1. Ch 29.Public Choice Theory & the Economics of Taxation

2. A.Public choice theory – economic analysis of gov’t decision making, politics, & elections. -- How/when/how much should gov’t intervene w/ externalities? -- Candidates offer alternative packages and voters choose.

3. Public Choice Theory Inefficient Voting Outcomes 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! -- Majority voting can produce inefficient decisions. -- (a) Majority voting leads to rejection of a public good that produce a greater public benefit than cost. -- (b) Results in accepting a public good with a higher cost than benefit.

4. B.Gov’t failure 1.Special interest effect 2.Rent seeking 3.Limited & bundled choice 4.Bureaucracy -- Failure due to inefficiency from certain characteristics of the public sector. -- Special interests: small group trying to get specific outcomes. -- Rent: payment beyond what’s necessary to keep a resource supplied; securing favorable gov’t policies that result in rent (higher profit or income) than normal. -- Bundled choice deals with Congress passing an Appropriations Bill that has many amendments (many w/ nothing to do with the bill); vote yea or nay.

5. C.The tax burden 1.Benefits-received principle 2.Ability-to-pay principle -- Benefits-received of taxation asserts businesses & households should purchase the goods & services of gov’t in same way as other commodities like a gas tax for road repairs. But, could the unemployed pay a tax for job training? -- Ability-to-pay taxation asserts that taxes are based on income & wealth. -- No scientific way to determine how much a person is able to pay in taxes.

6. 16 th Amendment (Congress to levy the Income Tax, 1913) Applied to mostly the rich when ratified in 1913. Extended to nearly everyone to finance WWII. 1943, withholding system adopted to ensure collections.

7. D.Taxes: 1.Progressive –  rate w/  income. 2.Proportional – rate stays same. 3.Regressive -  rate w/  income. -- The Federal tax system is Progressive. -- Overall U.S. tax system is only slightly Progressive (small redistribution of wealth). -- Many state & local tax systems are Regressive. -- In 1999, the lowest 20% of households paid an average of 4.6% Federal taxes. -- 1999, the top 10 % paid 30.6%.

8. “…nothing can be said to be certain except death and taxes.” -- Ben Franklin Types of Taxes: -- Personal income tax -- Corporate income tax -- Payroll tax -- Property tax -- Sales tax -- Excise tax (sin tax on alcohol or cigarettes) -- California’s ‘Proposition 13’ passed in 1978 capped the amount of property tax.

9. Tax Incidence Incidence of an Excise Tax 0 2 4 6 8 10 12 14 510152025 Q P Price (Per Bottle) Quantity (Millions of Bottles Per Month) S D S’ Tax $2 -- An excise tax of a specified amount, here $2 per unit, shifts the supply curve upward by the amount of the tax per unit: the vertical distance between S & St. -- This results in a higher price ($9) to consumers and a lower after-tax price ($7) to producers. -- Thus, consumers & producers share the tax burden (equally @ $1).

10. Tax Incidence Efficiency Loss of a Tax 0 2 4 6 8 10 12 14 510152025 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) -- The levy of a $2 tax per bottle of wine increases the price per bottle from $8 to $9 and reduces the equilibrium quantity from 15 to 12.5 million. -- Tax revenue to the gov’t is $25 million. -- The efficiency loss of the tax arises from the 2.5 million decline in output, the amount of that loss is shown as triangle abc.

11. Tax Incidence 0 P QQ P 0 Tax Incidence and Elastic Demand Tax Incidence and Inelastic Demand Demand Elasticity and the Incidence of an Excise Tax DeDe DtDt Tax StSt S StSt S Q2Q2 P1P1 PePe PaPa P1P1 PiPi PbPb Q1Q1 Q2Q2 Q1Q1 a a b b c c -- (a) if demand is elastic in the relevant price range, price rises modestly (P 1 to P e ) with an excise tax. -- Producer bears most of burden. -- (b) If demand is inelastic, the price to the buyer rises drastically (P 1 to P i ), most of tax on consumer.  Elastic demand: product or resource demand whose price elasticity is greater than 1.  Inelastic demand: coefficient is less than 1.

12. Tax Incidence 0 P QQ P 0 Tax Incidence and Elastic Supply Tax Incidence and Inelastic Supply Supply Elasticity and the Incidence of an Excise Tax D D S SStSt StSt P1P1 PaPa PePe P1P1 PbPb PiPi Q1Q1 Q2Q2 Q1Q1 Q2Q2 Tax a a b b c c -- With elastic supply, an excise tax results in a large price increase (P 1 to P e ), tax paid mostly by consumers. -- (b) If supply is inelastic, the price rise is small (P 1 to P i ), and seller bears most of tax.  Elastic supply: product or resource supply whose price elasticity is greater than 1.  Inelastic supply: coefficient is less than 1.

13. Incidence of U.S. Taxes Taxes on Goods and Services as a Percentage of Total Tax Revenues GLOBAL PERSPECTIVE United Kingdom Netherlands Germany Italy Sweden Canada France Japan United States 0 5 10 15 20 25 30 35 32.7 30.8 29.2 26.9 26.4 26.3 25.4 20.1 17.6 Source: Organization for Economic Cooperation and Development, 2002 -- A number of industrialized nations rely on a goods & services tax – sales tax, value-added taxes, and specific excise taxes – than the U.S. does. -- A value-added tax only applies to the difference between the value of a firm’s sales and the value of its purchases from other firms.

14. Facts About Income Inequality Lorenz Curve and Gini Ratio The Lorenz Curve 20406080100 20 40 60 80 100 0 Perfect Equality Lorenz Curve (Actual Distribution) Complete Inequality A B a b c d e f Gini Ratio = Area A Area A + Area B Percentage of Households Percentage of Income

15. Facts About Income Inequality Effect of Gov’t Redistribution 20406080100 20 40 60 80 100 0 Lorenz Curve Before Taxes and Transfers Percentage of Households Percentage of Income Lorenz Curve After Taxes and Transfers Impact of Government Taxes and Transfers