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Chapter 12 summary
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Summary of 11 pages for the course EKN 310 at UP (Chapter 12 summary)
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Chapter 12Tax efficiency, administrative efficiency and flexibility
Introduction:
Looking at the second property of a good tax → impact of the tax on efficiency.
- Taxes cause inefficient resource allocation through the distortionary impact on
prices = measure the efficiency cost of the tax through the excess burden it
causes.
- All taxes have a burden → that cannot be escaped.
o Inefficient taxes → cause an additional burden in excess of the
inescapable burden that all taxes inevitably have → more costly to society
than an efficient equivalent (for a given revenue)
- Excess burden → burden in addition to direct tax burden → greater than
necessary to generate certain amount of tax revenue.
Excess burden of taxation: indifference curve analysis
- Excess burden of a tax → welfare/deadweight loss to society due to suboptimal
resource allocation caused by a tax.
o Excess burden arises → tax has distorted relative prices = resources get
reallocated in an inefficient manner → proves costly to the welfare of
society → would have got more out of their resources had they been
employed more efficiently.
▪ This efficiency loss → deadweight loss of a tax.
- Assume 2 products (x and y).
o Pareto efficient equilibrium is assumed → MRSxy=MRTxy=Px/Py.
▪ Px/Py → relative price ratio → the equalizer in this equation.
o Levy a tax on product x → price of x becomes (1+t)Px.
o Equalizing price ratio no longer holds → Pareto efficient equilibrium no
longer holds.
o Price ratio changes from Px/Py to (1+t)Px/Py → ratio makes x more
expensive relative to product y → consumers reallocate resources towards
y.
▪ Substitute y for x in consumption → more of y is consumed and
produced, and less of x.
o Resources have shifted from production of x to the production of y →
product y is affected by the tax.
o Resource allocation → efficient before the tax on x → implies no welfare
gains occurred when shifting resources between x and y
▪ After tax → shift away from x towards y → implies less efficiency and
a welfare loss.
• Signifies a move from optimality in resource allocation to sub-
optimality.
- Use indifference analysis → illustrates the welfare losses and price distorting effects
of different taxes.
o After that → use consumer surplus approach → measure the magnitude of
excess burden under different conditions.
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, - Lump-sum taxes and general taxes:
o Lump-sum tax → fixed amount that an individual would have to pay in a
fiscal year → independent of income, wealth, or consumption.
▪ Like a head tax (levied on each member of society/on all
breadwinners in a household) or a poll tax.
o Lump-sum taxes → do not distort prices → do not affect people’s
consumption decisions.
▪ General/lump-sum taxes → do not cause substitutions in
consumption → have no substitution effect → do not induce
substitution = neutral taxes.
▪ Reduce everyone’s disposable income → have an income effect.
▪ Relative prices not distorted, and no substitutions arise = no excess
burden.
• Direct tax burden that is seen in the income effect.
• If above holds → tax considered to be an efficient tax.
o Disadvantage of lump-sum tax → tax is regressive in nature.
▪ Tax is a percentage of income decreases as income increases → tax
has more impact on the poor than the rich.
A
G
Quantity of Y
C
Y2 E2
E0
Y0
Y1 E1
U0
U1
U2
0 Q2 F Q1 Q0 D B
Quantity of X
- Graph analysis for lump-sum tax:
o Before-t budget → line AB
▪ Equilibrium = E0 → AB tangent to U0 (indifference curve)
o Lump-sum tax introduced → AB shifts to CD.
▪ Parallel shift = relative prices remain unchanged
▪ Revenue from the tax = AC (for Y) and DB (for X)
▪ New consumer equilibrium = E1
• Less of Y and X consumed than before.
▪ Consumer worse off than before → on lower indifference curve (U1).
o After tax → no substitution effect → no excess burden or dead-weight loss.
- Graph analysis on selective taxes:
o A selective tax on one product → produced the same revenue as the
lump-sum tax.
▪ Consumers were worse off → on a lower indifference curve than with
the lumpsum tax → reflecting the excess burden of taxes that distort
prices and cause substitutions and inefficiencies in the process.
o Initial equilibrium = E0 → AB tangent to U0.
Notes can only be purchased through the following details:
gorgataylor@gmail.com or 0829369077 2
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