Chapter 14

Taxes and Government Spending

 Learning objectives

 Understanding what are taxes

 Mention the types of taxes
 Calculate the incidence of a tax
 Analyze the pros and cons of different taxation types
 What are taxes?
 Taxation is the primary way that the government
collects money
 Without revenue, or income from taxes, government
would not be able to provide goods and services
 Economic Impact of Taxes

1. Resource Allocation
 Whenever a tax is placed on a good or service, it raises the product’s price to
the consumer. For example, people tend to buy less if the prices are higher .

2. Behavior Adjustment
 Taxes are sometimes used to encourage or discourage certain types of
activities. For example , homeowners can use the interest payment on
mortgages as tax deductions .

 A so-called Sin Tax—a relatively high tax designed to raise revenue while
reducing consumption of a socially undesirable product such as liquor or
tobacco—is another example of how a tax can change behavior.
 Economic Impact of Taxes

3. Income Redistribution
 Taxes are collected because the government needs to
pay for its spending like highways, schools and national
defense.
 The distribution of income—the way in which income is
allocated among families, individuals, or other groups
—is always affected by taxes. You probably think that
your income goes down if you pay a lot of taxes, but it
may go up if you receive a lot of transfer payments.
 Economic Impact of Taxes

4. Productivity and Growth

 Taxes can affect productivity and economic growth
by changing the incentives to save, invest, and work.
For example, some people think that taxes are
already too high. Why , they argue , should they work
to earn additional income if they have to pay out
some of it in taxes?
 Incidence of a Tax

Incidence of a Tax
 Finally, there is the matter of who actually pays the tax. This is known
as the incidence of a tax—or the final burden of the tax. This can
happen if we have an indirect tax—a tax that can be shifted to others.
Examples would be a business property tax or a sales tax. For
example, suppose that a city wants to tax a local electric utility to raise
revenue. If the utility is able to raise its rates, consumers will likely bear
some of the burden of the tax in the form of higher utility bills.
 This is not the case for a direct tax, or one that cannot be shifted to
others. An example of a direct tax is the personal income tax or a
driver’s license fee.
 Incidence of a Tax
 When products are inelastic, and consumers are willing to pay
more, the tax burden can fall on them. Think about paying a
utility bill. When the gas or electricity price increases, one still
has to pay the bill to keep the lights on.

 When the demand is

relatively inelastic and the
supply curve shifts
because of the tax , there
is going to be a new price
P1 and new quantity Q1.
Consumers pay a portion
of that Tax and producers
pay the other portion . The
amount consumer pays
went up from P to P1. This
is the amount of Tax that
consumers pay in higher
prices.
 Incidence of a Tax

 When the demand is relatively inelastic and the supply curve

shifts because of the tax , there is going to be a new price P1
and new quantity Q1. Consumers pay a portion of that Tax
and producers pay the other portion . The amount consumer
pays went up from P to P1. This is the amount of Tax that
consumers pay in higher prices .However, producers pay the
other portion. Which one is bigger?
 - When the demand is relatively inelastic , consumers pay a
larger portion of that tax, in other words the burden of the
tax is more on the consumers than the producers.
Demand is relatively inelastic
Incidence of a Tax

 When the demand is

relatively elastic and the
supply curve shifts to the
left because of the tax ,
there is going to be a new
price P1 and new quantity
Q1. Consumers pay a
portion of that Tax and
producers pay the other
portion . The amount
consumer pays went up
from P to P1 .Which one is
bigger?
Demand is relatively elastic
 `
Demand is relatively elastic

- When the
demand is
relatively elastic ,
producers pay a
larger portion of
that tax, in other
words the
burden of the tax
is more on the
producers than
the consumers.
 Incidence of a Tax

 https://www.youtube.com/watch?v=RAxc6FqbUo8
 Incidence of a Tax

 In this instance, let’s assume the government decides to impose a new

luxury tax on yachts priced above $100,000. Let’s find out if the tax
incidence falls more on the supplier or the consumer.
 The new luxury tax calls for a 10% tax on the higher-priced yachts.
However, the new tax also causes the demand for yachts to be cut in half
from 100 to 50 to compensate.
 We will start by finding the elasticity of supply and demand separately.
 Elasticity of demand = -50
 This massive drop in demand has caused the supplier to cut back on
supply from 150 to 100.
 Elasticity of supply = -33
 Incidence of a Tax

 We can now calculate the tax incidence for both the consumer
and supplier to determine how much the new tax policy affects
each group.
 Consumer tax burden =, 100 * (Es / (Ed + Es)).
 =?
 Consumer tax burden =, 100 * (Es / (Ed + Es)).
 = -.33 / -.83
 = .40 or 40%
 Supplier tax burden = 100 * (Ed / (Ed + Es))
 =?
 Supplier tax burden = 100 * (Ed / (Ed + Es))
 =-.50 / -.83
 = .60 or 60%
 In this case, the luxury tax has passed most of the new tax
policy cost onto the supplier. This scenario happened in
the United States after the government introduced a wealth
tax, causing the yacht industry sales and jobs to decline
sharply.
 Criteria for Effective Taxes
Equity, or fairness—the first criterion—means that taxes should be impartial and
just.
 Unfortunately, there is no overriding guide to make taxes completely equitable.
However, it does make sense to avoid tax loopholes—exceptions or oversights
in the tax law that allow some people or businesses to avoid paying taxes.
Loopholes are fairness issues, and most people oppose them on the basis of
equity. Ex: Student loan interest paid by you or someone else or moving
expenses.
Simplicity means that tax laws should be written so that both taxpayers and tax
collectors can understand them. This is because people seem more willing to
tolerate taxes when they understand them.
 A sales tax—a general tax levied on most consumer purchases—is much
simpler. The sales tax is paid at the time of purchase, and the amount of the tax
is computed and collected by the merchant. Some goods such as food and
medicine may be exempt, but if a product is taxed, then everyone who buys the
product pays the tax. In contrast, the individual income tax—the federal tax on
people’s earnings—is a prime example of a complex tax. The entire federal code
is thousands of pages long and even the simplified instructions from the Internal
Revenue Service (IRS), the branch of the U.S. Treasury Department in charge of
collecting taxes.
 Criteria for Effective Taxes

 Efficiency means that a tax should be relatively easy to

administer and reasonably successful at generating
revenue. The individual income tax is fairly efficient when
income taxes are collected. Because most payrolls are
computerized, an employer can easily withhold a
portion of an employee’s pay and send it to the IRS.
 The taxpayer does this by filing a tax return—an annual
report to the IRS summarizing total income, deductions,
and taxes withheld.
 Two Principles of Taxation

 These principles are the benefit principle and the ability-to-pay principle.
Benefit principle :This principle of taxation states that those who benefit from government
goods and services should pay in proportion to the amount of benefits they receive.

 Gasoline taxes are a good example of this principle. Because the gas tax is built into the
price of gasoline, people who drive more than others pay more gas taxes—and therefore
pay for more of the construction and upkeep of our nation’s highways.
 • Despite its attractive features, the benefit principle has two limitations. The first is that
those who receive government benefits like subsidized housing may also be the ones who
can least afford to pay for them. Even though they are often required to pay a certain
amount based on their income, they cannot pay in proportion to the benefits they receive.

 The second limitation is that benefits are often hard to measure. After all, the people who
buy the gas are not the only ones who benefit from the roads built with gas taxes. Owners
of property, like hotels and restaurants along the way, are also likely to benefit from the
roads that the gas tax helps provide.
 Principles of Taxation

 • Ability-to-pay This principle is based on the belief

that people should be taxed according to their ability to
pay, regardless of the benefits they receive. An example
is the individual income tax, which requires people with
higher incomes to pay more than those who earn less.

 This principle assumes that people with higher incomes

suffer less discomfort paying taxes than people with
lower incomes.
 Three Types of Taxes

 A proportional tax imposes the same percentage rate of taxation on everyone,

regardless of income.
 If the percentage tax rate is constant for all levels of taxable income, the
average tax rate—total tax paid divided by the total taxable income—also is
constant, regardless of income.
 The tax that funds Medicare—a federal health-care program available to all
senior citizens, regardless of income—is a proportional tax
 A progressive tax is a tax that imposes a higher percentage rate of taxation on
higher incomes than on lower ones. This tax uses a progressively higher
marginal tax rate, the tax rate that applies to the next dollar of taxable income.
 A regressive tax is a tax that imposes a higher percentage rate of taxation on
low incomes than on high incomes.
What is a proportional tax, progressive tax, and regressive
tax?

Proportional tax: same percentage regardless of

income.

Progressive tax: rate of taxation increases as income

increases.

Regressive tax: rate of taxation decreases as income

increases.
 When it comes to types of taxes, there are
three general systems that are focused on in
economics

1. Progressive Taxes

2. Regressive Taxes

3. Proportional taxes

https://www.youtube.com/watch?v=Ofy7JklzrOs
 Alternative Tax Approaches
The Flat Tax
 The concept of a flat tax—a proportional tax on
individual income after a specified threshold has been
reached.
The Value-Added Tax
 Another controversial proposal is to adopt the
equivalent of a national sales tax by taxing consumption
rather than income. This could be done with a value-
added tax (VAT)—a tax placed on the value that
manufacturers add at each stage of production.
 Questions

Defining:
 Explain the purpose of a sin tax and its function as
governmental restriction on the use of individual
property.
The purpose is to discourage harmful behaviors. The
restriction makes the personal behavior more
expensive.
 Questions

Defining :
 Explain the difference among a proportional tax, a
progressive tax, and a regressive tax.
A proportional tax refers to a tax that is the same
percentage regardless of income; a progressive tax is a
tax in which the rate of taxation as a percentage of
income increases as income rises; a regressive tax is a
tax in which the overall rate of taxation as a percentage
of income decreases as income rises.
 Questions

Explaining:
 Use your notes to explain the economic impact of
taxes as described in this lesson.
Taxes on goods and services generally are passed to
the consumer, which increases the cost and may
discourage consumers from buying more. A decline in
economic activity can affect production, which may
lead to fewer employment opportunities.
 Questions

Exploring Issues :
 How do taxes affect the decisions you make? In your
answer provide examples of how this type of financial
restriction of your earned property impacts your
economic choices. Evaluate the benefits and
drawbacks of this type of restriction.
Taxes increase the cost of goods or services, and so
may discourage purchases or require substitutes.
 Questions

Synthesizing:
 What makes a tax effective?
Equity, simplicity, and efficiency
 Questions
• How do taxes affect businesses and consumers? Taxes
may encourage or discourage certain behaviors among
businesses and consumers. Firms may choose certain
business practices to reduce their tax burden. Higher prices
for products may discourage consumers from purchasing
some products, resulting in lost sales to businesses.
• Is the income tax progressive, proportional, or
regressive? Explain.
The income tax is progressive because it is based on income
—the higher one's income, the greater the percentage of
income taxed.
 Tax Structures
 Proportional taxes are a tax for which the percentage
of income paid in taxes remains the same for all
income levels
 Tax Bases and Tax Structures

 Progressive Taxes are taxes for which the percent of

income taxed increases as income increases
 Regressive Taxes are taxes for which the percentage
of income taxed decreases as income increases
 Tax Incidence

 https://www.youtube.com/watch?v=RAxc6FqbUo8