Y = C + I + G

Review

The Government levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.

The Government can make buyers or sellers pay the tax.

The tax can be a % of a good’s price, or a specific amount for each unit sold.

Taxes

Causes of Increased Inequality

Taxes on Stocks versus Taxes on Flows

Taxes on Economic “Flows”Most taxes are levied on measurable economic flows. For example, a profits, or net income, tax is levied on the annual profits earned by corporations.

S1

D1

$10.00

500430

A Tax on Buyers

A tax on buyers shifts the D curve down by the amount of the tax.

A tax on buyers shifts the D curve down by the amount of the tax.

P

Q

D2

$11.00PB =

$9.50PS =

Tax

Effects of a $1.50 per unit tax on

buyers

The price buyers pay rises, the price sellers receive falls, equilibrium Q falls.

The price buyers pay rises, the price sellers receive falls, equilibrium Q falls.

S1

A Tax on Sellers

A tax on sellers shifts the S curve up by the amount of the tax.

A tax on sellers shifts the S curve up by the amount of the tax.

P

Q

D1

$10.00

500

S2

430

$11.00PB =

$9.50PS =

Tax

Effects of a $1.50 per unit tax on

sellers

The price buyers pay rises, the price sellers receive falls, equilibrium Q falls.

The price buyers pay rises, the price sellers receive falls, equilibrium Q falls.

S1

The Outcome Is the Same in Both Cases!

What matters is this:A tax drives a wedge between the price buyers pay and the price sellers receive.

P

Q

D1

$10.00

500430

$9.50

$11.00PB =

PS =

Tax

The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers!

Suppose the market for cigarettes is in equilibrium.

Suppose the State of Florida, decides to impose a tax of $1 per pack on the sale of cigarettes.

How does the tax affect the market for cigarettes?

AN IMPORTANT TAX PROBLEM

This kind of tax can be analyzed as if it were an input price increase. The tax is similar to having to pay a higher price for some input (government services?).

The tax will raise the supply curve by the amount of the tax per unit.

The tax raises the supply curve by the amount of the tax per unit

pE

QE

S

D

Q

price

S + tax

CIGARETTE MARKET

This distance is exactly $1.

The reason the supply curve shifts up by exactly the amount of the tax is that price would have to rise by the full amount of the tax to induce cigarette suppliers to supply the amount they supplied before the tax.

But price will rise by less than the amount of the tax, as the following diagram shows.

The new equilibrium price must be less than $1 higher than the old price.

D

S

$/Q

D

S

$/Q

S+Tax

Exactly $1.

New price

The state’s tax revenue is $1 times the number of units sold.

pE’

QE

S

D

Q

PS + tax

QE’

CIGARETTE MARKET

total tax collections

The tax burden on consumers is the part of the tax paid by consumers in terms of higher prices.

The tax burden on sellers is the part of the tax paid by firms in terms of lower receipts.

Tax Burden

Who pays the tax on cigarettes?

S+Tax

D

S

P

Q

Tax per unit

Go to hidden slide

Tax burden on each is determined by the elasticities of supply and demand.

Given the demand curve, more elastic (flatter) supply means greater tax burden for consumers.

Given the supply curve, more elastic (flatter) demand means greater tax burden for sellers.

[Hint: Don't try to memorize these statements. Instead, make sure you can figure out each case.]

For example:1) The more inelastic is the demand curve,

the greater will be the state’s tax revenue.2) The more inelastic is the supply curve,

the greater will be the state’s tax revenue.

Elasticity also determines the state's tax revenue.

The next (hidden) slide shows these principles for different elasticities of demand.

When demand is more elastic:- Price rises less.

- There's relatively more burden on sellers.- The state takes in less revenue.

Incidence of Per Unit Tax:Elastic and Inelastic Demand

S

DelastDinelast

S

Q Q

$/Q $/Q

Equal Pretax Sales

S+TaxS+Tax

tax base The measure or value upon which a tax is levied.

tax rate structure The percentage of a tax base that must be paid in

taxes—25 percent of income, for example.proportional tax

A tax whose burden is the same proportion of income for all households.

progressive tax A tax whose burden, expressed as a percentage of

income, increases as income increases. regressive tax

A tax whose burden, expressed as a percentage of income, falls as income increases.

Key Terms

average tax rate Total amount of tax paid divided by total income.

marginal tax rate The tax rate paid on any additional income earned.

The Economics of Taxation

Causes of Increased Inequality

Marginal versus Average Tax Rates

TABLE 19.3 Individual Income Tax Rates, 2007

Married Couples Filing Jointly Taxable Income Tax Rate

$0 – 15,650 10%$15,651 – 63,700 15%$63,701 – 128,500 25%$128,501 – 195,850 28%$195,851 – 349,700 33%More than $349,700 35%

Single Taxpayers Taxable Income Tax Rate

$0 – 7,825 10%$7,826 – 31,850 15%$31,851 – 77,100 25%$77,101 – 160,850 28%$160,851 – 349,700 33%More than $349,700 35%

Source: The Internal Revenue Service.

The Economics of Taxation

Causes of Increased Inequality

Marginal versus Average Tax Rates

TABLE 19.4 Tax Calculations for a Single Taxpayer Who Earned $100,000 in 2007

Total income $ 100,000

Personal exemption 3,400

Standard deduction 5,350

= Taxable income $ 91,250

Tax Calculation

0 - $7,825 taxed at 10% = $7,825 X .10 = $782.50

$7,825 - $31,850 taxed at 15% ($31,850 – $7,825) X .15 = $24,025 X .15 = $ 3,603.75

$31,850 - $77,100 taxed at 25% = ($77,100 – $31,850) X .25 = $45,250 X .25 = $11,312.50

Income above $77,100 taxed at 28% = ($91,250 - $77,100) X .28 = $14,150 X .28 =

$ 3,962

Total tax $19,660.75Average tax rate 19.7%Marginal tax rate 28%