Chapter 7 Homework
1) Using the graph below,
A) impose an excise tax of $30 per unit,
B) calculate and show tax incidence,
C) calculate and show tax revenue,
D) calculate and show deadweight loss.
E) calculate and show producer and consumer surplus
You should do this by 1) modeling the tax as an upward shift of the supply curve, 2) Determine the new
transacted quantity (use a rough estimate on the horizontal axis), 3) determine supply price and demand
price, 4) determine tax incidence by calculating how much higher demand price is and how much lower
supply price is, 5) calculate tax revenue based on the tax wedge and the transacted quantity, and 6)
calculate deadweight loss using the area of a triangle method.
2) Using the tax bracket table (below) for single filers, calculate the federal income tax payment
associated with a gross income of $75,000 per year and average tax rate.
Chapter 7
Taxes
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Taxes
An excise tax is placed on the sale of each unit of a good or
service
Our example will be a $40 tax placed on the sale of hotel
rooms, paid by the seller at time of sale.
Think of the tax as just an extra cost for suppliers
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Taxes
3
Taxes
4
Taxes
The tax is represented by a decrease in supply
The new equilibrium is between D and S2
The tax drives a “wedge” between D and S1
On either end of the wedge is supply price and demand price
We calculate the tax incidence with
1) the original market clearing price
2) the supply price
3) the demand price
Tax incidence – how the tax burden is shared between producers
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and consumers
Taxes
If the tax was placed on buyers of hotel rooms at time of
sale rather than sellers;
The tax is represented by a downward shift of the demand
curve
New equilibrium is found where D2 and S intersect
The wedge is driven between D1 and S
Tax incidence is figured the same as before
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Taxes
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Taxes
In fact, it doesn’t matter who officially pays the
tax – the equilibrium outcome is the same
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Incidence & Elasticity
Price elasticity of both supply and demand are what determines
tax incidence
The next example of the market for gasoline illustrates how
consumers can pay most of the tax
Free market equilibrium at $2
Excise tax of $1 (creates a wedge $1 high)
Supply price $1.95
Demand price $2.95
When the price elasticity of demand is low and the price elasticity
of supply is high, the burden of an excise tax falls mainly on
consumers.
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Incidence & Elasticity
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Incidence & Elasticity
The next example of the market for parking illustrates how
producers can pay most of the tax
Free market equilibrium at $6
Excise tax of $5 (creates a wedge $5 high)
Supply price $1.50
Demand price $6.50
When the price elasticity of demand is high and the price
elasticity of supply is low, the burden of an excise tax falls
mainly on producers.
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Incidence & Elasticity
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Incidence & Elasticity
When Ed > Es, tax is mostly paid by producers
When Ed < Es, tax is mostly paid by consumers
When Ed = Es, tax burden is shared equally
In sentence form;
When the price elasticity of demand is higher than the price
elasticity of supply, an excise tax falls mainly on producers.
When the price elasticity of supply is higher than the price
elasticity of demand, an excise tax falls mainly on consumers.
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Incidence & Elasticity
Application: Who pays the FICA tax?
Federal Insurance Contributions Act
Requires workers to contribute to Social Security (85%)
Medicare (15%)
Employees pay 6.2% of earnings, employers pay 7.47%
For example someone earning $100 will pay $6.20 of it as FICA
and their employer pays an additional $7.47.
Price elasticity of demand for labor is very elastic (Ed=3)
Price elasticity of supply for labor is very inelastic
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Workers pay most of the tax
Incidence & Elasticity
PRACTICE (see graph next slide)
(assume the tax causes Q=50)
1) show the tax wedge
2) what is the per unit tax?
3) how much of the tax is paid by consumers?
4) how much of the tax is paid by producers?
5) show deadweight loss on the diagram
6) show tax revenue on the diagram
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Incidence & Elasticity
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Costs & Benefits of Taxation
Cost –
Administrative costs
deadweight loss resulting from market distortion (quantity too
low) and loss of allocative efficiency
Benefit – revenue for the government to operate and
(hopefully) provide public goods in an allocative and
productively efficient way
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Costs of a Tax
The administrative costs of a tax are the resources used by
government to collect the tax, and by taxpayers to pay it,
over and above the amount of the tax, as well as to evade it.
Accounting services
Legal services for tax payers
Collection services
Legal services for government
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Deadweight Loss
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Deadweight Loss
Area:
B is deadweight loss that used to be consumer surplus
F is deadweight loss that used to be producer surplus
A is tax revenue that used to be consumer surplus
C is tax revenue that used to be producer surplus
Tax revenue will be used to provide government services
Deadweight loss isn’t good for anything, and is wasteful of
society’s resources
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Deadweight Loss
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Deadweight Loss
Looking at four scenarios based on various elasticities we
will find:
Deadweight loss is smaller when:
Demand is more inelastic
Supply is more inelastic
Deadweight loss is larger when:
Demand is more elastic
Supply is more elastic
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Deadweight Loss
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Deadweight Loss
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Deadweight Loss
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Deadweight Loss
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Revenue from Tax
Graphically, the revenue collected by an excise tax is equal to
the area of the rectangle whose height is the tax wedge
between the supply and demand curves and whose width is
the quantity transacted under the tax.
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Revenue from Tax
Revenue = $40 * 5,000 = $200,000
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Revenue from Tax
Revenue = $60 * 2,500 = $150,000
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Revenue from Tax
A tax rate is the amount of tax people are required to pay
per unit of whatever is being taxed.
An increase in the tax rate causes goods to bring more
revenue per unit (price effect) which increases revenue and
also be more expensive so that fewer units to be sold
(quantity effect) which decreases revenue
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Revenue from Tax
When supply and demand are both very price elastic (flat),
increasing the tax rate will lead to a large quantity effect
When supply and demand are both very price inelastic
(steep), increasing the tax rate will lead to a small quantity
effect
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Analysis
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Tax Fairness
Two principles of tax fairness
Benefits principle – those who benefit from the public spending
should bear the burden of the tax
Ability-to-pay principle – those who can better afford to bear
the burden of a tax should pay more of the tax
Efficiency v. Equity Tradeoff
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Types of Taxes
A lump-sum tax is the same for everyone, regardless of any
actions people take. A regressive tax.
Example: you are forced to pay a $50 fee to work in Wilkes-
Barre. If you earn $5,000 per year that is 1% of income. If
you earn $50,000 per year that is 0.1% of income.
A regressive tax takes a smaller share of the income of high-
income taxpayers than of low- income taxpayers.
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Types of Taxes
A proportional tax is the same percentage of the tax base
regardless of the taxpayer’s income or wealth.
Example: 10% tax on income. A person earning $10,000 pays
10% of their income. So does a person earning $200,000.
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Types of Taxes
The marginal tax rate is the percentage of an increase in
income that is taxed away.
A progressive tax takes a larger share of the income of high-
income taxpayers than of low- income taxpayers.
Example: The tax rate on the first $10,000 is 10% and
increases to 15% on all further income.
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Types of Taxes
The tax base is the measure or value, such as income or property
value, that determines how much tax an individual or firm pays.
The tax structure specifies how the tax depends on the tax base.
An income tax is a tax on an individual’s or family’s income.
A payroll tax is a tax on the earnings an employer pays to an
employee.
A sales tax is a tax on the value of goods sold.
A profits tax is a tax on a firm’s profits.
A property tax is a tax on the value of property, such as the value
of a home.
A wealth tax is a tax on an individual’s wealth.
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Types of Taxes
Proportional rate where everyone pays 25%
Progressive where highest earners pay 75%, else 0%
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Taxes in the USA
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Taxes in the USA
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Taxes in the USA
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Taxes in the USA
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http://www.bankrate.com/finance/taxes/tax-brackets.aspx
Tax payment | % Calculation
If income is $20,000
First bracket $9,075 x 10% = $907.50
Next bracket ($20,000 - $9,075) x 15% = $1,638.75
$907.50 + $1,638.75 = $2,546.25 Total federal income tax
payment
$2,546.25/$20,000 = 12.7% of gross (before tax) income
You try to calculate for income of $59,000
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http://www.bankrate.com/finance/taxes/tax-brackets.aspx
Tax payment | % Calculation
If income is $59,000
First bracket $9,075 x 10% = $907.50
Next bracket ($36,900 - $9,075) x 15% = $4,173.75
Next bracket ($59,000 - $ 36,900) x 25% = $5,525
$10,606.25 Total federal income tax payment
$10,606.25/$59,000 = 18% of gross (before tax) income
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Tax Rates by State
FYI
PA state income tax is 3.07% regardless of income
NY state income tax is 4% to 8.82% dependent on income
CA state income tax is 1% to 13.3% dependent on income
DE state income tax is 2.2% to 6.6% dependent on income
FL state income tax does not exist
CA is highest top bracket
http://taxfoundation.org/article/state-personal-income-tax-rates-and-brackets-2014-update
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