Taxation and income distributionBegin Unit 4TaxationSlide 4Slide 5Some terminologySlide 7Slide 8Partial equilibrium modelsUnit taxSlide 11Ad valorem taxesSlide 13Tax on gross price? …or net price?Slide 15Other types of taxesSummaryProblem: Ad valorem taxNo taxesWith a taxSlide 21Inevitable: Death and…Taxation and income distributionToday: Some basic tax theoryBegin Unit 4TodayParts of chapter 14An introduction to some basic theories related to taxationTaxationTaxes are typically used to finance public projectsDeadweight loss comes with most forms of taxationThis will be discussed in next lectureTaxation and income distributionThe US federal tax system has been set up so that people with high incomes have higher average tax ratesDo people consume more leisure with high marginal tax rates?Usually yes Public project financingPeople with high tax rates probably have high willingness to pay for many public projectsTaxation and income distributionIncome CategoryAverage Federal Tax RateShare of Federal TaxesLowest Quintile 5.6% 1.1%Second Quintile 12.1 5.2Third Quintile 15.7 10.3Fourth Quintile 19.8 19.0Highest Quintile 26.5 64.2All Quintiles 21.6 100.0Top 1% 31.2 21.3Source: Congressional Budget Office [2004]. These figures are based on projections that rely on assumptions about inflation and income growth. They include all tax law as of 2001.Table 14.3 Average federal tax rates and share of federal taxes by income quintile (2006)Some terminologyStatutory incidenceWho legally has to pay for the taxEconomic incidenceHow much does real income change to all parties due to a tax?Some terminologyLump sum taxA tax that has to be paid no matter how a person behavesProportional taxAverage tax rate is independent of incomeProgressive taxAverage tax rate increases with incomeRegressive taxAverage tax rate decreases with incomeSome terminologyUnit taxA tax that is paid per unit of a goodAd valorem taxA tax that is a percentage of the purchase pricePartial equilibrium modelsWith partial equilibrium models, only one market is examined at any one timeIgnores possible spillover effectsUsually easier to analyze than general equilibrium modelsTwo types of taxes analyzedUnit taxAd valorem taxUnit taxYou have likely seen unit taxes beforeEcon 1 (or equivalent)Econ 100A/B (or equivalent)Either the buyer or seller pays a given dollar amount for each unit sold or purchasedBefore Tax After TaxConsumers PaySuppliers Receive$1.40$1.00$1.20$1.20D0S0D1S1Partial Equilibrium ModelsQuantity$Ad valorem taxesAssume that the consumer pays an ad valorem taxExample: 6% sales tax (of the net price) imposed on the consumerThe ad valorem tax shifts the demand curve by the same percentage (relative to the horizontal axis)Ad valorem taxesPounds of food per yearPrice per pound of foodDfSfQ0QmQrP0PmPrDf’Tax on gross price? …or net price?A tax on the gross price (paid by consumers) lowers the willingness to pay by the percentage of the taxExample25% tax of gross price when demand is P = 4000 – 20QNew demand after tax is P = (1 – 0.25) (4000 – 20Q)P = 3000 – 15QTax on gross price? …or net price?A tax on the net price (paid by consumers) is more complicatedYou need to find the new demand such that when the tax is added, you get the new demandExample25% tax of net price when demand is P = 4000 – 20QWTP with the tax is 5/4 of WTP without the taxIn other words, WTP without the tax is 4/5 the WTP with the taxNew demand after the tax is P = (1 – 4/5) (3000 – 20Q), which leads to P = 3200 – 16QOther types of taxesTaxes from workingIncome taxSocial Security taxHospital insurance tax (Medicare)Capital taxesProblem: Mobility of capital may move capital out of the country with taxationTaxes on profitsAccounting profitsEconomic profitsSummaryHigh income people pay a higher percentage of their income in taxesDifferent forms of taxation exist Unit taxAd valorem taxTaxes on wagesCapital taxesProfit taxesProblem: Ad valorem taxSupply: P = QDemand: P = 1710 – QWhat is the equilibrium in the absence of a tax?What is the equilibrium if there is a 10% tax of the gross price?No taxesSet Q = 1710 – QQ = 855Since P = Q from the supply curve, P = 855With a taxA tax on the gross price implies that the willingness to pay goes down by 10% for each unitNew demand is P = 1539 – 0.9QSet Q = 1539 – 0.9QQ = 810With a taxWhat about price?Price without the tax is 810This is the price that suppliers receivePrice with tax is 810/0.9 = 900This is the price that consumers payInevitable: Death