CHAPTER 17: PUBLIC CHOICE THEORY AND THE ECONOMICS OF TAXATION Introduction As we have seen, government plays an important role in addressing market failures. But it also plays a significant role in taxation and redistribution of income, and sometimes policy can create inefficiency. Chapter 17 introduces the types, effects, and efficiency loss of taxation. This begins a series of chapters dealing with specific government policy issues. Material from Chapter 17 consistently appears in a few multiple-choice questions and infrequently in a free-response question on the AP microeconomics exam. Public Choice Theory and Government Failure Government has an important responsibility to provide public goods when the market fails, but the dynamics of a democratic system can complicate that effort. Because voters cannot indicate the strength of their desires for public goods, it is difficult for policymakers to determine the appropriate provision of public goods. Government failure occurs when a government policy creates inefficiency in the market. Special interest effects allow a small, vocal group to obtain policy for their own benefit at the expense of the wider society. Interest groups with an incentive to promote a particular policy outcome lobby strongly, leaving policymakers with a distorted understanding of public positions. Logrolling, or vote trading, can lead to inefficient outcomes, including spending for pork barrel projects, or earmarks-special projects that may benefit a small group or a candidate's reelection but not society in general. And to promote reelection, policymakers prefer programs that bring immediate, clear benefits but that defer or hide costs. Inefficiency within bureaucratic institutions also contributes to government failure. Bear in Mind Public choice theory and government failure have not been directly tested on the AP economics exams and are only briefly discussed here. Apportioning the Tax Burden Once government determines which public goods will be provided, it must determine who will pay for those public goods through taxes. The benefits-received principle holds thatthose who receive the most public goods should pay the most in taxes. Gasoline taxes, which are used to fund highway building and maintenance, use this system. However, this principle is clearly ineffective in the case of imposing higher taxes on those who receive food stamps, housing subsidies, and unemployment checks; the low income or unemployment status that qualifies them for the benefits also indicates they are the least able to afford a higher tax rate. Further, how can indirect benefits of public goods be calculated? The ability-to-pay principle instead holds that taxpayers should be charged according to their income; those with higher incomes should pay higher tax rates. Federal income taxes are based on this principle, under the argument that those with higher incomes are more financially able to pay taxes than those with lower incomes. The problem with this principle is the difficulty in determining the relative ability of any particular household to pay a certain tax rate. Progressive, Regressive, and Proportional Taxes Under a progressive tax, such as the federal income tax, as income rises, the percentage of income paid in taxes rises. Proportional tax has each taxpayer pay the same percentage of income in taxes, regardless of income. With a regressive tax, those with lower incomes pay a higher 144 Chapter 17: Public Choice Theory and the Economics of Taxation
1 I! percentage of their income in taxes than those with higher incomes. Sales taxes are regressive taxes, though they may seem to be proportional. Those with lower incomes spend a greater portion of their income on taxable items, while those with higher incomes save and invest part of their income-which is not subject to the sales tax. The lower-income taxpayer may pay 5 percent of his income in sales tax, while the higher-income taxpayer pays only 3 percent of his income in sales tax. Social Security payroll taxes are also regressive, in that only the first $100,000 of income is subject to the payroll tax. Workers earning less than $100,000 pay the payroll tax on their entire income, while those earning higher incomes pay no more payroll tax, and other significant earnings in interest, dividends, and other benefits are not subject to the Social Security payroll tax at all. Tax Incidence p $12 10 ~ g 8.0......e e 6 &: 4 2 o 5 10 15 20 25 Q Quantity (millions of bottles per month) Efficiency loss (or deadweight loss) of a tax Policymakers must also consider the tax incidence, or who pays the final burden of the tax. Sometimes taxes can be shifted to other people. When graphing a tax increase, the supply curve shifts directly upward by the amount of the tax. Market equilibrium shifts to a lower quantity and a higher price. We then need to determine how the burden of the tax is divided. Is it paid by the firm or by the consumers? In this case, the price to consumers rose from $8 to $9, so consumers paid $1 of the tax. But because the tax is $2, the firm must pay the oth~ $1 of the tax. The firm's revenue at the new equilibrium is $87.5 million ($7 x $12.5 million), while the government's revenue is $25 million ($2 x $12.5 million). A deadweight loss again appears in the triangle abc, representing the loss of producer and consumer surplus resulting from the tax. Production and consumption have fallen from the point where marginal benefit equals marginal cost of production (supply equals demand), so we no longer achieve allocative efficiency. Bear in Mind It is important to be able to identify producer and consumer surplus, after-tax deadweight loss, the firm's revenue, the tax revenue, and the relative burdens of the tax to consumers and the firm. Previous AP microeconomics free-response questions have asked students to identify such information from a graph presented in the question or from graphs the student has been asked to draw. It is also important to recognize the differences in the tax burden on consumers and the firm based on the elasticity of demand for the product. Chapter 17: Public Choice Theory and the Economics of Taxation 145
Elasticities and the Tax Burden P P P, Q2 QI Q Q2 QI Q (a) (b) Tax incidence and elastic Tax incidence and inelastic demand demand Demand elasticity and the incidence of an excise tax With elastic demand, consumers are sensitive to price changes. An increase in the price results in a much lower quantity demanded. If we apply the $2 tax increase with elastic demand, quantity shifts significantly to the left. From points above the new output, you can see that the difference between the original price and the new price (a), the tax burden passed on to consumers, is very small. At that output, the difference between the original price and the old supply curve (c) indicates the burden on the firm. The area abc indicates the deadweight loss. When demand is elastic, consumers pay little of the tax burden, while the firm pays most of the burden, and the area of deadweight loss is large. In the extreme, if demand were perfectly elastic (horizontal), any attempt to raise the price of the product through a tax would reduce demand to zero. So if the firm wanted to remain in operation, it would be forced to absorb the entire cost of the tax. The. more elastic the demand for the product, the more the firm must absorb the burden of the tax. When demand is inelastic, consumers are less sensitive to price change, so they only slightly reduce the quantity demanded after the tax. As a result, most of the tax burden is shifted to consumers, while firms pay little of the burden, and the deadweight loss is small. This is why governments tend to place excise taxes on gasoline, cigarettes, alcohol, and other products for which consumer demand is inelastic; consumers will continue to buy the product, generating more government revenue and leaving little burden of the tax on firms. In the extreme situation of a perfectly inelastic (vertical) demand curve, firms would pass the entire tax on to consumers and there would be no deadweight loss because quantity did not change. The more inelastic the demand for the product, the more the tax burden is passed on to consumers. 146 Chapter 17: Public Choice Theory and the Economics of Taxation I ~l
Tax incidence and elastic supp~ Tax incidence and inelastic supply Supply elasticity and the incidence of an excise tax Similarly, when supply is more elastic, firms are able to pass more of the tax burden on to consumers. When supply is inelastic, the 'tax burden primarily falls on the firms. Bear in Mind Previous AP microeconomics exam questions have focused on differences in the elasticity of demand for the product, rather than elasticity of supply. Benefits of Taxes Because of the free-rider problem, taxes are necessary to raise the funds to pay for public goods. The government also uses taxes to redistribute income. By using progressive income taxes and redistributing those funds to those with lower incomes through safety net programs like T ANF, food stamps, and rent subsidies, the government has equalized incomes somewhat. In addition, we have seen that taxes can actually improve efficiency in the case of negative externalities. Government can impose taxes in a way that forces firms to absorb all of their costs and return the market to allocative efficiency. Multiple-Choice Questions 1. Public policy regarding economic issues can be difficult to develop for all of the following reasons EXCEPT (A) special interest effects. (B) logrolling. (C) pressure in support of pork barrel projects. (D) (E) budget surpluses cannot be equally divided among programs. policymakers have an incentive to support programs that help their reelection efforts. 2. Which of the following taxes illustrates the benefit principle of taxation? (A) regressive payroll taxes used to pay for national defense (B) gasoline taxes used to pay for highway building and maintenance (C) cigarette taxes used to pay for NASA (D) progressive income taxes used to pay for the local police force (E) property taxes used to pay for local economic development Chapter 17: Public Choice Theory and the Economics of Taxation 147
1i 3. 4. 5. 6. 7. 8. A tax which charges those with higher incomes a higher tax rate is (A) progressive. (B) regressive. (C) proportional. (D) excise. (E) efficient. The federal government primarily redistributes income through (A) regressive Social Security taxes and highway programs. (B) proportional property taxes and education programs. (C) progressive excise taxes and law enforcement programs. (D) regressive sales taxes and national defense programs. (E) progressive income taxes and safety net programs. If the state places an excise tax on a product with relatively elastic demand, supply, equilibrium output, and equilibrium price will change in what ways? Supply Output Price (A) (B) (C) (D) (E) If an excise tax is placed on a product with relatively inelastic demand and elastic supply, who will pay most of the burden of the tax? (A) the firm (B) consumers (C) the firm and consumers equally (D) the government (E) foreign consumers who purchase those products as exports The deadweight loss associated with a tax increase is largest when (A) demand is perfectly inelastic. (B) demand is relatively inelastic. (C) demand is unit elastic. (D) (E) demand is relatively elastic. consumers will buy the same quantity, regardless of price. For what purposes do governments institute taxes? I. To provide public goods II. To redistribute incomes III. To resolve positive externalities (A) I only (B) III only (C) I and II only (D) II and III only (E) I, II, and III 148 Chapter 17: Public Choice Theory and the Economics of Taxation
Free-Response Questions Assume the government imposes a per-unit sales tax in each of the three markets below, all of which have identical upward-sloping supply curves. (a) In the pharmaceuticals industry, consumers buy exactly the same amount of heart medicine, regardless of the price. (i) Using a correctly labeled graph, identify each of the following: (a) the equilibrium price and quantity before the tax (b) the equilibrium price and quantity after the tax (ii) Explain how the burden of the tax will be distributed between the consumers and the producers. (b) In the food industry, consumer demand for fish sandwiches is relatively elastic. (i) Using a correctly labeled graph, identify each of the following: (a) the equilibrium price and quantity before the tax (b) the equilibrium price and quantity after the tax (ii) Explain how the burden of the tax will be distributed between the consumers and the producers. (c) In the fruit industry, consumer demand for apples is perfectly elastic. (i) Using a correctly labeled graph, identify each of the following: (a) the equilibrium price and quantity before the tax (b) the equilibrium price and quantity after the tax (ii) Explain how the burden of the tax will be distributed between the consumers and the producers. (d) Is a deadweight loss more likely to develop in the pharmaceuticals industry or in the food industry as a result of the tax? Explain. (e) Assume that the quantity of heart medicine and the quantity of fish sandwiches sold per day are equal. If the government imposed a $1 per unit tax on heart medicine and fish sandwiches, which would bring the government more revenue? Explain. Multiple-Choice Explanations 1. (D) The federal government generally runs budget deficits, not surpluses. Decisions on policy often hinge on the interests of those promoting the policy, not an objective consideration of effects and efficiencies involved. 2. (B) The benefit principle calls for those who benefit most from a program to pay the most taxes to support it. Those who use highways the most are most likely to buy the gasoline and, therefore, support the highways. 3. (A) A progressive tax is based on the ability-to-pay principle, stating that those with the highest incomes are best able to afford the tax. 4. (E) The federal government taxes those with the highest incomes at higher tax rates and then redistributes that money to those with lower incomes through T ANF, food stamps, rent subsidies, and other income programs. 5. (C) The supply curve shifts upward (essentially to the left), decreasing the equilibrium output and increasing the equilibrium price. 6. (B) Consumers of the product pay the majority of the tax burden, because with their inelastic demand, the quantity purchased falls very little when the price rises; therefore, the firm can pass the tax increase on to consumers. 7. (D) When consumers are sensitive to the change in price due to the tax, the quantity sold drops significantly, causing a greater deadweight loss. 8. (C) Taxes are used in the case of negative (not positive) externalities to force firms to absorb all of their costs of production, in order to try to move the market back to allocative efficiency. Chapter 17: Public Choice Theory and the Economics of Taxation 149
Free-Response Explanations 16 points (4 + 4 + 4 + 2 + 2) (a) 4 points: 1 point is earned for correctly identifying price and quantity before the tax. 1 point is earned for correctly identifying a higher price and no change in quantity. 1 point is earned for stating that consumers will pay the entire tax. 1 point is earned for explaining that because demand is perfectly inelastic, the firm can pass the entire tax on to the consumers. (b) 4 points: 1 point is earned for correctly identifying price and quantity before the tax. 1 point is earned for correctly identifying a higher price and a lower quantity. 1 point is earned for stating that firms will pay a larger burden of the tax than consumers will. 1 point is earned for explaining that because consumers are so sensitive to the price change, the firm must absorb more of the tax in order to avoid losing sales. (c) 4 points: 1 point is earned for correctly identifying price and quantity before the tax. 1 point is earned for correctly identifying a lower quantity and no change in price. 1 point is earned for stating that firms will pay the entire tax. 1 point is earned for explaining that because demand is perfectly elastic, the firm must absorb the entire tax or the quantity demanded will fall to zero. (d) 2 points: 1 point is earned for stating that the deadweight loss will develop in the food industry. 1 point is earned for explaining that the quantity of fish sandwiches demanded fell as a result of the tax, while the quantity of heart medicine demanded did not change. (e) 2 points: 1 point is earned for stating that the government would earn more revenue from a tax on heart medicine. 1 point is earned for explaining that, with the tax, the same quantity of heart medicine but a lower quantity of fish sandwiches would be sold, which would lower the revenue. 150 Chapter 17: Public Choice Theory and the Economics of Taxation