© 2013 Pearson Does Congress decide who pays the taxes? © 2013 Pearson Taxes CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to Explain how taxes change prices and quantities, are shared by buyers and sellers, and create inefficiency Explain how income taxes and Social Security taxes change wage rates and employment, are shared by employers and workers, and create inefficiency Review ideas about the fairness of the tax system © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS Tax Incidence Tax incidence is the division of the burden of a tax between the buyer and the seller When a good is taxed, it has two prices: • A price that includes the tax • A price that excludes the tax Buyers respond to the price that includes the tax Sellers respond to the price that excludes the tax © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS The tax is like a wedge between the two prices Suppose that the government puts a $10 tax on MP3 players How does the price paid by the buyer change? How does the price received by the seller change? How is the burden of a tax shared between the buyer and the seller? © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS Figure 8.1(a) shows what happens when the government taxes buyers of the MP3 players With no tax, the price is $100 and 5,000 players are bought A $10 tax on buyers shifts the demand curve to D – tax © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS The buyer’s price rises to $105—an increase of $5 a player The seller’s price falls to $95—a decrease of $5 a player The quantity decreases to 2,000 players a week The government’s tax revenue is $20,000 © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS Figure 8.1(b) shows what happens when the government taxes sellers of the MP3 players With no tax, the price is $100 and 5,000 players a week are bought A $10 tax on sellers of MP3 players shifts the supply curve to S + tax © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS The buyer’s price rises to $105—an increase of $5 a player The seller’s price falls to $95—a decrease of $5 a player The quantity decreases to 2,000 players a week The government’s tax revenue is $20,000 © 2013 Pearson 8.1 TAXES ON BUYERS AND SELLERS Taxes and Efficiency A tax places a wedge between the buyers’ price (marginal benefit) and the sellers’ price (marginal cost) The equilibrium quantity is less than the efficient quantity and a deadweight loss arises © 2013 Pearson 8.2 INCOME TAX AND SOCIAL SECURITY TAX The government collects tax revenue shown by the purple rectangle Workers pay most of the tax because the supply of labor is more inelastic than the demand for labor © 2013 Pearson 8.2 INCOME AND SOCIAL SECURITY TAX A Social Security Tax on Employers Payroll tax is a tax on employers based on the wages they pay their workers Figure 8.10 on the next slide shows the effects of a payroll tax © 2013 Pearson 8.2 INCOME TAX AND SOCIAL SECURITY TAX A Social Security Tax on Employers With no tax, the wage rate is $12.00 an hour and 4,000 people are employed A tax on employers of $2.50 an hour shifts the demand curve to LD – tax © 2013 Pearson 8.2 INCOME TAX AND SOCIAL SECURITY TAX The wage rate falls to $10.00 an hour— a decrease of $2.00 an hour The number of workers employed decreases to 3,000 © 2013 Pearson 8.2 INCOME TAX AND SOCIAL SECURITY TAX Employers’ total cost of labor rises to $12.50 an hour—the $10.00 wage rate plus the $2.50 tax The government collects tax revenue shown by the purple rectangle © 2013 Pearson 8.3 FAIRNESS AND THE BIG TRADEOFF Whenever political leaders debate tax issues, it is fairness, not efficiency, that looms above all other considerations There are two conflicting principles of fairness of taxes: • The benefits principle The ability-to-pay principle â 2013 Pearson 8.3 FAIRNESS AND THE BIG TRADEOFF The Benefits Principle The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from public goods and services This arrangement is fair because it means that those who benefit most pay the most But to implement it, we would need an objective way of measuring each person’s marginal benefit from public goods and services © 2013 Pearson 8.3 FAIRNESS AND THE BIG TRADEOFF The Ability-to-Pay Principle The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden A rich person can more easily bear the burden of providing public goods than a poor person can, so the rich should pay higher taxes than the poor This principle compares people according to Horizontal equity Vertical equity â 2013 Pearson 8.3 FAIRNESS AND THE BIG TRADEOFF Horizontal equity is the requirement that taxpayers with the same ability to pay should pay the same taxes Vertical equity is the requirement that taxpayers with a greater ability to pay bear a greater share of the taxes © 2013 Pearson 8.3 FAIRNESS AND THE BIG TRADEOFF The Marriage Tax Problem • In the U.S tax code, a married couple is considered a single taxpayer • This arrangement means that if they each earn the same income as before a marriage, the married couple might pay more tax than they did before marriage © 2013 Pearson 8.3 FAIRNESS AND THE BIG TRADEOFF The Big Tradeoff Questions about the fairness of taxes conflict with efficiency questions and create the big tradeoff Taxes on capital incomes create the greatest deadweight loss—are the most inefficient But most of the capital is owned by a small number of rich people, so (most people believe) taxes on capital are the fairest Our tax system is an evolving attempt to juggle the two goals of efficiency and fairness © 2013 Pearson Does Congress Decide Who Pays the Taxes? Congress says that employers and workers pay the same Social Security tax contributions (7.65 percent each in 2011) But because the elasticity of demand for labor is much greater than the elasticity of supply of labor, workers end up paying most of the Social Security tax But there is one thing that Congress can to influence who pays a tax It can pass a tax law (or tax rebate law) that doesn’t impact the margin on which decisions turn Recently, Congress passed such a law © 2013 Pearson Does Congress Decide Who Pays the Taxes? On February 17, 2009, the President signed the American Recovery and Reinvestment Act Among the Act’s many provisions is a “Making Work Pay” tax credit of $400 for a single worker and $800 for a couple A tax credit is a fixed reduction in the amount paid in personal income tax (in the current case, $400) For most people, a tax credit has no effect on their supply of labor The tax credit doesn’t influence the work-hours choice © 2013 Pearson Does Congress Decide Who Pays the Taxes? A 20% income tax rate shifts the labor supply curve from LS to LS + tax The pre-tax wage rises by $1 to $20 per hour, the after-tax wage falls by $3 to $16 per hour, and the workweek fall from 40 hours to 35 hours Workers pay 75% of the tax and employers pay 25% © 2013 Pearson Does Congress Decide Who Pays the Taxes? Suppose that Congress now passes an Act that gives workers a tax rebate of $30 a week Tax paid by worker falls Marginal tax rate remains at 20%, but now workers pay only 68% of the tax and employers pay 32% Congress has worked around the elasticities! © 2013 Pearson ... difference The supply of land is highly inelastic The tax on land income is fully borne by the landowners and the quantity of land is unaffected by the tax With no change in the quantity of land, the... elasticites of demand and supply: • For a given elasticity of supply, the buyer pays a larger share of the tax, the more inelastic is the demand for the good • For a given elasticity of demand,... inelastic supply—the market for spring water A tax of 5¢ a bottle does not change the price paid by the buyer but lowers the price received by the seller by 5¢ Marginal benefit equals marginal cost,