TAXES

1
TAXES

• PRINCIPLES OF MICROECONOMICS

Dr. Fidel Gonzalez Department of Economics and
Intl. Business Sam Houston State University
2
OPPORTUNITY COST
MARGINAL ANALYSIS
Elasticity
Elasticity
SUPPLY
DEMAND
MARKET EQUILIBRIUM
CONSUMER SURPLUS, PRODUCER SURPLUS AND TOTAL
SURPLUS
MARKET EFFICIENCY
MARKET FAILURE
Pigouvian Taxes Quotas Coase Theorem Command and
control
EXTERNALITIES
TAXES
PUBLIC GOODS
COMMON GOODS
ARTIFICIALLY SCARCE GOODS
GAME THEORY
3
GOVERNMENT INTERVENTIONTAXES
Taxes are the most common for of government
intervention
We are going to consider excise taxes. These
are taxes imposed on the sale of certain
products.
In all cases taxes bring revenue to the
government. However, in some cases the government
may want to affect the behavior of people.
The government will set a tax in the following
goods and services to reduce its consumption

• Alcohol
• Cigarettes
• Betting

Other taxes design to bring money to the
government but not to change behavior are
Gasoline, Phone Service, Cable TV, Boats,
Aircraft, Guns.
Sales Tax imposed in most of the things you buy,
usually a percentage of the sale amount (7, 8
depending on the city or state)
4
GOVERNMENT INTERVENTIONTAXES
A tax will affect the demand or supply depending
on who pays the tax
If the tax is imposed on the consumer then the
demand is affected.
Lets go back to the example of John and the donuts
The government imposes a tax of 2 dollar per
donut bought by John
This is tax imposed on the consumer because the
consumer pays the tax.
For example before the tax John is willing to
pay 5 for the second donut.
Because of the tax when John is willing to pay 5
to get the second donut, the net benefit he gets
from it is 3 because two dollars goes to the
government. Since the net benefit goes down, the
amount of donuts desired decreases.
5
Review Marginal Willingness to Pay and Demand
P
Linear demand curve
D old
D new
donuts
The demand curve shifts down and to the left when
the tax is imposed on consumers
The price paid by the John for each donut goes up
because of the tax
Because the good is more expensive the quantity
demanded of donuts goes down at every price.
6
Marginal Willingness to Pay and Demand
P
The vertical difference between the new demand
and the old demand is equal to the tax per unit.
6
For example, the marginal benefit of the second
unit (Q2) is 6 when there is no taxes.
Tax2
However, when the government puts the tax on the
consumer the marginal benefit the consumer gets
for the second unit is 6 - 2 4.
4
D old
D new
donuts
2
The vertical difference between the old demand
and the new demand is the tax for all the
quantities.
7
GOVERNMENT INTERVENTIONTAXES
If the tax is imposed on the producer, the supply
goes down, shifting up and to the left.
In this case, for each unit sold Krispy Cream has
to pay two dollars to the government in taxes.
Hence the cost of each unit goes up by two dollars
The first donut cost 2 to produce. Before, when
the price was 2 Krispy donuts was producing the
first unit because that was enough to cover its
MC for the first unit. However, after the tax if
Krispy cream produces the first unit when P2,
it will lose money. Why? If is produces the
first donut when P2, Krispy Cream has to pay 2
to the government in taxes (Taxes2) and it will
not have money to cover the MC2. Hence, Krispy
Cream will be losing money, producing the first
unit at P2 will mean a negative profit of 2
When P3, Krispy Crem will get to keep only 1
(because 2 go to the government since the tax is
2) and the MC of the first unit is 2. Hence, it
will not be able to cover the MC so Krispy Cream
will not produce. If P4, then in that case
Krispy Cream will get to keep 2 (because 2 go
to the government since the tax is 2). In this
case, Krispy Cream gets to keep 2 after paying
the tax and it can cover the cost of porducing
the first unit which is 2.
When P5, Krispy cream gets to keep 3 which is
enough to produce the second unit (MC of the
second unit is 3), so Krispy Cream will produce
the second unit.
8
Review Marginal Cost and Supply

6
P
S new
5
Linear supply curve
4
S old
3
2
4
3
2
1
donut
The supply curve shifts up and to the left when
the tax is imposed on producers
The price received by Krispy Cream for each donut
goes down because of the tax
Because the cost of producing the good goes up,
the quantity supply of donuts decreases at every
price.
9
Marginal Cost and Supply
The vertical difference between the new supply
and the old supply is equal to the tax per unit.
P
S new
S old
For example, the MC of producing the second unit
(Q2) is MC3 when there is no taxes.
5
Tax2
3
However, when the government puts the tax on the
producer the cost of producing the second unit is
3 2 5.
2
Therefore, the vertical difference between the
Snew and Sold is 2 (5-32) when Q2. Moreover,
the vertical distance between the two of them is
always going to be equal to the tax (2 in this
case). That is, for any quantity the vertical
distance between the two supply curves will be
the tax.
10
GOVERNMENT INTERVENTIONTAXES
Lets observe what happens to the market price and
quantity when a tax of 2 is imposed on consumers.
1) The tax imposed on consumers shifts the demand
curve down.
P,
S
2) The new equilibrium quantity goes down from 3
to 2 donuts.
Pc5
3) The price paid by the consumer goes up from 4
to 5.
P4
Pp3
The price actually paid by the consumer is called
consumer price (Pc).
D0
D1
donuts
3
2
4) The price received by the producer goes down
from 4 to 3.
The price actually received by the producer is
called producer price (Pp).
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GOVERNMENT INTERVENTIONTAXES
The government sets a tax of 2 per donut sold in
the market.
P,
S
In this case the consumer used to pay 4 per
donut bought but now pays 5 In fact, the
consumer is paying one dollar of the two dollars
of the tax.
Pc5
P4
Pp3
D0
D1
3
2
donuts
In this case the producer used to receive 4 per
donut sold but now receives 3 In fact, the
producer by receiving less is paying one dollar
of the two dollars of the tax.
12
GOVERNMENT INTERVENTION Producers and
Consumers Price
The consumer price is the actual amount paid by
the consumer, that is its out-of-pocket payment.
The money paid by the consumer is divided between
the government and the producer. The amount that
goes to the government is the tax and the amount
that goes to the producer is the producers
price. Imagine you go to Starbucks and buy a cup
of coffee. The cup of coffee is 3 plus a tax of
1 dollar. The consumers price is 4, that is
the amount of money the consumer pays for the cup
of coffee is 4. The 4 are divided in 1 dollar
to the government (this is the tax) and 3 to
Starbucks.
We can write the relationship between Pc, Pp and
taxes as follows Pc Pp tax

4
3
1
From the 4 paid by consumer the government keeps
1 (tax 1)
From the 4 paid by consumer the producer keeps
3 (Pp 3)
Consumer pays 4 (Pc4)
13
GOVERNMENT INTERVENTION Producers and
Consumers Price Graphically
From the previous graphs we can have two rules to
obtain the Pc and Pp graphically. Note, that the
Pc is how much the consumer pays at the new
quantity. This means, that in order to get Pc
(graphically) you have find the Price using the
original demand curve at the new quantity in the
market (that is the quantity after the tax was
imposed).
Find what Pc is using the original demand curve
at Q2, which is the new quantity after the tax
(Pc5, the P using new quantity Q2 and the old
demand)
S1
S
S
P,
P,
Pc5
Pc5
P4
P4
D0
D
D1
donuts
donuts
3
2
3
2
14
GOVERNMENT INTERVENTION Producers and
Consumers Price Graphically
The Pp is how much the producer gets to keep at
the new quantity. This means, that in order to
get Pp (graphically) you have find the Price
using the original supply curve at the new
quantity in the market (that is the quantity
after the tax was imposed).
Find what Pp is using the original supply curve
at Q2, which is the new quantity after the tax.
In this case Pp3 (the price using the old
supply at the new Q2)
S1
S
S
P,
P,
P4
P4
Pp3
Pp3
D0
D
D1
donuts
3
2
3
2
donuts
15
GOVERNMENT INTERVENTIONTAXES
Q What happens if the government imposes the tax
of 2 on the producer and not in the consumer ?
1) The tax imposed on producers shifts the supply
curve to the left.
S1
P,
S
2) The new equilibrium quantity goes down from 3
to 2 donuts.
Pc5
3) The price paid by the consumer goes up from 4
to 5. Hence, Pc5
P4
Pp3
4) The price received by the producer goes down
from 4 to 3. Hence, Pp3
D
donuts
3
2
This is a very important result whether the tax
is imposed on consumers of producers does not
affect the new quantity, Pc or Pp. We obtain the
same solution if we imposed the tax on the
consumer or in the producer. The only difference
is that when the tax is imposed on consumers we
shift the demand and when the tax is imposed on
producers we shift the supply curve. However at
the end we obtain the same solution regardless of
whether we shifted the demand of the supply curve.
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GOVERNMENT INTERVENTIONTAXES
Because it does not matter whether the tax is
imposed on consumers or producers, the legal
incidence of the tax is irrelevant. Moreover,
since shifting demand or supply gives us the same
solution when the draw a tax in the supply or
demand graph I can not draw the shift as shown in
the graph below
The solution shown in the graph could have been
obtained by shifting the demand down to the left
or the supply up to the right. Since both give
the same I do not have to show the shift on the
graph. Note that in the graph I only show the
original demand and original supply.
P,
S
Pc5
P4
Pp3
D
donuts
3
2
Also remember that to show Pc and Pp all I need
is the new quantity and the old demand and old
supply. This is another reason why I do not have
to draw the shift in the demand or in the supply.
In the graph above I have all the information
that really matters Pc, Pp, new Quantity, Old
Quantity and the tax.
17
GOVERNMENT INTERVENTIONTAXES AND WELFARE
Now, we can see what happens to the economy.
J(7-5)x2/2 2
K(5-4)x 2 2
L(5-4)x(3-2)/2 0.5
7
J
M(4-3)x2 2
K
L
N(4-3)x(3-2)/2 0.5
N
M
O(3-1)x2/2 2
O
1
Consumer Tax Incidence K 2 Producer Tax
Incidence M 2
J
2
JKL
4.5
MNO
O
4.5
2
4
JKLMNO
9
JKMO
8
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GOVERNMENT INTERVENTIONTAXES
Main result
1) When the government imposes a tax, the total
welfare of the economy as measured by the total
surplus goes down by 1. This creates a
deadweight loss (DWL)
7
DWL
J
K
L
N
M
O
1
2) The tax can have different incidence on the
consumer than on the producer. Who has a higher
incidence depends on the elasticity of supply and
demand.
Total Surplus Before Quota JKLMNO
Total Surplus After Quota JKMO
Loss in welfare L N
The loss in welfare is called Deadweight Welfare
Loss (DWL)
DWL L N
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GOVERNMENT INTERVENTIONTAXES
Supply is perfectly inelastic, producers pay all
the tax
Demand is perfectly inelastic, consumer pays all
the tax
S
P,
D
P,
S
Pc
tax
PcP
tax
PpP
Pp
D
Q
Q
Q
Q
Note that if demand or supply are perfectly
inelastic, there is no deadweight loss. In this
case the quantity in the market does not
decrease. The government takes part of the
consumer or producer surplus, but the total
surplus does not change
20
GOVERNMENT INTERVENTIONTAXES AND WELFARE
Q Why when the government imposes a tax there is
a decrease in the welfare?
A tax increases the price paid by consumers and
producers, hence the quantity in the market drops
compared to the equilibrium level.
John consumes two donuts and Krispy Cream sells
two donuts
But we can make both of them better off by
producing a third donut.
The third donut gives John a benefit of 4 (his
willingness to pay for the third donut is 4).
The production of the second donut costs Krispy
Cream 4.
At the equilibrium price of P 4
John will be willing to buy the third donut it
costs him 4 and he values it in 4
Krispy Cream will be happy to sell the third
donut it costs them 4 to produce and they
receive 4 for it.
John and Crispy cream could be better off
eliminating the tax.
21
ExcerciseTAXES AND WELFARE
Now, solve this problem for the rum market (the
answers are in the next slide)
1) What is the producer price
P
SMC
2) What is the consumer price
6
3) What is the new market quantity?
5
4) Obtain the total tax revenue.
4.5
5) Fill out the table below
3
D

MWPMB
6) What happens to the welfare after the tax?
(complement your answer with numbers)
rum
4.5
3
rum
18
7) What is the consumer tax incidence?
8) What is the producer tax incidence?
9) What is the DWL?
22
ExcerciseTAXES AND WELFARE
Now, solve this problem for the rum market (the
answers are in the next slide)
1) Pp3
P
SMC
2) Pc5
6
3) Q3
5
4) Tax Revenue2x36
4.5
5) See the table below
3
D

MWPMB
6) Welfare goes down by 1.5
rum
4.5
3
18
7) Consumer incidence (Pc-P)xQ (5-4.5)x(3)
1.5
7) Producer incidence (P-Pp)xQ (4.5-3)x(3)
4.5
9) DWL1.5
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TAX INCIDENCE
The difference between the equilibrium price
before taxes and the consumer price is called tax
incidence for the consumer.
P,
S
The tax incidence for the consumer tells us how
much of the tax is actually paid by the consumer
for each unit bought in the market
Pc5
P4
Pp3
The difference between the equilibrium price
before taxes and the producer price is called tax
incidence for the producer.
D0
3
2
donuts
Tax incidence for the consumer Pc P 5 4
1 per donut
The total tax incidence for the consumer is the
tax incidence per unit times the number of units
bought in the market
Total tax incidence for the consumer 1 x 2 2
In total the John pays 2 dollars in taxes but
only 1 per donut.
24
TAX INCIDENCE
Total tax incidence for the producer P Pp 4
3 1 per donut
The total tax incidence for the producer is the
tax incidence per unit times the number of units
sold in the market
P,
S
Total tax incidence for the producer 1 x 2 2
Pc5
tax
P4
Pp3
In total the Krispy Cream pays 2 dollars in
taxes but only 1 per donut sold.
D
3
2
donuts
The difference between the Pc and Pp is equal to
the tax
Tax per unit Pc Pp
Tax per unit 5 3 2
Government Revenue from the tax is the tax per
unit times the units sold/bought in the market
tax x new quantity.
Government Revenue 2 x 2 4 (this is the
shaded area shown in the graph)
Government Revenue is also equal to the total
consumer incidence plus the total producer
incidence, Government Revenue 2 2 4
25
TAX INCIDENCE
The tax incidence can be shown graphically.
Tax incidence for the consumer (Pc - P) x Qnew
(5-4) x 2 2 Pc-P is equal to one side the
area B and Qnew is equal to the other side of B.
Hence, the tax incidence for the consumer is the
area of B.
P,
S
Pc5
tax
B
P4
C
Pp3
Tax incidence for the producer (P - Pp) x Qnew
(4-3) x 2 2 P-Pp is equal to one side the
area C and Qnew is equal to the other side of C.
Hence, the tax incidence for the producer is the
area of C.
D
3
2
donuts
Shaded Area is the government revenue
Government Revenue from the tax is the tax per
unit times the units sold/bought in the market
tax x new quantity. This is equal to the shaded
area. Also, we know that the tax incidence of the
consumer plus the tax incidence of the producer
is equal to the government revenue, therefore
BCshaded area government revenue
26
TAX INCIDENCE AND ELASTICITY OF DEMAND AND SUPPLY
The demand for crack is more inelastic than the
supply of crack because the supply is flatter
than the demand.
Market for Crack
P,
S
Pc
tax
Since the demand for crack is more inelastic than
the supply when the government imposes a tax,
crack addicts end up paying most of the tax.
P
Pp
D
Q
Q
Qt
The quantity in the market does not fall by much
by the price paid by crack addicts increase
substantially.
What do you think is the effect of cigarette
taxes on people that are currently smokers?
It increases the amount the have to pay but the
quantity does not change that much.
Tobacco companies are hurt but not too much.
27
TAX INCIDENCE AND ELASTICITY OF DEMAND AND SUPPLY
Market for Hotels
The supply of Hotels is more inelastic than the
demand for Hotels because the demand is flatter
than the supply.
P,
S
Since the supply of Hotels is more inelastic than
the demand when the government imposes a tax,
hotel owners end up paying most of the tax.
Pc
tax
P
Pp
D
Q
Q
Qt
The quantity in the market does not fall by much
but the price received by hotel owners decrease
substantially.
28
TAX INCIDENCE AND ELASTICITY OF DEMAND AND SUPPLY
Who pays a higher incidence depends on whether
the price elasticity of demand (Ed) is higher,
lower or equal to the price elasticity of supply
(Es). The table below summarizes the three
different cases.