Review chapters 19, 20, 21,22, 23, 24, 8 Know how to compute the tax burden on consumers and on producers, given pre-tax equilibrium price and

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1 Review chapters 19, 20, 21,22, 23, 24, 8 Know how to compute the tax burden on consumers and on producers, given pre-tax equilibrium price and post-tax equilibrium price: Consumer tax burden equals (post-tax price - pre-tax price)+per-unit tax payments by consumers. Producer tax burden equals (pre-tax price - post-tax price)+per-unit tax payment by producers. Know how to show consumer tax burden and producer tax burden on a graph. Consumer tax burden plus producer tax burden equals per-unit tax. The burden of a tax falls more heavily on the side of the market that is less elastic. Intuitively, the more elastic side of the market is better able to change its behavior (buy or sell less of the good) to avoid the tax. Demand for a good is more elastic if the good has many close substitutes. Supply of a good is more elastic if suppliers have alternative uses for their inputs. If the demand curve is perfectly inelastic and the supply curve is not, then all of the tax burden falls on consumers. If the supply curve is perfectly inelastic and demand curve is not, then all of the tax burden falls on producers. If one of the curves is perfectly elastic, that side of the market bears none of the burden and the other side bears all of it. In general when there is no interference with the market, the statutory burden of the tax (who actually pays the tax) makes no difference to tax incidence and post-tax quantity traded. But when there is a government-mandated minimum wage, it can make a difference (show drawings). When the tax is on suppliers of labor (workers), the minimum wage doesn t come into effect, and there is no unemployment. When the tax is on buyers of labor (firms), the minimum wage does come into effect, and there is unemployment. Tax incidence in general equilibrium Consider the effect of a tax on a good on factor markets. With perfectly elastic demand for the good, perfectly elastic labor supply and perfectly inelastic capital supply, the burden of the tax ends up falling on capital. So investors in the firms get lower returns on their investment. This is plausible for the short run. In the long run, supply of capital is likely to be elastic. In the long run, the only factor of production that has inelastic supply is land. With perfectly elastic labor and capital supply and demand for the good, land bears the whole burden of a tax on the good. Rents to land will decrease. If demand for the good is not perfectly elastic, consumers of the good will bear some of the burden of a tax in the form of higher prices. Firms demand for labor and capital still shifts down due to the tax, but not by as much as when demand for the good was perfectly elastic. So the return to capital in the short run decreases less than when demand for the good was perfectly elastic. If also labor supply is not perfectly elastic, then capital, labor, land and consumers share the burden of a tax on the good. This is likely to happen if the tax has a 1

2 relatively large scope. There can be spillovers to other product markets as well. If consumers bear any of the tax burden, their incomes are less, and they will tend to buy fewer normal goods and more inferior goods. They will also tend to buy fewer complements of the taxed good and more substitutes. Do exercise 15 on page 574. Deadweight loss due to taxation The more elastic supply and demand are the more of a deadweight loss there is due to a tax of fixed size. Deadweight loss increases proportionally to the tax size squared. page 606, exercise 4. page 607, exercise 12. answer: This can be interpreted as a question about insurance. Worker s compensation benefits are insurance payments that workers get if they become sick or injured due to their job. The government forced firms to pay the premiums on this insurance that workers would get in the event of job-related injury. Due to workers risk-aversion, the benefit to workers of having workers compensation could be greater than the cost to firms of providing it if insurance was close to actuarially fair. This is why firms could decrease wages by more than the premium paid for workers compensation and still have workers working for them. If this is the case, though, why would firms have to be mandated by the government to provide this compensation; why not provide it on their own? The price of workers compensation if firms bought it on their own would be higher due to adverse selection: Insurance companies would assume that if a firm is buying workers compensation, it must have a higher than average risk of accident. There is also a moral hazard problem - if a firm s workers are insured the firm may not take as many necessary precautions to avoid accidents. The first problem of adverse selection goes away when all firms are mandated to provide workers compensation. The second problem of moral hazard remains. About the deadweight loss from the implicit benefit tax, one possibility is that the equilibrium is in the portion of the supply curve that is backwards-bending. In that case the incidence of a tax on labor can be bigger than the size of the tax (see graph). When a supply curve is backward-bending, the total surplus is greater with a tax than without. Thus the deadweight loss due to the tax is negative, since deadweight loss is the total surplus without a tax minus the total surplus with the tax. Also the tax burden on firms here is negative. How is this related to the insurance argument? In the partial equilibrium analysis, the gain in total surplus comes from the government taking revenue out of the system. The surplus to producers (workers) could fall in the graph due to the tax. But in fact the government is paying workers insurance from the 2

3 additional revenue. The workers are actually at least as well off because they are now insured (although some workers who didn t value insurance wouldn t be, but if they are all similar and value insurance they would be at least as well off). The firms gain because they are paying less to their workers. So it could be a Pareto improvement as long as workers get enough benefit from insurance. page 607, exercise 17. For labor supply and taxation (ch.21), there are substitution effects and income effects of a higher income tax rate. Substitution effects make an individual work more when after-tax wage rate is higher, because leisure becomes relatively more expensive. Income effects make an individual work less when after-tax wage rate is higher because more leisure can be afforded. Taxation and savings - ch.22 Savings is the difference between income and consumption. There are income effects and substitution effects of taxation on savings too. The relevant tax is the capital income tax, the tax on income from savings. Income effects make a person consume more and save less when after-tax income is higher (the capital income tax is lower), because more consumption (now) can be afforded. Substitution effects make a person save more and consume less when the capital income tax is lower, because a dollar now buys you more future consumption than before, so future consumption becomes cheaper relative to current consumption. Theories of savings - they describe reasons why people save. 1. Consumption smoothing - people who have diminishing marginal utility of consumption like to have more equal amounts of consumption across time, rather than wildly varying amounts of consumption. Saving accomplishes this by carrying over income from one period to another. For instance, people save for retirement because they know that their income will be lower then, and they want their consumption to be similar in retirement to what it was when they were working. 2. Precautionary saving - people save to insure themselves against bad outcomes, like unemployment or high medical expenses in the future. Precautionary saving is a way to carry over income across states. People with diminishing marginal utility of consumption like for their levels of consumption to be similar across states of the world, as well as across time. Insurance is a kind of precautionary saving, but there are contingencies for which only limited insurance can be bought (such as unemployment). For these contingencies, people save. 3. Target saving - saving only the amount necessary to finance some payment (such as down payment on a house). Unlike the precautionary saving and consumption smoothing motives, where it is unclear whether substitution effects or income effects always dominate, for target saving the income effect clearly dominates the substitution effect. If the after-tax rate of return to savings 3

4 increases, the income effect causes people to save less, because now less is needed to reach the target. Another model related to savings is the self-control model. This model assumes that people are not completely rational, so that they can t always control their short-term impulses to consume more than would be optimal from a long-term point of view. Using this model, people would favor savings methods that prevent them from taking out the savings before it is time, such as pensions that are automatically deducted from their earnings and can t be accessed until they are retired. Some economists think that the savings rate in the United States is lower than optimal, and that the low savings rate is impeding economic growth. To encourage savings, the government allows people to contribute parts of their income tax-free (so the contributions are deducted from taxable income) to a retirement fund such as a 401(k) or an IRA; the balances are taxed as regular income when they are withdrawn after retirement. The ability to contribute tax-free and pay the tax only when balances are withdrawn raises the return to savings because the income that is not taxed initially accumulates interest. However, there is also a type of fund for retirement where the income is taxed as it is contributed and untaxed when it is withdrawn. This is called a Roth IRA. This type of fund is attractive to people who expect their income after retirement to be higher than their income before retirement, or if they expect taxes to go up by the time they retire. Then such a fund provides consumptionsmoothing across time. Ch capital gains taxation Capital gains are taxed under the income tax. Capital gains are taxed on realization, not on accrual. This creates a tax preference for capital gains over other forms of savings. Reasons for taxation on realization are lack of information about market value of an asset when it is not being bought, and that people might not be able to finance the tax payment if it were taxed on accrual - might have to sell the asset to finance tax. There should be some way of accounting for inflation. Inflation tends to make the real capital gain less than the nominal capital gain. But people are taxed on nominal capital gain. It would be better if the tax system were indexed to inflation for capital income. Benefits of a lower capital gains taxation. 1. Decreases the lock-in effect: The lock-in effect refers to people holding on to assets for a long time only to get more benefits from the deferred tax (because capital gains are taxed on realization). The lower the capital gains tax, the less of a lock-in effect there will be, as the benefit from deferred tax payments will be less. The lock-in effect is harmful to efficiency because it prevents assets 4

5 from being put to their most productive use. If a person doesn t sell an asset just because they want defer their tax payment, they could be missing out on an opportunity to put their money to a more productive use. Or the asset could be not being used in the most productive way - consider a house that the owner isn t selling to not have to pay the capital gains tax, but isn t using either. An example of the harmfulness of the lock-in effect is that it could cause people to hold on to stocks in older, less dynamic companies for a longer time, rather than switching to invest in newer and more dynamic companies. In that case their investment money is misplaced. This is an argument for having a lower capital gains tax rate. 2. Encouraging entrepreneurship. In the beginning stages of a business, capital gains rather than corporate income are the main source of benefit to the entrepreneur. The rise in value of the business asset is what gives the firm its value. But there are counterarguments to this argument. Taxation may encourage, not discourage risk taking. Only a small fraction of capital gains go to entrepreneurs. And capital gains tax reduction reward entrepreneurs for having taken risks in the past, and thus are a costly (to the government) way to encourage future entrepreneurship. Ch corporate taxation page 722, exercise 8. 5

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