2012 Pearson Addison-Wesley

Debate over Minimum Wage: Pros

Increases the standard of living for the poorest and most vulnerable
class(already got a job) in society and raises average
Removes low paying jobs, forcing workers to train for, and move to
higher paying jobs
Increases technological development
As the price of labor increases, technology that increases
business efficiency but need more capital investment is more
appealing.
Encourages people to join the workforce rather than pursuing money
through illegal means
Stimulates consumption, by putting more money in the hands of lowincome people

2012 Pearson Addison-Wesley

Taxes
Everything you earn and most things you buy are taxed.
Who really pays these taxes?
The Congress require you and your employer pay equal
share of the Social Security tax, does it obvious that you
and your employer bear same amount of the Social
Security tax?
When a state sales tax is added to the price of the things
you buy, isnt it obvious that you pay these sales taxes?
Youre going to discover that it isnt obvious who pays a tax
and that law can not decide who will pay!
2012 Pearson Addison-Wesley

Taxes
Tax Incidence
Tax incidence is the division of the burden of a tax between
buyers and sellers.
EX: in labor market, firms buy labors and workers sell
labor. Therefore, a tax incidence of 20% for firms on social
security tax means
Tax incidence doesnt depend on tax law!
Even the law requires your employers to pay for all of the
social security tax, it does not mean they actually pay all of
the tax, why?
Because the price of labor, your wage might go down!

2012 Pearson Addison-Wesley

Taxes
The law might impose a tax on buyers or sellers, but the
outcome will be the same.
To see why, we look at the tax on cigarettes in New York
City.
On July 1, 2002, New York City raised the tax on the sales
of cigarettes from almost nothing to $1.50 a pack.
What are the effects of this tax?

2012 Pearson Addison-Wesley

Taxes
A Tax on Sellers
Figure 6.5 shows the effects
of this tax.
With no tax, the equilibrium
price is $3.00 a pack.
A tax on sellers of $1.50 a
pack is introduced.
Supply decrease.
Supply curve shifts upward
by $1.50 at each price
(S+tax).
What happens to the equilibrium
price and quantity?
2012 Pearson Addison-Wesley

Taxes

The market price paid by buyers

rises to $4.00 a pack and the
quantity bought decreases.
Buyers pay $1.00 a pack more
compared with a price of $3.00
before.
Sellers have to pay $1.50 tax for
each pack they sell at a price of
$4.00, so they only receive $2.50
a pack.
Sellers receive 50 a pack less
compared with before.

What about the tax incidence ?

2012 Pearson Addison-Wesley

Taxes
A Tax on Buyers
Again, with no tax, the
equilibrium price is $3.00 a
pack.
A tax on buyers of $1.50 a
pack is introduced.
Demand decreases.
Demand curve (D-tax) shifts
downward by $1.50 at each
price.
2012 Pearson Addison-Wesley

Taxes
What is the new equilibrium
price?
The market price is $2.50.
The price received by sellers
is $2.50 a pack.
Although the price reduces to
$2.50, buyers have to pay
$1.50 per pack tax.
So the actual price facing the
buyers is $4.00 per pack.
Compared with before(no tax, price at $3), How much less does
sellers receive and how much more does the buyers pay?
2012 Pearson Addison-Wesley

Taxes
When a tax is levied on
buyers,
buyers pay $1.00 of the
tax. Sellers pay the other
50 of the tax.
Thats exactly the same
as before when sellers
were taxed!
Tax incidence is the same
regardless of whether the
law says sellers pay or
buyers pay.
2012 Pearson Addison-Wesley

Taxes
The tax incidence does not depend on the law. But what
determines tax incidence?
When an item is taxed, its price might rise by the full amount of
the tax, by a lesser amount, or not at all.
If the market price rises by the full amount of the tax, buyers pay
the tax.
If the market price rise by a lesser amount than the tax, buyers
and sellers share the burden of the tax.
If the market price doesnt rise at all, sellers pay the tax.
So the tax incidence depends on the change in price, but what
really determines the price change?

2012 Pearson Addison-Wesley

Taxes
Tax Incidence and Elasticity of Demand
The division of the tax between buyers and sellers depends
on the elasticities of demand and supply.
To see how, we look at two extreme cases.

Perfectly inelastic demand: Buyers pay the entire tax.

Perfectly elastic demand: Sellers pay the entire tax.
The more inelastic the demand, the larger is the buyers
share of the tax.

2012 Pearson Addison-Wesley

Taxes
Perfectly Inelastic Demand

Demand for this good is

perfectly inelasticthe
demand curve is vertical.
When a tax is imposed on the
seller, supply decreases and
supply curve shifts upward.
Price increases by the same
amount of tax.
Buyers pay the entire tax and
sellers pay 0.

2012 Pearson Addison-Wesley

Taxes

Perfectly Elastic Demand

The demand for this good is

perfectly elasticthe demand
curve is horizontal.
When a tax is imposed on the
seller, supply decreases and
supply curve shifts upward.
But the price doesnt change.
Sellers pay the entire tax and
buyers pay 0.

2012 Pearson Addison-Wesley

Taxes
Tax Incidence and Elasticity of Supply
To see the effect of the elasticity of supply on the division
of the tax payment, we again look at two extreme cases.

Perfectly inelastic supply: Sellers pay the entire tax.

Perfectly elastic supply: Buyers pay the entire tax.
The more elastic the supply, the larger is the buyers share
of the tax.

2012 Pearson Addison-Wesley

Taxes
Perfectly Inelastic Supply
The supply of this good is
perfectly inelasticthe supply
curve is vertical.
When a tax is imposed on the
seller, supply does not
change, neither does the
price.
Sellers pay the entire tax and
buyers pay 0.

2012 Pearson Addison-Wesley

Taxes
Perfectly Elastic Supply
The supply of this good is
perfectly elasticthe supply
curve is horizontal.
When a tax is imposed on this
good, supply curve shifts upload
by $1.
The price increases by the same
amount of tax, $1.
Buyers pay the entire tax and
sellers pay 0.

2012 Pearson Addison-Wesley

Taxes
Tax Incidence and Elasticity
The more elastic the demand, the less does the market
price change in response to a tax, the smaller is the
buyers share of the tax.
The more elastic the supply, the less does the market price
change, the smaller is the producers share of the tax.
Which side has a larger elasticity, the tax incidence on that
side is smaller.
Thinking: who bears most of the Social Security tax and
income tax?

2012 Pearson Addison-Wesley

Taxes
Tax Revenue
Tax revenue=tax base * Tax rate=tax per unit * Unit sold
EX: A sales tax of 5% (tax rate) on total sales of $2000 (tax
base) raises total revenue of $100.
Taxes and Efficiency
Except in the extreme cases of perfectly inelastic demand
or perfectly inelastic supply when the quantity remains the
same, imposing a tax creates inefficiency.
Figure 6.10 shows the inefficiency created by a $20 tax on
MP3 players.

2012 Pearson Addison-Wesley

Taxes
With no tax, 200 thousands of
MP3 players are produced
and sold at a price of $200 at
equilibrium
Total surplus (the sum of
consumer surplus and
producer surplus) is
maximized.
Marginal social benefit equals
marginal social cost at
equilibrium.
The market is efficient.
2012 Pearson Addison-Wesley

Taxes
With a tax of $20 per unit on
sellers, supply curve shifts
upward by $20 at each price.
The new equilibrium price is
$210, and the quantity is only 4
thousand per week.
Consumers have to pay more
for each MP3 players and they
can buy less.
With a smaller quantity and
higher price, consumer surplus
shrinks.
Consumers lose.

2012 Pearson Addison-Wesley

Taxes
Although sellers can sell
each MP3 player for a
higher price at $210, they
need to pay $20 for each.
So the actual price facing
sellers is only $190 and
they can produce less.
With a smaller quantity
and lower price, producer
surplus also shrinks.
Producers also lose.
2012 Pearson Addison-Wesley

Taxes
The government can collect
in total $80 thousand per
week ($20 per unit *
4thousand).
The government gains.
But the decreased quantity
still creates a deadweight
loss.
The whole society lose.
So the tax is inefficient.

2012 Pearson Addison-Wesley

Taxes
Taxes and Fairness
Economists propose two conflicting principles of fairness to
apply to a tax system:
The benefits principle
People should pay taxes equal to the benefits they receive
from the services provided by government.
EX: high taxes on alcohol and tobacco to pay for public
health-care service, high fuel taxes to pay for freeways
The ability-to-pay principle
People should pay taxes according to how easily they can
bear the burden of the tax.
EX: high rates of income tax on high income

2012 Pearson Addison-Wesley