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Chapter 7

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Economics

ECON 1116

Osborne Jackson

Spring

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2/3-2/10/2014 Chapter 7 Taxes
- Excise tax: a tax on sales of a good or service.
The Effect of Excise tax on quantities and prices:
How do we know that 5,000 rooms will be supplied at a price of $100? The price of net
tax is $60 and original supply curve = 5k rooms will be supplied @ 60 (point B)
Tax leads to inefficiency by distorting incentives and creating missed opportunities for
mutually beneficial transactions. 2/3-2/10/2014 Chapter 7 Taxes
If you compare 7.2 and 7.3, you will immediately notice that they show the same price
effect. In each case, consumers pay an effective price of $100, producers receive an
effective price of $60, and 5,000 hotel rooms are bought and sold. In fact, it doesn’t
matter who officially pays the tax—the equilibrium outcome is the same.
Incidence tax: a measure of who actually pays the tax (in the chart, evenly split).
Price elasticity and incidence:
The incidence of an excise tax depends on the price elasticity of supply and the price
elasticity of demand
When excise tax is mostly paid by
consumers:
- price elasticity of demand for gasoline
is assumed to be very low, so the
demand curve is relatively steep.
- price elasticity of supply of gasoline is assumed to be very high, so the supply
curve is relatively flat.
Exicse tax paid by producers: 2/3-2/10/2014 Chapter 7 Taxes
Assume that price elasticity of supply is low, because parking lots have few alternative
- supply curve for parking spaces relatively steep.
Price elasticity of demand is assumed high, because consumer can switch from
downtown spaces to spaces a little further away. (Spaces are not subjected to the tax).
- demand curve relatively flat.
- Elasticity demand high: buyers can move to other towns
- Supply elasticity low: sellers must sell their house due to job transfer or
provide funds for retirement.
- Elasticity of supply is high demand is low (excise tax mainly on consumers).
- Elasticity of supply is low demand is high (excise tax mainly on producers).
** So elasticity—not who officially pays the tax—determines the incidence of an
excise tax. 2/3-2/10/2014 Chapter 7 Taxes
Benefits and cost of Taxation
- Revenue from excise tax: how much government collect from excise tax
The tax revenue collected is:
Tax revenue = $40 per room × 5,000 rooms = $200,000
The area of the shaded rectangle is:
Area = Height × Width = $40 per room × 5,000 rooms = $200,000
or
Tax revenue = Area of shaded rectangle
This is a general principle: The revenue collected by an excise tax is equal to the area
of the rectangle whose height is the tax wedge
between the supply and demand curves and
whose width is the quantity transacted
under the tax.
Tax Rates and Revenues:
Tax Rate: the amount of tax people are required
to pay per unit of whatever is being
taxed.
- The relationship between tax rates and revenues are not one for one.
At this lower tax rate, 7,500 rooms are rented, generating tax revenue of:
Tax revenue = $20 per room × 7,500 rooms = $150,000 2/3-2/10/2014 Chapter 7 Taxes
To put it another way, a 100% increase in the tax rate from $20 to $40 per room leads to
only a one-third, or 33.3%, increase in revenue, from $150,000 to $200,000 (($200,000
– $150,000)/$150,000 × 100 = 33.3%).
Panel (b) depicts what happens if the tax rate is raised from $40 to $60 per
room, leading to a fall in the number of rooms rented from 5,000 to 2,500. The revenue
collected at a $60 per room tax rate is:
Tax revenue = $60 per room × 2,500 rooms = $150,000
This is also less than the revenue collected by a $40 per room tax. So raising the tax
rate from $40 to $60 actually reduces revenue.
Fall of in tax revenue caused by reduction in # of rooms rented more than offset the
increase in the tax revenue caused by the rise in the tax rate. (setting a tax rate so high
that it deters a significant number of transactions is likely to lead to a fall in tax revenue).
Revenue effect of increasing an excise tax tax increase affects tax revenue in two
ways.
1. Tax increase means that the government raises more revenue for each unit of
the good sold, which other things equal would lead to a rise in tax revenue.
2. tax increase reduces the quantity of sales, which other things equal would lead to
a fall in tax revenue.
a. The end result depends both on the price elasticities of supply and
demand and on the initial level of the tax. If the price elasticities of both
supply and demand are low, the tax increase won’t reduce the quantity of
the good sold very much, so tax revenue will definitely rise.
b. If the price elasticities are high, the result is less certain; if they are high
enough, the tax reduces the quantity sold so much that tax revenue falls.
c. If the initial tax rate is low, the government doesn’t lose much revenue
from the decline in the quantity of the good sold, so the tax increase will
definitely increase tax revenue. 2/3-2/10/2014 Chapter 7 Taxes
d. If the initial tax rate is high, the result is again less certain. Tax revenue is
likely to fall or rise very little from a tax increase only in cases where the
price elasticities are high and there is already a high tax rate.
Costs of Taxation: 2/3-2/10/2014 Chapter 7 Taxes
RECAP 4-5: Fall in the price of a good a gain in consumer surplus that is equal to the
su

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