CHAPTER OVERVIEW - Mr Clotzman at Uni High guide... · Web viewCHAPTER OVERVIEW This chapter includes a study of public choice theory, an economic analysis of government decision

Public Choice Theory and the Economics of Taxation

CHAPTER THIRTY-ONEPUBLIC CHOICE THEORY AND

THE ECONOMICS OF TAXATION

CHAPTER OVERVIEWThis chapter includes a study of public choice theory, an economic analysis of government decision making, and selected topics related to public expenditures and tax revenues. The theoretical discussion includes an examination of the inefficiency of voting outcomes, interest-group influence, political logrolling, and the paradox of voting outcomes. The median-voter model is considered. Also examined is public sector failure, or the failure of public decisions to promote the general welfare.

Attention is then focused on how public goods are financed. The ability-to-pay vs. the benefits-received principles of taxation are evaluated. Progressive, proportional, and regressive taxes are defined and illustrated with examples. The concepts of tax incidence and efficiency loss are also reviewed. This chapter concludes with a discussion of the structure of the U.S. tax system.

WHAT’S NEWThis chapter has been condensed without significant loss of content. The full-page discussion of “The Issue of Freedom” has been deleted.

Tax data and Global Perspective 31-1 have been updated, and new examples have been added to the “Last Word.”

A new web-based question replaces an outdated one.

INSTRUCTIONAL OBJECTIVESAfter completing this chapter, students should be able to

1. Explain the problems created with majority voting and the median-voter outcome.

2. State four reasons given by public choice theorists for government’s inefficiency in providing public goods and services.

3. Differentiate between the benefits-received and ability-to-pay principles of taxation.

4. Identify which taxes are progressive, proportional, and regressive.

5. Describe how elasticities of demand and supply are related to the incidence of a sales or excise tax.

6. Explain the relationship between the elasticities of demand and supply and the efficiency loss of a particular tax.

7. Describe the probable incidence of the personal income tax, corporate income tax, sales and excise taxes, and property tax.

8. Explain the U.S. structure relative to the progressivity or regressivity of Federal, state, and local taxes.

9. Define and identify the terms and concepts listed at end of the chapter.

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COMMENTS AND TEACHING SUGGESTIONS1. Have students investigate the use of special-interest lobbyists. They may be shocked by their

findings; some may even discover a new career objective since some lobbyists are extremely well paid. The sheer number of interest groups that hire lobbyists to represent them may also be surprising to students. The process of lobbying legislatures is itself a big business. Point out that state legislatures are under the same kind of pressure from interest groups as the Senate and the House of Representatives.

2. The IRS has regional Taxpayer Education Coordinators who will provide informational materials and/or speakers on the subject of federal taxes. Contact your local IRS office for information on how to reach the coordinator for your area. Most state revenue departments also have public information departments that may provide speakers and/or materials on the subject of state taxes. Finally, many states have independent tax research councils who provide information to interested parties. These organizations are good sources of unbiased materials because their support usually depends on their providing good information about the impact of various taxes and proposed taxes.

3. If you are covering this chapter near tax-filing season, an interesting exercise is to look at the tax tables for the federal income tax and have students identify various tax “loopholes” differences between tax on same income for married, head-of-household, and single individuals; the difference between a deduction and a tax credit; and other items that may be of interest to you or your students. It is then fun to have students try to discover or imagine the reasons behind various tax breaks or to design a tax system that would be more fair in their view. This is also a good group exercise.

4. Students could be asked to come up with their own examples of public sector failures after reading this chapter and, in each case, identify the cause of the “failure.”

5. The following “Concept Illustration” on Rent-seeking may be useful.

CONCEPT ILLUSTRATION … Rent Seeking

The French economist Frédéric Bastiat (1801-1850) is remembered for his wit and capacity to point out absurdities in the arguments of his opponents. In the following passage, he satirizes appeals to government for special benefits at someone else’s expense, or what today we call "rent-seeking." His message is timeless: When rent-seekers succeed, it is often at the expense of the general interest.

When, unfortunately, one has regard to the interest of the producer, and not to that of the consumer, it is impossible to avoid running counter to the general interest, because the demand of the producer, as such, is only for efforts, wants, and obstacles.

I find a remarkable illustration of this in a Bordeaux newspaper.M. Simiot proposes this question:

Should the proposed railway from Paris to Madrid offer a solution of continuity at Bordeaux?

[Mr. Simiot argues that] the railway from Paris to Bayonne should have a break at Bordeaux, for if goods and passengers are forced to stop at that town, profits will accrue to bargemen, pedlars, commissionaires, hotel-keepers, etc.

Here we have clearly the interest of labor put before the interest of consumers.

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But if Bordeaux has a right to profit by a gap in the line of railway, and if such profit is consistent with the public interest, then Angoulême, Poitiers, Tours, Orleans, nay, more, all the intermediate places, Ruffec, Châtellerault, etc., should also demand gaps, as being for the general interest, and, of course, for the interest of national industry; for the more these breaks in the line are multiplied, the greater will be the increase of consignments, commissions, transshipments, etc., along the whole extent of the railway. In this way, we shall succeed in having a line of railway composed of successive gaps, and which may be denominated a Negative Railway.

The principle of restriction is the very same as the principle of gaps; the sacrifice of the consumer’s interest to that of the producer, in other words, the sacrifice of the ends to the means. 1

1Frédéric Bastiat, Economic Sophisms (Edinburgh: Oliver & Boyd, Ltd., 1873), pp. 80-81, abridged.

STUDENT STUMBLING BLOCKS1. Because government programs are currently viewed with a great deal of suspicion by many

citizens, it may be difficult to focus the students’ attention on the theoretical aspects of this chapter, as opposed to the emotional reaction that government is inherently wasteful and inefficient. While there is a focus on public sector failure in this chapter, recall that there are also market failures that led to the need for government action in the first place. How to balance the public and private sectors is a question that deserves attention at this point.

2. Students, as well as the general public, often make the mistake of assuming that moving into a higher tax bracket means that one pays the higher percentage on all taxable income. Giving them examples of hypothetical taxpayers poised to move into higher tax brackets (Should he or she accept the raise?) should help dispel the confusion.

LECTURE NOTES

I. Introduction

A. In the last chapter we examined some examples of market failure in the private sector and the government policies designed to remedy them. This chapter examines more closely the public sector and its failures that elicit disenchantment.

B. This chapter deals with two main topics.

a. “Public choice theory” is the economic analysis of government decision making that helps us to understand public sector problems.

b. The economics of taxation.

II. Revealing society’s preferences through majority voting is the way collective decisions are made in a democracy.

A. Majority voting can lead to inefficient outcomes; that is, the majority can defeat a proposal that would have provided greater benefits than costs and adopt one that costs more than the benefits it provides (see Figure 31-1).

1. Illustration of an inefficient “no” vote result: Suppose there are 3 voters who each will have to pay $300 in tax if a proposal is adopted. It is worth $700 to one, $250 to the

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second and $200 to the third. The second and third voters will vote “no” and defeat the proposal despite the fact that the total benefits ($1150) exceed the $900 cost.

2. Illustration of an inefficient “yes” vote result: Take the same three voters as above and the same level of taxation. Now the proposal is worth $100 to the first voter and $350 to each of the others. The vote will be 2 to 1 in favor of the proposal even though the total benefit of $800 is less than the $900 cost.

3. Conclusion: The problem is that the one-person one-vote rule does not measure intensity of preferences, so the result may not be economically efficient.

B. Interest groups may improve the economic efficiency of results by registering intense feelings with elected representatives or by organizing major efforts to get the vote to go their way.

C. Logrolling or vote trading may also secure favorable decisions for those who feel strongly about certain issues, but it may also negate an efficient outcome in favor of a special interest group where the value of the benefits received does not justify the cost. The efficiency of the outcome will depend on the circumstances.

D. The paradox of voting is that society may not be able to rank its preferences consistently through majority voting.

1. Table 31-1 demonstrates a situation in which three voters have expressed their rankings of three public projects; each has a different ranking. If voting is done on pairs of projects, it can be shown that national defense will win over roads, and roads will win over weather warning systems. But the logical conclusion that the community prefers national defense to weather warning systems is not the case—they would each get the same number of points (if points were awarded for a 1st, 2nd, and 3rd choice). In other words, if one choice must receive a majority of the votes, there will not be a consistent outcome in this case unless somehow the strengths of the rankings can be measured.

2. Government might find it difficult to provide the “correct” public goods by acting in accordance with majority voting.

E. The median-voter model suggests that under majority rule the median voter will in a sense determine the outcomes of elections. The median voter is the person holding the middle position on an issue.

1. The textbook example has three voters deciding among three types of weather warning systems. The first is willing to spend $400; the second, $800; the third, $300. The median-voter model suggests that the $400 proposal will win. In a choice between the $400 and $800 proposal, the first and third will vote for the $400 type. In a choice between the $400 and $300, the first and second will vote for the $400 type. In other words, both extreme voters prefer the median choice rather than the other extreme, so the median voter will tend to predominate.

2. Real-world examples occur in political positions where candidates seem to aim their appeal at the median voters within each party to get the nomination and later at the middle of the population in an effort to win the election.

3. Implications of the median-voter model.

a. Many people will be dissatisfied by the extent of government involvement in the economy.

b. Some people may “vote with their feet” by moving into political jurisdictions where the median voter’s preferences are closer to their own.

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c. Median preferences can change over time.

III. Government failure can occur as well as market or private sector failure. The fact that the latter exist does not mean that the public sector improves efficiency.

A. Special interests and “rent seeking” may promote the interests of a small group at the expense of society at large.

1. The special-interest effect refers to the situation where a small number of people will receive large gains at the expense of a much larger number of people who individually suffer small losses. The small group will be well informed and highly vocal on the issue and press politicians for approval. The large numbers who will each suffer small losses will not have the incentive to be informed or feel strongly. The result is that the politician will support the special-interest program, whose supporters will notice the vote in their favor, and ignore the majority who don’t feel strongly.

2. Pork-barrel politics is an example of the special-interest effect. In this case, the benefit goes to a single political district and to the politician from that political district. The cost of the project is spread out to many individuals who will never receive the benefits. Pork-barrel politics is often combined with logrolling.

3. Rent-seeking behavior occurs when a transfer of wealth at someone else’s or society’s expense occurs through government action. Here the term “rent” means any payment to a resource supplier, business, or other organization above that which would accrue under competitive market conditions. Examples include tax loopholes that benefit only certain groups; public works projects that cost more than the benefits they yield; and occupational licensing that requires more than is necessary to protect consumers.

B. Clear benefits, hidden costs (or the reverse, immediate costs and future more vague benefits) are another dilemma for politicians trying to decide on public programs. Where the benefits are recognizable and popular, the politician may vote for the program even if the costs exceed these benefits, if the costs are diffuse or hidden.

C. Limited and bundled choice is another problem with public goods. The voter must choose between a few candidates who will have the power to select the public goods and services to be financed by the voter’s tax money. The choices are “bundled” in that the limited set of candidates will govern over a variety of issues, and the voter’s preferences may not perfectly align with any candidate. In the private sector, the consumer has a multitude of choices available, and can generally separate out those goods and services not desired.

D. Bureaucracy and inefficiency can be another problem in the public sector because there is not the profit motive or competitive pressure to perform efficiently. Ironically, the typical response of government to a program’s failure may be to increase its budget and staff.

1. Government employees, together with the special-interest groups they serve, often have the political clout to block attempts to pare down or eliminate their agencies.

2. There is a tendency for government bureaucracy to justify continued employment by looking for and eventually finding new problems to solve.

E. Imperfect institutions exist in both the public and private sectors, which often makes it difficult to decide which institutions would perform best in the production of certain goods and services.

IV. Apportioning the tax burden and deciding how the public sector should be financed is also a complex question.A. Benefits received versus ability to pay principle of taxation.

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1. The benefits-received principle asserts that households and businesses should be taxed in relationship to the services they receive. For example, gasoline taxes are earmarked for highway construction and maintenance.

a. How can the government decide which citizens receive how much benefit from less divisible public goods like national defense?

b. Government efforts to redistribute income would be self-defeating if the benefits-received principle of taxation were applied universally—welfare recipients would have to pay for their welfare at the extreme version of this.

2. The ability-to-pay principle asserts that the tax burden should rest more heavily on those with greater income and wealth. The rationale is that those people with much income or wealth will value their marginal dollars less than those with low incomes, where each dollar is very meaningful.

B. Progressive, proportional, and regressive taxation systems relate to the above issues. (Key Question 7)

1. A tax is progressive if its average rate increases as income increases; the tax grows both absolutely and proportionately with income.

2. A tax is proportional if its average rate remains the same; the tax payment grows absolutely with income but remains the same proportionate to income.

3. A tax is regressive if its average rate declines as income increases; the tax may or may not increase in the absolute amount, but it declines in proportion to income.

C. Applications in existing tax structure.

1. The federal personal income tax is mildly progressive, with marginal tax rates ranging from 10 to 35 percent. Certain deductions that favor high-income groups erode the progressivity of this tax.

2. Sales taxes are not as proportional as they seem if they are on all goods. A general sales tax is regressive because, although everyone pays the same percent on expenditures, the rich tend to spend a much smaller fraction of their incomes, while the poor may spend all of their incomes. Therefore, the rich will pay a smaller overall proportion of their income in sales taxes.

3. The federal corporate income tax is essentially a flat-rate tax with a set rate, but if it is passed on to consumers in the form of higher prices it may actually be regressive in its impact.

4. Payroll taxes are regressive. The social security portion of the tax (6.2 percent) is not applied to income above a certain level ($87,000 in 2003). On the other hand, the Medicare tax (1.45 percent) is applied to all wage income. A person making $100,000 paid the same amount of social security tax as the person making $87,000, i.e., 6.2 percent times $87,000 or $5,394. The tax payment would be 7.65 percent of the $87,000 income (the $5,394 plus $1261.50 Medicare tax), but about 6.84 percent of the $100,000 income.

5. Property taxes tend to be regressive because landlords pass along this cost to tenants who have lower incomes; housing costs are a larger proportion of income for the poor than for the rich, so economists estimate that the property tax on that housing would end up being a greater proportion of low incomes than of high incomes.

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V. Tax Incidence and Efficiency Loss

A. Tax incidence refers to who actually bears the economic burden of a tax (see Figure 31-2).

1. The division of the burden is not obvious. Figure 31-2 shows the impact of a $2 per-bottle tax on wine that was priced at $8 per bottle before the tax.

2. S is the no-tax supply situation and S t is the after-tax supply curve. The new equilibrium price rises to $9, not $10 as one might expect with the $2 tax.

a. Consumers pay $1 more per bottle.

b. Producers receive $1 less per bottle.

3. In this example, consumers and producers share the burden of the tax equally. The incidence is not completely on either one.

B. Elasticities of demand and supply explain the incidence of an excise or sales tax.

1. Given supply, the more inelastic the demand for the product, the larger the portion of the tax is shifted forward to consumers (Figure 31-3b). Figure 31-3a shows the situation if demand is more elastic.

2. Given demand, the more inelastic the supply (Figure 31-4b), the larger the portion of the tax borne by producers or sellers. Figure 31-4a shows the situation if supply is more elastic.

C. Efficiency loss is one result of an excise or sales tax.

1. Figure 31-5 illustrates the concept of efficiency loss, which occurs as a result of an excise tax or sales tax. The efficiency loss is the reduction of well-being that occurs because there will be less produced at the higher price caused by the tax. It is the sacrifice of net benefit accruing to society because consumption and production of the taxed product are reduced below their allocatively efficient levels.

2. Elasticities play a role in determining the extent of the efficiency loss. Other things being equal, the greater the elasticities of supply and demand, the greater the efficiency loss of a particular tax.

3. Qualifications to the analysis relate to the idea that the goals of tax policy may be more important than the goal of minimizing efficiency losses from taxes. Two examples are given.

a. Redistributive goals—Excise taxes placed on luxury items in 1990 resulted in efficiency losses, but the benefits from redistributing income from the wealthier consumers who buy luxury items may have been worth the loss in efficiency. However, these luxury taxes were unpopular and have been repealed.

b. Reducing negative externalities—If there is less alcohol and tobacco consumption as a result of excise taxes, the taxes may have socially desirable consequences.

D. Probable incidence of U.S. taxes is estimated for various taxes.

1. The personal income tax generally falls on the individual except for those who can control the price of their labor services and pass on the cost of the tax through higher fees.

2. The incidence of the corporate income tax is uncertain. Some corporations may be able to shift the burden by charging higher prices; others may find there is decreased profitability and the burden is then borne by stockholders.

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3. Excise taxes can be shifted to the consumer where demand is inelastic. This is true generally with the small range of products on which excise taxes are levied (gasoline, cigarettes, and alcoholic beverages). However, because sales taxes cover such a wide range of products, the incidence of sales taxes is just as likely to fall on the seller—it depends on the respective elasticities of demand and supply for the product.

4. The incidence of property taxes may fall on the property owner, or in the case of rental and business property, the tax would be largely shifted onto the tenant or the customer.

5. Global Perspective 31-1 indicates that the U.S. is less dependent upon sales and excise taxes than many other industrialized nations.

E. Table 31-2 summarizes the discussion of the shifting and incidence of taxes.

VI. The U.S. Tax Structure

A. It is difficult to determine the overall progressivity or regressivity of the American tax structure. Disagreement among economists persists.

B. The Federal tax system: The system is progressive.

1. In 1999, the average Federal tax rate for the 20 percent of taxpayers with the lowest incomes was only 4.6 percent. The tax rate for the 20 percent of the taxpayers with the highest income was 29.1 percent. The tax rate was 30.6 percent for the top 10 percent of tax payers and 34.4 percent for the top 1 percent. The top 5 percent of all taxpayers paid 50 percent of the total Federal income tax collected.

2. This progressivity is offset by the social security tax, which is regressive. Because of the cap of $87,000, taxpayers who earn more, pay a lower percentage of their income as tax than do lower and middle income earners.

C. The state and local tax system: State and local tax structures are largely regressive as a percentage of income. Both sales and property taxes fall as a proportion of income when income rises.

D. Combined Tax Structure: Overall, the American tax structure is slightly progressive. The American system of transfer payments does reduce income inequality and is estimated to quadruple the incomes of the poorest one-fifth, which makes the tax-transfer system more progressive than the tax system alone.

VII. LAST WORD: “Public Sector Failure” in the News

A. It took 23 Federal employees to approve the purchase of laptop computers costing $3,500 each. The same computers were priced at $1,500 each in a retail store.

B. As a part of a radiation cleanup project, the EPA spent an average of $651,700 to custom-build 10 new homes that replaced old houses that were valued at $147,000 each.

C. There are Congressional provisions that require the government to purchase certain equipment from a single firm, as is the case with security locks for government buildings.

D. Appropriations bills sometime contain riders that are unrelated to the bill itself, such as the 1999 emergency legislation for Yugoslavia and relief from Hurricane Mitch that gave approval for open-pit gold mining in eastern Washington State.

E. The 2003 Appropriations bills provided $4 million for preservation of orangutans and gorillas around the world. The disaster relief section of the bill authorized livestock compensation payments for catfish farmers.

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ANSWERS TO END-OF-CHAPTER QUESTIONS

31-1 Explain how affirmative and negative majority votes can sometimes lead to inefficient allocations of resources to public goods. Is this problem likely to be greater under a benefits-received or an ability-to-pay tax system? Use the information in Figure 31-1a and b to show how society might be better off if Adams were allowed to buy votes.

The problem arises because the one-person one-vote rule does not allow voters to register the strength of their preferences. In the text’s example, three people—Adams, Benson, and Conrad—have preferences with regard to the benefits of national defense as follows: It is worth $700 to Adams, $250 to Benson, and $200 to Conrad for a total of $1,150 worth of benefits. The national defense program would cost $900 to be borne by each voter equally, or $300 each. This program would lose a majority vote because neither Benson nor Conrad would be willing to pay $300 for it. However, the total benefit to society in this three-voter world would have been $1,150. A “no” vote is therefore inefficient in the economic sense.

On the other hand, suppose the program was worth $100 to Adams, but $350 each to Benson and Conrad for a total benefit of $800. In this case the program would win because both Conrad and Benson would vote for it, but Adams would not. The $900 spending program would be approved even though it was worth only $800 to society. In this case a “yes” vote is inefficient in the economic sense.

The problem is likely to be greater under an ability-to-pay system. Under a benefits-received scheme, the users of the public goods are the ones who will pay for it. If they perceive that the benefit exceeds the cost, they will vote for it. Those not intending to use the public good (and thus bear the taxes associated with its use) will be less likely to object to the project. Under an ability-to-pay system there is a mismatch between the beneficiaries of the public good and those who bear the cost. Those benefiting but not contributing will be inclined to vote for the public good, even if they would not be willing to pay for those benefits themselves. Those contributing but not benefiting are unlikely to support, even if the net benefit to society is great.

In Figure 31-1a, we can see that society would be better off if Adams had been allowed to pay enough to Benson to get Benson’s “yes” vote. Benson should be willing to vote “yes” for any amount above $50, because then his benefits would exceed the $300 cost of the defense program. Let’s say Adams paid him $75 to vote “yes.” Then, Benson receives $75 plus $250 worth of defense benefits for a total benefit of $325 for which he pays $300 in taxes. Meanwhile, Adams has received his $700 worth of defense benefits for a cost of $300 in taxes and a $75 payment to Benson.

In Figure 31-1b, Adams could pay $75 to Benson again to vote “no.” Now Adams incurs only a $75 cost rather than the $200 cost differential between his cost and benefits from the defense program in Figure 31-1b. If the program had passed, Benson would have gained $50 in net benefits, but without the program and with Adams’ payment he has gained $75 in net benefits.

31-2 (Key Question) Explain the paradox of voting through reference to the accompanying table, which shows the ranking of three public goods by voters Jay, Dave, and Conan.

Public Good Jay Dave Conan

CourthouseSchoolPark

2d choice3d choice1st choice

1st choice2d choice3d choice

3d choice1st choice2d choice

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The paradox is that majority voting does not always provide a clear and consistent picture of the public’s preferences. Here the courthouse is preferred to the school and the park is preferred to the courthouse, so we would surmise that the park is preferred to the school. But paired-choice voting would show that the school is preferred to the park.

31-3 (Key Question) Suppose that there are only five people in a society and that each favors one of the five highway construction options shown in Table 30-2 (include no highway construction as one of the options). Explain which of these highway options will be selected using a majority paired-choice vote. Will this option be the optimal size of the project from an economic perspective?

Project B (New 2-lane highway wins) using a paired-choice vote. There is no “paradox of voting” problem here and B is the preference of the median voter. The two voters favoring No new construction and Widening, respectively, will prefer New 2-lane highways—project B—to New 4- or 6-lane highways. The two voters preferring New 4- and 6-lane highways will prefer a New 2-lane highway to Widening or No new construction. The median voter’s preference for B will prevail. However, the optimal size of the project from an economic perspective is C—it would provide a greater net benefit to society than B.

31-4 (Key Question) How does the problem of limited and bundled choice in the public sector relate to economic efficiency? Why are public bureaucracies alleged to be less efficient than private enterprises?

The electorate is faced with a small number of candidates, each of whom offers a broad range or “bundle” of proposed policies. Voters are then forced to choose the individual candidate whose bundle of policies most resembles their own. The chances of a perfect identity between a particular candidate’s preferences and those of any voter are quite slim. As a result, the voter must purchase some unwanted public goods and services. This represents an inefficient allocation of resources.

Government bureaucracies do not function on the basis of profit, so the incentive for holding down costs is less than in the private sector. Also, because there is no profit-and-loss test of efficiency, it is difficult to determine whether public agencies are operating efficiently. Nor is there entry of competing entities to stimulate efficiency and develop improved public goods and services. Furthermore, wasteful expenditures can be maintained through the self-seeking lobbying of bureaucrats themselves, and the public budgetary process can reward rather than penalize inefficiency.

31-5 Explain: “Politicians would make more rational economic decisions if they weren’t running for reelection every few years.”

Because political officeholders must seek voter support every few years, they favor programs with immediate and clear-cut benefits and with vague or deferred costs. Conversely, politicians will reject programs with immediate and easily identifiable costs but with long-term, less measurable benefits. Such biases can lead politicians to reject economically justifiable programs and to accept programs that are economically irrational.

Politicians may make these and other irrational decisions in order to curry favor with the voters. But what kind of irrational decisions might be made by politicians who did not have to face the voters again and stand for reelection?

31-6 Distinguish between the benefits-received and the ability-to-pay principles of taxation. Which philosophy is more evident in our present tax structure? Justify your answer. To which principle of taxation do you subscribe? Why?

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The benefits-received principle holds that governments should supply public goods and services in much the same manner as does private business. Those who make use of government services should pay for them. This principle is at work in the gasoline tax, with the proceeds going to the building and upkeep of roads, and in the sale of postage stamps. However, even here the principle is hardly fully respected. Some drivers get paved highways, while others who drive just as much do so on dirt roads. And the same first-class postage stamp will move a letter ten miles or three thousand.

The redistribution of income by government—transfer payments—would be impossible on the benefits-received principle. People on welfare receive benefits because they need more from government than they could possibly contribute in taxes.

The ability-to-pay principle of taxation takes account of this fact and assesses tax liability based on a person’s ability to pay: The higher one’s income, the higher the tax and the higher the percentage of one’s income paid in tax. The objection to this principle is that it cannot be decided in principle how much more a wealthy person should pay than one of restricted means. The decision then becomes a political one—with the decision everywhere being not to make the wealthy pay fully in accordance with their ability to pay. In summary, it seems that the ability-to-pay principle is the one that is the most, if half-heartedly, respected in the United States.

31-7 (Key Question) Suppose a tax is such that an individual with an income of $10,000 pays $2,000 of tax, a person with an income of $20,000 pays $3,000 of tax, a person with an income of $30,000 pays $4,000 of tax, and so forth. What is each person’s average tax rate? Is this tax regressive, proportional, or progressive?

Average tax rates: 20; 15; and 13.3 percent. Regressive.

31-8 What is meant by a progressive tax? A regressive tax? A proportional tax? Comment on the progressivity or regressivity of each of the following taxes, indicating in each case where you think the tax incidence lies.

a. The Federal personal income tax

b. A 4 percent state general sales tax

c. A Federal excise tax on automobile tires

d. A municipal property tax on real estate

e. The Federal corporate income tax

A progressive tax is one whose average rate increases as income increases. One pays in tax a larger proportion of ones income as ones income increases.

A regressive tax is one whose average rate declines as income increases. One pays in tax a smaller and smaller proportion of one’s income as income increases, though it is possible for the absolute amount to increase.

A proportional tax is one whose average rate remains the same regardless of the size of income.

(a) Mildly progressive (“mildly” because of loopholes). Incidence is usually on the taxpayer. However, those who charge a fee for services (that is, the self-employed) may be able to increase their fees enough to have the fee-payer in effect pay the tax. Also, some unions may be able to get big enough wage increases to pay the increased income tax.

(b) Regressive. The poor spend all their income, mostly on commodities subject to the sales tax. Thus the sales tax is, in effect, on all their income. The wealthier one is, the smaller the proportion of ones income is spent on commodities subject to the sales tax. (Stocks and

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bonds and real estate are not subject to this tax.) Thus, the average tax rate declines as income increases. The incidence of the tax is mostly on the consumers who buy the taxed commodities.

(c) Regressive for the same reasons as for state general sales taxes. The incidence, again, is mostly on the buyer. There are no substitutes for automobile tires (assuming one does not give up driving a car), so the demand is relatively inelastic.

(d) The incidence is on (1) owners in the case of an owner-occupied residence or land; (2) tenants if the property is rented; or (3) consumers if the property is used in business. In the case of (1) and (2), the tax tends to be proportional since the tax is based on the value of the property, and the lower one’s income, the lower the value of the property one owns or rents. In the case of (3), the tax will be regressive for the same reasons the state general sales tax is regressive.

(e) The incidence is probably shared between the corporation’s shareholders and the buyers of the corporation’s products. To the extent that it is on the shareholders, the tax is proportional. To the extent it is on the consumers, it is regressive for the same reasons the general sales tax is regressive.

31-9 (Key Question) What is the incidence of an excise tax when demand is highly inelastic? Elastic? What effect does the elasticity of supply have on the incidence of an excise tax? What is the efficiency loss of a tax, and how does it relate to elasticity of demand and supply?

The incidence of an excise tax is likely to be primarily on consumers when demand is highly inelastic and primarily on producers when demand is elastic. The more elastic the supply, the greater the incidence of an excise tax on consumers and the less on producers.

The efficiency loss of a sales or excise tax is the net benefit society sacrifices because consumption and production of the taxed product are reduced below the level of allocative efficiency which would occur without the tax. Other things equal, the greater the elasticities of demand and supply, the greater the efficiency loss of a particular tax.

31-10 Advanced analysis: Suppose the equation for the demand curve for some product X is P = 8 - .6Q and the supply curve is P = 2 + .4Q. What is the equilibrium price and quantity? Now suppose an excise tax is imposed on X such that the new supply equation is P = 4 + .4Q. How much tax revenue will this excise tax yield the government? Graph the curves and label the area of the graph that represents the tax collection “TC” and the area that represents the efficiency loss of the tax “EL.” Briefly explain why area EL is the efficiency loss of the tax but TC is not.

Demand is P = 8 - .6Q; Supply is P = 2 + .4Q

In equilibrium, Qd = Qs, which can be found by setting the demand and supply equations equal to each other:

8 - .6Q = 2 + .4Q

8 – 2 = .4Q + .6Q

6 = Q

Plugging Q = 6 back into each equation:

P = 8 - .6(6) = 4.4 ; P = 2 + .4(6) = 4.4

P = 4.4

An excise tax of $2 is imposed, and the vertical intercept of the supply equation increases by 2 units:

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New supply is P = 4 + .4Q, and again solving for equilibrium:

8 - .6Q = 4 + .4Q

8 – 4 = .4Q + .6Q

4 = Q

Plugging Q = 4 back into each equation:

P = 8 - .6(4) = 5.6 ; P = 4 + .4(4) = 5.6

P = 5.6

The total revenue yielded by this tax is $8, and is found by multiplying the per unit yield ($2) by the number of units sold after the tax is imposed.

The area EL represents the loss to society that results from the reduction in consumption and production of good X. The loss occurs because the fifth and sixth units are no longer produced. The area TC represents a shifting from buyers and sellers in the market to government and, by extension, the beneficiaries of public goods provided with the taxes collected. There is no loss of output to society in area TC.

31-11 (Last Word) How do the concepts of “pork-barrel” politics and “logrolling” relate to the items listed in the Last Word?

Both of these political techniques are examples of special interest effects. “Pork-barrel” politics refers to the practice that congressional representatives follow when they obtain unneeded benefits for their own districts, and “logrolling” is a related practice whereby one group of legislators helps another with the understanding that at some point in the future they, in turn, will be helped.

The Last Word contains some examples of public spending that undoubtedly resulted from such practices. These include the purchasing of equipment that is not asked for by the military and buying equipment from a single firm both to benefit particular Congressional districts; building

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projects that are outlandishly costly; and appropriations bills that are so large, contain so much detail, with provisions that benefit small groups or individuals.

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CHAPTER OVERVIEW - Mr Clotzman at Uni High guide... · Web viewCHAPTER OVERVIEW This chapter includes a study of public choice theory, an economic analysis of government decision