Public Finance (MPA405) Dr. Khurrum S. Mughal

Lecture 23: Taxation, Prices Efficiency, and the Distribution of Income Public Finance

Lump-Sum Taxes –A Lump-sum tax is a fixed tax that is owed by everyone and is not subject to something taxpayers can change. –It is independent of income, consumption, or wealth. –An example is a Head Tax, which is constant for everyone.

Inefficiency in Taxation and the Lump-Sum Tax Inefficiency in taxation results from the ability to avoid taxes by avoiding a taxed activity. Because lump-sum taxes are unavoidable, they serve as the benchmark by which other taxes are measured. They only have income effects

Inefficiency in Taxation and the Lump-Sum Tax No price distortion –Reduce buying power without affecting “MSB=MSC” –Doesn’t affect the attainment of efficient outcomes –Efficient allocation of resources with the pattern of demand originating from new demand due to new income distribution

A price distorting tax is a tax that alters the relative price of goods. Example: Tax on Gasoline –The budget line pivots on the y-axis shifts on x-axis –The purchase price increased for consumers –Also shows a scenario if a Lump-sum tax was applied instead Price Distorting Taxes

Price Distorting Tax Versus A Lump-Sum Tax Expenditure on Other Goods per Year (Dollars) Gasoline per Year (Gallons) 0Q1Q1 Y* QTQT QLQL Y1Y1 YTYT A L BB'L' T U3U3 U2U2 U1U1 E'' E' E T

Individuals utility level declines in case of price distorting subsidy Individual is much better off in case of lump-sum tax –There is no substitution effect since the product is not expensive relative to other goods Implication

Unit Taxes A unit tax adds to the price by a fixed amount. Examples include the 32 cents per pack of cigarettes and 24 cents per gallon of gasoline in federal taxes.

Tax Terms The Gross Price (P G ) is the price paid by consumers. The Net Price (P N ) is the price received by producers after the tax is paid. P N = P G – T

Impact of A Unit Tax on Market Equilibrium Example: Unit tax on Gasoline –The supply curve would shift left showing increased price at existing demand curve –The marginal social cost now includes tax. –Excess burden is created

Tax Revenue Impact of A Unit Tax on Market Equilibrium Price (Dollars) Gasoline per Year (Gallons) 0 Q1Q1 Q* 1.15 = PGPG 0.90 = P N S = MSC D = MSB 1.00 Excess Burden T = $0.25 S T = MSC + $0.25 QQ A B C

Excess Burden of a Unit Tax DWL = 1/2T  Q =1/2 ×T 2 × (Q*/P*) × (E S E D )/(E S – E D )

Implication of the DWL Calculation A doubling of the per unit tax quadruples the Deadweight Loss. Even if the revenue collected is returned to supplier and the seller, deadweight loss cannot be removed.

Excess Burden is Zero When Demand or Supply is Perfectly Inelastic Demand Supply after Tax Supply Price Quantity per Month 0q A Price 0q B Supply Demand Net Price after Tax Quantity per Month

Efficiency Loss Ratio of a Tax The Efficiency Loss Ratio is the deadweight loss per dollar of revenue raised DWL/R.