Topic 2 Efficiency and - PowerPoint Presentation

1. Topic 2Efficiency and equity: what is the cost of taxation

2. Efficiency of taxation: Does taxation impose costs on society as a whole?Taxes are mainly used to pay for public services and to redistribute incomeBroadly: three types of “social costs” to society as a whole1) Administrative costs (time spent by tax authorities, civil servants, tax inspectors, police and justice system)2) Compliance costs (time spent by business filling in forms etc)3) Distortion costs (economic inefficiency arising because people change their behaviour because of the tax)

3. Do people change the way they work if they pay tax or receive benefits?Redistributive (progressive) taxes and benefits take money from richer people and give it to poorer peopleBut: does society as a whole lose anything in this transfer? Are market outcomes “distorted”: E.G. Do rich people work less hard if they are taxed more?Do poor people work less hard if they receive benefits?If the government taxes X, do people buy less of X?Economists “try” to answer these types of questions using EVIDENCETHEORETICAL TOOLS (WELFARE ECONOMICS)EMPIRICAL TOOLS (DATA AND STATISTICS)

4. Theoretical tool: WELFARE ECONOMICSImagine a good sold in a perfectly competitive market that costs $1.50 / litre. Consumers buy 100 litres/day.What would happen to the price if the government imposes a tax of $0.50 /litre on producers?How much revenue would the government raise per day?Would the consumer or the producer pay the tax?Would society as a whole lose or gain?

5. Taxation in a perfectly competitive marketEffect of a $0.50/litre tax on a good:The price to the consumer increases to $1.80The price to the producer decreases to $1.30The QUANTITY available in the market reducesThere is a “deadweight” welfare loss from the tax (society as a whole loses)Note: the effect of the tax is to create TWO PRICES: one that the consumer pays and the other that the producer recieves

6. Deadweight lossThe deadweight loss occurs because people SUBSTITUTE the taxed good for other goodsThey would not have otherwise have CHOSEN to consume this other goodSo UTILITY (overall happiness) is lower because of this induced change in their consumptionIn real life, we see that people make some “strange” changes to their lives to avoid consuming taxed goods(see article on PRADO)

7. Examples of deadweight loss from taxationWindow tax in the 18thC -> people fit smaller windowsTax on hats -> people stop wearing hatsTax on beards -> men clean-shave

8. Deadweight loss depends on the elasticities of the demand & supply curves

9. Principle 1: Deadweight loss depends on the elasticities of supply and demandImportant note: The DWL refers to the loss in TOTAL societal utility. If demand is price – inelastic:This means that people do not want to change their behaviour because of price increasesIn this case the tax transfers wealth from the consumer to the governmentThe CONSUMER’s utility will be greatly reduced, and the “government’s” utility will be “almost equivalently” increasedSo the DWL (the total loss to society) is small If demand is price-elastic:The consumer substitutes from the taxed good (1st best) to another (2nd best) goodThe consumer’s utility will be reduced, but the government will not obtain much revenueSo the DWL (the total loss to society) is large

10. Principle 2: It does not matter whether the consumer or the producer pays the taxIn a perfectly competitive market, it does not matter whether the consumer or producer pays the taxThe change in price and quantity will be the same whoever (legally) has to payIf the consumer pays the tax, the demand curve shifts down by the amount of the taxIf the producer pays the tax, the marginal cost curve (= the supply curve) shifts up by the amount of the tax Note: This result is not always true in imperfect competition

11. Exercise to calculate deadweight lossP = 90– Qd ( demand function)P = 2 Qs (supply function)1) Find equilibrium price and quantity2) The government now imposes a tax of 15 / unit on the producer. Find the new equilibrium price to the consumerFind the new equilibrium price to the producerFind the new equilibrium quantityEstimate the revenue raised from the taxEstimate the deadweight lossWhat happens if the consumer has to pay the 15/unit tax?

12. Exercise : answersP = 90– Qd ( demand function)P = 2 Qs (supply function)1) Find equilibrium price and quantity Q=30; P=602) The government now imposes a tax of 15 / unit. Find the new equilibrium quantity Q=25 Find the new equilibrium price to the consumer P=50Find the new equilibrium price to the producer P = 65Estimate the government revenue raised by the tax 375Estimate the deadweight loss 0.5*15*5 = 37.5

13. Income tax and labour supplyIncome tax is a tax on hours worked, reducing a person’s take-home salaryMicro-economic theory: “Working” is usually something people only do for moneyThey would rather be enjoying “leisure” (a normal good)So a tax on work, by making each additional hour of work less attractive, makes that hour of “leisure” more attractiveSo (in theory) if marginal income tax rates are high, people might choose to work less hours

14. Income tax and labour supplyPOSSIBLE, THEORETICAL effect of a 20% tax on labour supply (assuming each hour of leisure is a normal good)This theory predicts a tax increase may reduce hours worked (and produce DeadWeight Loss to society). This is the idea behind the “Laffer curve” (see topic 5)Assumes that the worker pays the tax. But the same result if the firm pays

15. Societal loss because of income tax on richer versus poorer workersWelfare theory makes a further prediction: The loss to society (deadweight) of a given % tax will be greater for richer workers than poorer workersThe theory assumes a person’s wage measures the “importance” or “value” of that person’s work to society as a whole“Theory of human capital”So if that person works fewer hours, society as a whole will lose that valuable (=important) activity

16. Societal loss of income tax on richer versus poorer workers

17. Difficulty of measuing the social costs of taxationThe “human capital” theory assumes that every person is paid a salary equal to their marginal product to society. This is highly questionableThe analysis does not take account of externalities (positive or negative)Governments may impose taxes for reasons other than collecting revenue (see Topic 8)

18. Social insuranceA social insurance scheme is an insurance scheme that is strictly regulated by the governmentMembership is often obligatory for all employees (workers)It is often financed by a monthly contribution paid by the employer (the firm) This is very similar to a payroll tax. It is a cost to the firm(The employee might also contribute a share)However, unlike general taxation, the worker or their family receives some personal benefitExamples are: pensions, unemployment insurance, medical insurance

19. Social insurance (= a tax with benefits)The monthly contribution by the firm is like a tax on working hoursAs with any tax, the theory predicts (in perfect competition): It will increase the price of labour for the firm ...And reduce the wage received by the worker...And it will reduce employment Regardless of whether the firm or the worker “legally” has to pay the contributionHowever, the “benefit” part of the insurance (the pension, or the health insurance etc.) will make work MORE attractive for those who benefitBecause of the benefit, some people will now prefer to take paid work than other uses of their time, such as care for children etc.This will increase the SUPPLY of labour in that group of workers

20. ExampleMost people in USA get their health insurance from their firmFirms bought this health insurance from private insurance companiesBefore 1970, few firms offered health plans that included pregnancy and childbirth cover(Pregnant women / families had to pay their own hospital fees & the US had very high maternal & perinatal mortality rates )A new law made inclusion of pregnancy & childbirth cover compulsory in employer-provided health insurance policiesAfter the new law, insurance companies were obliged to offer pregnancy and childbirth coverBUT monthly contributions charged to firms by health insurance companies for this cover were higher for female workers of child-bearing age than for male workers of similar age and health

21. A social insurance program (a tax with benefits)

22. Exercises

23. Deadweight lossP = 100– 0.5Qd ( demand function)P = 2 Qs (supply function)1) Find equilibrium price and quantity2) The government now imposes a tax of 15/ unit. Find the new equilibrium price to the consumerFind the new equilibrium price to the producerFind the new equilibrium quantityEstimate the revenue raised from the taxEstimate the deadweight loss

24. Debate questionDiscuss the effect of introducing a new law that requires firms to provides workers with health insurance cover for pregnancy and childbirth expenses (compared to the situation before when this cover did not exist)Advice: Read Gruber (2007) Chapter 23 Page 615Describe the health insurance cover available in the USA before the new law, and explain the aim of the new law. Which groups of workers will be affected by the law? How are they affected?Use microeconomic analysis (with graphs) to explain the theoretical impact of the new law on the demand for labour (Remember: the demand for labour is the demand by the firm for workers. Think about SUBSTITUTION effects from the point of view of the firm). Explain the impact of the new law on labour supply (Again, think about SUBSTITUTION effects from the point of view of the worker)Summarise how Jon Gruber used data to show the impact of the new law on wages and employment of women of childbearing age (You need to explain what “difference in difference” means). Discuss and comment on these results (you may wish to comment on the gender discrimination by firms in this case study and how govermnent might act to avoid this)

25. Gruber Chapter 23 p615