CHAPTER OUTLINE

1. Explain how taxes change prices and quantities,are shared by buyers and sellers, and create inefficiency.

A. TaxIncidence

B.  Taxesand Efficiency

C. Incidence,Inefficiency, and Elasticity

D. Incidence,Inefficiency, and the Elasticity of Demand

1.  PerfectlyInelastic Demand: Buyer Pays and Efficient

2.  PerfectlyElastic Demand: Seller Pays and Inefficient

E.  Incidence,Inefficiency, and the Elasticity of Supply

1.  PerfectlyInelastic Supply: Seller Pays and Efficient

2.  PerfectlyElastic Supply: Buyer Pays and Inefficient

2. Explain how income taxes and Social Securitytaxes change wage rates and employment, are shared by employers and workers,and create inefficiency.

A. ThePersonal Income Tax

B.  TheEffects of the Income Tax

1.  Taxon Labor Income

2.  Taxon Capital Income

3.  Taxon the Income from Land and Other Unique Resources

C. TheSocial Security Tax

1.  ASocial Security Tax on Workers

2.  ASocial Security Tax on Employers

 

n What’s New in this Edition?

Chapter 8 is an updated version ofChapter 8 from the fifth edition, with updated data for the Eye applications.

n Where We Are

We use the demand and supply model tostudy how taxes affect markets. We study taxes on goods and services and taxeson income. The demand and supply model shows the effect these taxes have onprices and quantities and the deadweight loss they create. We conclude byexamining the two main ideas of fair taxes, the benefits principle and theability-to-pay principle.

n Where We’ve Been

We developed the demand and supply modelin Chapter 4. We have used it see how unregulated markets work (Chapters 4, 5,and 6) and how markets with price controls and price supports work (Chapter 7).In Chapter 5 we studied the elasticities of demand and supply, which determinetax incidence.

n Where We’re Going

Chapters 9,10, and 11 continue the theme of examining how markets work by examining globalmarkets, externalities and then public goods and common resources. Chapter 9 examineshow global markets work and the effects of government policies such as tariffs.Chapter 10 shows how an unregulated market can lead to a deadweight loss when goodswith external costs or goods with external benefits are produced. Chapter 11covers public goods and common resources. Both Chapters 10 and 11 counterbalanceChapters 7 and 8 because they show situations in which government interventioncan lead to efficiency rather than inefficiency.

IN THECLASSROOM

nClass Time Needed

This material can take more time thanexpected because students need to understand why a tax shifts the supply curveor demand curve vertically by the amount of the tax. Once they grasp thispoint, the rest of the material goes more quickly. So, start with a discussionof this point and spend the necessary time. But, try to cover this chapter inno more than two class sessions.

           Anestimate of the time per checkpoint is:

·            8.1 Taxes on Buyers andSellers—40 minutes to 50 minutes

·            8.2 Income Tax and SocialSecurity Tax—25 minutes to 45 minutes

·            8.3 Fairness and the BigTradeoff—10 minutes to 15 minutes

Classroom Activity: As homework, priorto beginning this chapter, you can require your students to use MyEconLab tofind news articles on the economic impact of taxation. At the beginning ofclass, students could share what they had learned. I would assign the studentsto provide a copy of the article and a short type-written summary of thearticle’s main points. By requiring the work typed, the instructor is assuredthat students don’t just bring in any article but actually have to do some thinking.

Classroom Activity: You can divide theclass into three groups (local, state, and federal) and have each groupbrainstorm a list of types of pertinent taxes and what things those taxessupport. These lists could then be shared with the entire class. The idea is toa) show that we do get something for our tax money and b) lead toward understandingthe difference between those who pay and those who benefit.

      Brainstorming the purposes that taxes serve in theU.S.will helpto explain why we have them (in spite of the deadweight loss they see in themodels) and serve as a preview of the concepts coming up in future chapters.Basically, you can set the stage that taxes are used to provide various goodsand services (especially those with positive externalities or public goods),discourage certain activities (especially those with negative externalities oroverconsumption of common resources), and change the distribution of goods andservices (reduce inequality with a progressive tax system, income maintenance,and subsidized goods and services).

 

CHAPTER LECTURE

n 7.1       Taxes on Buyers and Sellers

Lecture launcher: You can involve students in your lecture on tax incidence bydrawing the demand-supply graph and asking them if a tax was imposed in thismarket, which curve would be affected? You can ask for a show of hands or avoice vote, but you’ll probably get more votes for the demand curve becausestudents see themselves—the consumer—as always paying the entire tax. Ofcourse, the fun part of the lecture is showing how consumers rarely pay the entiretax.

Tax Incidence

Taxincidence is the division of the burden of atax between the buyer and the seller. The buyers’ burden arises when the pricepaid by the buyers rises after the tax is imposed. The sellers’ burden ariseswhen the price they receive falls after the tax is imposed. The tax incidencedoes not depend on whether the tax law imposes the tax on buyers or on sellers.

·        A tax on sellers:

·        Imposing a tax on sellers decreasesthe supply because the tax is like a cost that sellers must pay. The supplycurve shifts leftward and the vertical distance between the initial supplycurve and the new supply curve is equal to the amount of the tax. The pricepaid by buyers rises, the price received by sellers falls, and the quantity decreases.

·        The figure shows the effect of a taximposed on sellers. The initial price is $12 and the initial quantity is10,000. When the tax is imposed, the supply curve shifts from S to S+ tax. The length of the double headed equals the amount of the tax, $2.With the tax imposed, buyers pay $13, sellers receive $11, and the quantity decreasesto 9,000.

qLand Mine: Students havedifficulty envisioning why the supply curve shifts with imposition of a salesor excise tax, especially because they’ve always believed it’s the buyer thatpays the tax. They don’t seem to realize that it’s the firms that are responsiblefor sending the tax into the government. Remind them that this fact is why itmakes sense to shift the supply curve leftward (reflecting this added “cost” tothe firm).

qLandMine: A related stumbling block in this chapter isthe result that imposing a tax shifts the supply curve so that the verticaldistance between the curve without the tax and the curve with the tax is equalto the amount of the tax. Remember that in previous chapters there was emphasison the horizontal nature of the shift, that is, that a decrease in supply isrepresented by the supply curve shifting leftward. Tell your students that inthis case the supply curve has again shifted leftward—only you do not know byhow much it has shifted. After this lead-in, explain to the students that thevertical shift equals the amount of the tax. This explanation is easiest if youuse numbers. For instance, suppose that before any tax is levied, 1 millioncans of soda are supplied if the price of a can of soda is 75¢. This assumptionmeans that suppliers will produce 1 million cans of soda if they receive 75¢ acan. Now suppose the government imposes a 25¢ a can tax on soda. To havesuppliers produce 1 million cans of soda now requires that the price, includingthe tax, be $1.00 a can because from the $1.00 the 25¢ tax is paid, leavingsuppliers with 75¢.

·        A tax on buyers:

·        Imposing a tax on buyers decreases thedemand because the tax lowers the amount they are wiling to pay to the sellers.The demand curve shifts leftward and the vertical distance between the initialdemand curve and the new demand curve is equal to the amount of the tax. Theprice paid by buyers rises, the price receivedby sellers falls, and the quantity decreases.

·        The figure shows the effect of a taximposed on buyers. The initial price is $12 per DVD and the initial quantity is10,000 DVDs per month. When the tax is imposed, the demand curve shifts from Dto D -tax. The length of the double headed equals theamount of the tax, $2. With the tax imposed, buyers pay $13 per DVD, sellersreceive $11 per DVD, and the quantity of DVDs decreases to 9,000 per month.

·        Thefigures above confirm the general conclusion: Regardless of whether the tax isimposed on buyers or sellers, the tax leads to the same outcome in which thenew equilibrium price and quantity are identical. The tax burden is split thesame way regardless of who is responsible for paying the tax to the government.

Taxes andEfficiency

·        Taxesplace a wedge between the price buyers pay and sellers receive. It therefore putsa wedge between marginal benefit and marginal cost and creates inefficiency.The quantity produced is less than the efficient quantity.

·        Taxes create an excessburden, which isthe amount by which the burden of a tax exceeds the tax revenue received by thegovernment—the deadweight loss from a tax.

Incidence,Inefficiency, and the Elasticity of Demand

·        Perfectly Inelastic Demand: BuyerPays and Efficient: The buyer pays the entire tax if demand is perfectlyinelastic (so the demand curve is vertical). In general, the less elastic the demand, thelarger the tax burden paid by the buyers. When demand is perfectly elastic, theoutcome is efficient because marginal cost equals marginal benefit.

·        Perfectly Elastic Demand: SellerPays and Inefficient: The seller pays the entire tax if demand isperfectly elastic (so the demand curve is horizontal) In general, the more elastic the demand, thelarger the tax burden paid by the sellers. Because marginal benefit exceedsmarginal cost, the outcome is inefficient.

Describe the situation faced by smokers, asthe recent hike in the federal tax on cigarettes impacted many of your students.First, the demand for cigarettes is highly inelastic. So, with the government’shefty taxes placed on cigarettes, the price paid by buyers rises substantially.The incidence of the tax falls heavily on buyers. In addition, stategovernments have sued tobacco companies for past and future health care costsarising from the smoking-related illnesses. Tobacco companies settled thesesuits, paying billions of dollars in penalties, which raised their costs anddecreased their supply. But smokers’ very inelastic demand for cigarettes meansthat the tobacco producers were able to pass on most of these costs to smokerswithout bearing a significant decrease in the quantity sold.

Incidence,Inefficiency, and the Elasticity of Supply

·        Perfectly Inelastic Supply:Seller Pays and Efficient: The seller pays the entire tax if supply is perfectly inelastic (sothe supply curve is vertical). In general, the more inelastic the supply, thelarger the tax burden paid by the sellers. When supply is perfectly elastic, marginalbenefit equals marginal cost, so the outcome is efficient.

·        Perfectly Elastic Supply:  Buyer Pays and Inefficient: The buyer paysthe entire tax if supply is perfectly elastic (so the supply curve ishorizontal). Ingeneral, the more elastic the supply, the larger the tax burden paid by thebuyers. Marginal benefit exceeds marginal cost, so the outcome is inefficient.

If either the demand or the supply isperfectly inelastic, there is no deadweight loss from the tax because theequilibrium quantity does not change. In all other cases, there is a deadweightloss.