changes because of the tax and incorporates effects due to both losing income and tax-induced change in relative prices.  Compensated Response Substitution Effect The tendency of an individual to consume more of one good and less of another because of a decrease in the price of the former relative to the latter

15-8 Income vs. Substitution Effect  Income Effect The effect of a price change on the quantity demanded due exclusively to the fact that the consumer’s real income has changed  Substitution Effect Compensated Effect

15-9 Questions and Answers Pounds of corn per year Pounds of barley per year C1C1 D F A CbCb CaCa B 1 = B 2 E2E2 i ii E1E1 J B3B3 R K If the demand for a commodity does not change when it is taxed, does this mean that there is no excess burden? S Uncompensated Response (E 1 to E 2 ) Income Effect (E 1 to E 3 ) Substitution Effect (E 3 to E 2 ) Compensated Effect E3E3

15-10 Questions and Answers  Lump Sum Tax Problems Tough Politically  British Prime Minister Margaret Thatcher

15-11 Questions and Answers  Does consumer maximization help us understand this? Whiteboard

15-12 Questions and Answers  Does an income tax entail an excess burden? Whiteboard

15-13 Excess Burden Measurement with Demand Curves Pounds of barley per year Price per pound of barley a DbDb SbSb q1q1 q2q2 i h S’ b PbPb (1 + t b )Pb gf d Tax revenues Excess burden of tax Excess burden = ½ ηP b q 1 t b 2

15-14 Appendix A – Formula for Excess Burden A = ½ * base * height = ½ * (di) * (fd) fd = ∆P b = (1 + t b ) * P b – P b = t b * P b di = ∆q η = (∆q/∆P b )(P b /q) Price Elasticity ∆q = η(q/P b )∆P b since ∆Pb = t b * P b ∆q = η(q/Pb)*(t b P b ) = η * q * t b since di = ∆q A = ½(di)(fd) = ½(ηqt b )*(t b P b ) = ½ * η * P b * q * (t b ) 2

15-15 Appendix A – Formula for Excess Burden  What do we get intuitively?  Tax several goods small amounts. The Squared Term! Tax Doubles? Excess Burden Quadruples!

15-16 Appendix A – Formula for Excess Burden  Airline-Tickets  Federal Taxes = 10%  n = 1 Price Increases 1% Quantity Decreases 1%  $86 billion = p*q  Excess Burden > (.5)(86)((0.1) 2 billion $ $430 million

15-17 Excess Burden of a Subsidy Housing services per year Price per unit of housing services m DhDh Sh’Sh’ h2h2 h1h1 u q ShSh (1 – s)P h PhPh no r Excess burden v

15-18 Excess Burden of Income Taxation Hours per year Wage rate per hour SLSL L1L1 L2L2 a g (1 – t)w w f i h Excess burden d Excess burden = ½ εωL 1 t 2

15-19 Value of Marginal Product (VMP)  Dollar value of the additional output produced for each hour worked  Downward Slope?

15-20 The Allocation of Time Between Housework and Market Work $ $ 0 0’ Hours worked in home per year Hours worked in market per year H* w1w1 w1w1 VMP home VMP mkt (1 – t)VMP mkt H1H1 a b e c d w2w2 (1 – t)w 2 Excess burden = ½ (ΔH)tw 2

15-21 Does Efficient Taxation Matter?  Why no excess burden budget?  Is efficiency the primary objective of government policy?  Does excess burden mean a tax is bad?