15.3

• How to Tax Fairly:

  • horizontal equity
  • vertical equity
• Horizontal Equity: This principle suggests that individuals with similar financial situations should be taxed equally.
• Vertical Equity: This principle refers to the redistribution of wealth, taxing individuals based on their ability to pay. The goal is to reduce the income gap between the "haves" and the "have-nots" by requiring wealthier individuals to pay higher taxes.
• Progressive Tax System:

  • A progressive tax system reflects ability to pay, meaning that individuals with higher incomes pay a larger percentage of their income in taxes.
  • Another important principle is the benefit principle, which suggests that individuals who benefit most from public goods (like roads or police) should pay more for them. For example, car owners should be taxed to fund road construction.
• Tax Incidence

  Tax incidence refers to who bears the ultimate burden of a tax. This concept can differ from the initial impact of a tax. To explain this further, we look at the labour market graph
• While taxes generally lead to inefficiency, some taxes can actually improve welfare when they correct market failures such as externalities. For example:

  • Taxes on cigarettes can reduce consumption because smokers impose a negative externality (harmful effects on others) by polluting the air.
• Deadweight Loss:

  • The deadweight loss is the loss of economic efficiency when the quantity of a good traded is below the socially optimal level due to taxation. It’s visually represented by a triangle
• • Tax incidence falls on both the buyer and the seller, but how much each party bears depends on the elasticity of supply and demand.
  • When supply is inelastic, the seller (firms) bears more of the tax burden.
  • When supply is elastic, the buyer (workers) bears more of the tax burden.
• • if the supply is inelastic, workers still supply the same quantity of labour, but their wage after tax is lower.
  • Firms face no burden since the quantity of labour supplied remains unaffected, and the entire tax incidence falls on workers.
• Horizontal equity focuses on equal tax treatment for individuals with similar incomes.
• Vertical equity ensures that those with higher incomes pay a larger share of taxes, redistributing wealth from the rich to the poor.
• Progressive taxes are based on the principle of ability to pay, while benefit principles ensure that those who benefit most from public goods contribute more to their funding.
• Tax incidence determines who ultimately bears the burden of a tax.

  • When supply is inelastic, workers bear the full burden of the tax.
  • When supply is elastic, firms and workers share the tax burden.
• Taxes can sometimes make things better when they fix problems in the market, such as when there’s a negative externality.

  • Negative Externality Example: Cigarettes
  • Smoking harms others (pollutes the air), so the government can tax cigarettes to discourage people from smoking too much.
  • This tax actually improves the market by reducing the harmful effects on others.
• Before Tax:

  • The demand for workers (jobs offered by firms) is represented by the DD curve.
  • The supply of workers (people willing to work) is the SS curve.
  • The point where they meet, E, is where firms and workers agree on a wage W and the number of hours worked L.
• • After Tax:
  • When the government adds a tax on wages, the supply of workers shifts to SS’, which means:
  • Firms pay more: Firms now have to pay a higher wage, W'.
  • Workers take home less: Workers take home a lower wage, W’’.
  • The tax burden is split between:
  • Firms, which pay the higher wage W'.
  • Workers, who receive the lower wage W’’ after tax.
  • Deadweight Loss: This triangle A’E’E shows the inefficiency caused by the tax. It means fewer people work, and less money is made overall.
• • Before Tax: The market is at E, where everything is efficient. Firms are happy with the wage, and workers are happy with how much they get paid.
  • After Tax: When the tax is added, the new equilibrium point is E':
  • Firms now pay a higher wage W'.
  • Workers get a lower take-home wage W’’.
  • The quantity of labour (hours worked) drops from L to L’.
• • Inelastic Supply: This just means that no matter how low the wage, workers will still supply the same amount of labour (vertical line in the graph).
  • When a tax is added:
  • The tax moves the wage firms pay from W to W' (higher).
  • The take-home wage for workers moves from W to W'' (lower).
  • Workers still supply the same amount of labour (L), but they receive less pay.