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Taxation and Efficiency


									Chapter 13: Taxation and Efficiency

   I.     Excess burden

          a. Loss of welfare beyond the tax revenues

          b. Results from distortion of economic decisions resulting from the tax

   II.    Measuring Excess Burden

          a. Tax on barley rotate budget constraint

                  i. Prior to tax consumer utility was maximized at E1 at consumption levels
                     of C1 and B1

                 ii. With tax, consumer can no longer afford C1 and B1
b. With tax consumer utility is maximized at E2 with consumption of C2 and B2

       i. Consumer has moved from utility level i to ii

c. Measure the equivalent variation

       i. Reduction in income that would place the consumer on the same
          indifference curve as the tax

      ii. Tax income equivalent of the tax moves the consumer to E3 and
          consumption level C3 and B3

      iii. Excess burden is distance E2N
             iv. The logic is that the tax changes the relative prices of good and causes the
                 consumer to consume a bundle of goods different from the preferred
                 bundle thus creating a welfare loss.

III.   Lump sum tax

       a. Tax that doesn’t change behavior

       b. Has no excess burden

       c. Regressive nature of tax makes it politically unpopular

IV.    Income tax

       a. Has no excess burden if tax does not change people’s behavior

       b. People work and earn as much after the tax as they did before

       c. Evidence is that people change behavior in response to income taxes

V.     Tax on products with inelastic demand

       a. Consumption remains same after tax as before

       b. Still have excess burden since reduce consumption of other products

VI.    Impact of tax divided into two components

       a. Income effect – change in consumption due to reduction in income

       b. Substitution effect – change in consumption due to change in relative prices

VII.   Excess Burden measured with demand curves

       a. The deadweight loss associated with a tax measures the excess burden of a tax

       b. Measured using compensated demand curves

              i. Every price change has two effects

                      1. Substitution effect – results from the change in the relative prices
                         of the goods

                      2. Income effect – results from increase/decrease in income caused
                         by the price change.
               ii. Compensated demand curve is the demand curve that results from the
                   substitution effect alone.

              iii. Example: Demand for gasoline if government reimbursed consumer for
                   the gasoline taxes paid.

                       1. The check eliminates the income effect leaving only the
                          substitution effect

               iv. Compensated demand curves difficult to derive

               v. For most goods income effect is small so often ignored in practice

        c. Measured the same as done in chapter 12 - Figure 13.5

VIII.   Excess burden of a subsidy

        a. A subsidy has an excess burden like a tax

        b. In this case the price distortion causes more consumption of the product than is
           economically desirable.

        c. Example: Qd = 500 – 10P and Qs = 20P – 100. A $6 subsidy is applied

IX.     Differential taxation of inputs

        a. Taxing inputs differentially skews the production decision

        b. Example: Mortgage interest deduction

                i. Results in more single family homes being constructed

               ii. Results n less multifamily houses being constructed

              iii. Excess burden exists to the extent decision is skewed.

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