CHAPTER 17 Taxation
Test Yourself
1. The tax is regressive, since the average tax rate falls as income rises:
Tax Rate
Income Tax Marginal Average
$20,000 $2,000 .10 .10
30,000 2,700 .07 .09
40,000 3,200 .05 .08
50,000 3,500 .03 .07
2. The answers to these questions are not obvious, and students may be able to argue various points of view.
(a) The progressive income tax promotes vertical equity, if one believes that income differentials should be reduced. It promotes horizontal equity, unless one thinks that the exemptions and deductions (“loopholes”) are too large.
(b) The excise tax on cigarettes serves no principle of tax equity. Since the poor spend a higher proportion of their income on cigarettes than do the rich, it violates vertical equity. Since people with the same income spend different amounts on cigarettes, it violates horizontal equity. And since the revenue is not used for smoking-related health costs, it violates the benefit principle. The tax still may be justified, if one believes the government has a legitimate interest in reducing smoking.
(c) The gasoline tax is consistent with the benefit principle of taxation: highway users pay a tax that is used to build and repair highways.
3. (a) Before the tax is imposed, the equilibrium price is $4.00 and the equilibrium quantity is 240 million cartons.
(b) After the tax is imposed, the supply curve shifts up by the amount of the tax to:
Price
Price Quantity Quantity
(including tax) (excluding tax)
Demanded Supplied
$4.25 $3.00 210 160
4.50 3.25 180 180
4.75 3.50 150 200
5.00 3.75 120 240
So the new equilibrium quantity will be 180 million cartons. The new equilibrium price paid by the consumers (including the tax) will be $4.50, while the price received by the producers (excluding the tax) will be $3.25.
(c) Regardless of who pay it, the tax is a wedge of $1.25 between the price paid by the consumer and the price received by the seller. In the situation described in part (b), the seller may list the price at $3.25, and then require the buyer to pay a tax of $1.25 above this. Or the seller may list the price at $4.50, including tax, and give $1.25 of this to the government. In either case, the net price paid by the consumer is $4.50, the net price received by the seller is $3.25, and the equilibrium quantity is 180.
(d) The sellers shift $0.50 of the tax to the buyers, since the market price rises from $4.00 to $4.50. They do this by reducing output, which raises the market price.
(e) There is excess burden borne by both buyers and sellers. The buyers’ excess burden arises from the fact that they are purchasing fewer cigarettes than before the tax. The sellers’ excess burden arises from the fact that they are producing fewer cigarettes than before.
(f) Cigarette consumption has fallen from 240 million cartons to 180 million cartons. This may actually be the goal that the government sought, in its attempt to improve health.
Discussion Questions
2. Critics opposed President Bush’s tax cuts for many reasons. Some argued that tax cuts would eliminate the federal government’s budget surplus and possibly lead to a future budget deficit. Another criticism was that the tax cuts were skewed towards the rich, thereby increasing the gap between the rich and the poor. The counter to these concerns is that since the Bush tax cuts reduced marginal tax rates the efficiency of the economy should improve. Also some supporters of the tax cuts pointed out that although the rich would receive tax cuts, they also pay the highest taxes. Some Bush supporters also argued that the government should return some of the budget surplus to the taxpayers.
3. The taxes that the government tried to levy on Mr. Figg led to inefficiencies, because Figg changed his behavior away from activities that he preferred. The burden of the taxes on Figg was substantial, since it would require a lot of money to compensate him for the changes in his life. Almost this entire burden is in the form of excess burden; because Figg changed his activities he ends up paying little if any money to the government.
4. Students could take steps to avoid taxes (legally) by buying fewer consumer goods, driving less, or working less. The annoyance, or the decline in utility, caused by these changes is the excess burden of the tax.
5. Students may or may not agree with the former president. Most taxes are in fact levied only for the purpose of raising revenue. If they lead to behavior changes, these create excess burdens and cause inefficiencies. In such cases, most people would agree with the president that these effects should be avoided (to the extent possible). But some taxes are imposed in order to change behavior (for example, effluent charges). Many people (but not, apparently, the former president) would regard these as legitimate. Stated more broadly, many people would argue against the former president by stating that in some cases it is a “legitimate government purpose” to “regulate the economy or bring about social change.”