Public Choice Theory and the Economics of Taxation Chapter 17 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 –Over or underproduction of a public good –Individuals think only of themselves –Strength of preferences ignored 17-3

Majority Voting Interest groups-people band together to persuade others of public good merits. Logrolling-trading of votes to secure outcomes. Can turn into inefficient outcome.

Majority Voting Inefficient Majority “No” Vote Inefficient Majority “Yes” Vote $300 Benefit; Tax 0 0 $700 $250 $200 $100 $350 Adams Benson Conrad “NO” “YES” “NO” MSB > MSC $1,150 > $900 Inefficient Since “NO” Wins! MSB < MSC $800 < $900 Inefficient Since “YES” Wins! 17-5

Majority Voting Paradox of voting-unable to rank preferences. –Paired choice majority voting –Flawed procedure –Outcome depends on vote order Median voter model –Politicians appeal to the middle –Extremes pick the middle –Implications by voter 17-6

Government Failure Special-interest effect –Pork-barrel politics-securing a government project that yields benefits mainly to a single district Rent-seeking behavior Clear benefits, hidden costs Limited and bundled choice Bureaucracy and inefficiency Imperfect institutions 17-7

The Tax Burden Total cost of taxes imposed on society How should the tax burden be apportioned? Benefits-received principle- goods/services purchased the same way as other commodities Ability-to-pay principle- apportioned based upon income 17-8

Tax Burden Progressive tax-average rate increases as income increases. –Larger % of income as income increases Regressive tax-average rate declines as income increases –Smaller % of income as it income increases Proportional tax-remains the same regardless of income

Types of Taxes Personal income tax Sales tax Corporate income tax Payroll tax Property tax 17-10

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

Tax Incidence of an Excise Tax Q P Price (Per Bottle) Quantity (Millions of Bottles Per Month) S D StSt Tax $

Tax Incidence Why impose an excise tax? –Discourage consumption –Redistributive goals –Reduce negative externality Burden of the excise tax? –Depends on elasticity –Availability of substitutes 17-13

Tax Incidence and Elasticity 0 P QQ P 0 Tax Incidence and Elastic Demand Tax Incidence and Inelastic Demand Smaller efficiency loss with inelastic demand DeDe DiDi Tax StSt S StSt S Q2Q2 P1P1 PePe PaPa P1P1 PiPi PbPb Q1Q1 Q2Q2 Q1Q1 a a b b c c 17-14

Tax Incidence and Elasticity 0 P QQ P 0 Tax Incidence and Elastic Supply Tax Incidence and Inelastic Supply Smaller efficiency loss with inelastic supply D D S SStSt StSt P1P1 PaPa PePe P1P1 PbPb PiPi Q1Q1 Q2Q2 Q1Q1 Q2Q2 Tax a a b b c c 17-15

Efficiency Loss of a Tax Q P Price (Per Bottle) Quantity (Millions of Bottles Per Month) S D S’ Tax $2 Tax Paid by Consumers Tax Paid by Producers Efficiency Loss (or Deadweight Loss) 17-16

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) 17-17

U.S. Tax Structure Federal tax system progressive State and local system is regressive Overall tax structure slightly progressive 17-18

Taxes on General Consumption Percentage of GDP, 2005 Iceland Denmark Sweden New Zealand France Germany Italy Canada Japan United States Source: Organization for Economic Cooperation and Development Sales tax, excise tax, value-added tax 17-19

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 17-20

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 17-21

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