1. More on taxation Today: Studying taxation graphically What should be taxed? Why?

2. Changes in consumption due to taxes Recall that people typically consume less of a good or service once it is taxed  Example: Yacht tax in the early 1990s Tax on yachts over $100,000 purchased in the US People bought yachts in other countries Net economic impact  $16.6 million in taxes collected (less than the $31 million predicted)  Less income tax paid by workers (7,600 jobs lost in the US)

3. Today Studying taxation graphically How do people react to taxes?  Deadweight loss  Ramsey rule  Equity/fairness  Tax avoidance

4. Study of taxation graphically Individual behavior Excess burden in a market with horizontal supply Taxes on labor Subsidies Pigouvian taxes

5. How do taxes affect individual behavior? Pounds of corn per year Pounds of barley per year E1E1 B1B1 C1C1 D F A CbCb CaCa B0B0 E2E2 i ii G

6. Market excess burden, horizontal supply Pounds of barley per year Price per pound of barley a DbDb SbSb q1q1 q2q2 i h S’ b PbPb (1 + t b )P b gf d Tax revenues Excess burden of tax Remember: Excess burden and deadweight loss mean the same thing

7. Taxing labor Hours per year Wage rate per hour SLSL L1L1 L2L2 a g (1 – t)w w f i h Excess burden d

8. Subsidies lead to excess burden, too 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

9. Recall: Pigouvian taxes reduce excess burden Q per year $ MB 0 MD MPC MSC = MPC + MD Q1Q1 Q* c d (MPC + cd) Pigouvian tax revenues i j

10. Recall double dividend hypothesis Industry with negative externality  Pigouvian tax  Reduces excess burden If tax proceeds are used to reduce other taxes, excess burden from these taxes are lowered Criticism: An environmental tax could lead to an increase in the excess burden in the labor market

11. An economist’s analysis Given an amount of revenue that is generated, taxes should be imposed such that one of the following goals is achieved  Excess burden is minimized  Social welfare is maximized

12. The real world Taxes are often imposed that have the lowest amount of political resistance Excess burden seems less important than revenue generation  Sometimes efficiency is completely ignored

13. Efficient taxation/tax dodging Although the yacht tax was likely implemented to be “equitable,” efficiency suffered on all margins  Excess burden due to the tax  Decreased overall tax revenue collected due to jobs lost in the US What kinds of taxes lead to less excess burden?

14. Efficient taxation Assume that the amount of tax revenue collected is set at a constant level Should everything be taxed at the same rate in order to make the most efficient outcome?  Taxing each good at the same rate is known as neutral taxation

15. Marginal excess burden X per year PXPX DXDX P0P0 X0X0 c P 0 + u X b X1X1 ∆X a Excess Burden P 0 + (u X + 1) f X2X2 i ∆x ej h g Marginal Excess Burden

16. The Ramsey rule How do we tax to reduce excess burden?  Ramsey rule Percentage reduction in quantity demanded for every good is the same Back to our old question: Should everything be taxed at the same rate in order to make the most efficient outcome? NO  One other concept to keep in mind Marginal excess burden generally increases as the tax increases

17. Equity concerns From the Ramsey rule, inelastic goods should be taxed at higher rates in order to gain efficiency  Coffee  Theater/opera  Salt  Many prescription drugs Example: Insulin needed to live

18. Should we look at fairness, too? Many people believe that fairness is just as important as efficiency  This type of person would… Probably not want to tax insulin Impose a higher tax on goods that high-income people consume more of Not want to impose a lump sum tax

19. Tax evasion/tax avoidance Tax evasion  Not paying taxes that are legally owed to a government Tax avoidance  Altering behavior to legally pay less in taxes

20. Examples of tax avoidance Recall yacht tax in the early 1990s  Tax on yachts over $100,000 purchased in the US  Tax avoidance: People bought yachts in other countries  Net economic impact in the US was negative 18 th century tax in Brazil  Tax on finished churches  Tax avoidance: Build churches that were complete except for some trivial part that was not built This church is not “finished” since it is missing one of its towers

21. Other examples of tax avoidance Uffa Fox built a home made from a floating bridge in Britain  Fox would sail his home whenever tax collectors would try to collect property tax Cyprus used to have a tax on finished structures  Many houses would had steel bars sticking out of the top floor

22. One more tax avoidance example Thai tax on outside signs  Highest tax on signs in English only  Medium tax on signs in English and Thai  Lowest tax on signs in Thai only How have people responded?

23. One more tax avoidance example Thai tax on outside signs  Highest tax on signs in English only  Medium tax on signs in English and Thai  Lowest tax on signs in Thai only How have people responded?  Put their store information on curtains inside the store  Make signs with English words in big letters and Thai words in tiny writing

24. Tax evasion theory Marginal benefit of cheating on taxes is constant  $1 for each dollar in taxes avoided Marginal cost is increasing  Probability of getting caught cheating increases as the number of “red flags” increases If MB > MC for some people (for the first dollar in tax evasion), an underground economy develops

25. A tale of two people (Dollars of underreporting) $ $ MC = p * marginal penalty MB = t R* R* = 0

26. Summary: Efficient taxation/tax dodging Efficient taxation comes from the Ramsey rule  Percentage reduction in quantity demanded for every good is the same Equity concerns are important in many people’s minds Tax evasion and tax avoidance are used to lower the amount of taxes a person pays  Note that tax evasion is illegal

27. Are you a tax evader? Tax dodger? One more lecture to go Wednesday  Read pages 380-385, 398- 401, 406-409, and 415-419  Federal taxes  Marriage penalty  Labor decisions with taxes