More on taxation

Today: Studying taxation graphically

What should be taxed? Why?

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)

Today

Studying taxation graphically How do people react to taxes?

Deadweight loss Ramsey rule Equity/fairness Tax avoidance

Study of taxation graphically Individual behavior Excess burden in a market with horizontal

supply Taxes on labor Subsidies Pigouvian taxes

How do taxes affect individual behavior?

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Pounds of barley per year

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Market excess burden, horizontal supply

Pounds of barley per year

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Tax revenues

Excess burden of tax

Remember: Excess burden and deadweight loss mean the same thing

Taxing labor

Hours per year

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Subsidies lead to excess burden, too

Housing services per year

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Recall: Pigouvian taxes reduce excess burden

Q per year

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MD

MPC

MSC = MPC + MD

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c

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Pigouviantax revenues

i

j

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

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

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

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?

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

Marginal excess burden

X per year

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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

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

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

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

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

18th 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

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

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?

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

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

A tale of two people

(Dollars of underreporting)(Dollars of underreporting)

$ $MC = p * marginalpenalty

MC = p * marginalpenalty

MB = tMB = t

R* R* = 0

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

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