1. Chapter Public Goods Tax System And The 9 2.

CHAPTER CHECKLIST1. Distinguish between public goods and privatePublic Goodsand theTax SystemChapter9goods, explain the free-rider problem, and explainhow the quantity of public goods is determined.2. Explain the effects of income taxes and review themain ideas about the fairness of the tax system.Copyright 2002 Addison WesleyLECTURE TOPICS Public Goods and the Free- Rider The Tax System9.1 PUBLIC GOODSProblem Public GoodsPublic goodA good or service that can be consumedsimultaneously by everyone and from which no onecan be excluded.Private goodA good or service that can be consumed by only oneperson at a time and only by those people who havebought it or own it.1

9.1 PUBLIC GOODS9.1 PUBLIC GOODSGoods are either:Goods are either:NonrivalNonexcludableIf the consumption of a good or service by one persondoes not decrease the quantity of the good availablefor someone else.If it is technologically impossible, or extremely costly,to prevent a person from enjoying the benefits of agood or service.ororRivalExcludableIf the consumption of a good or service by one persondecreases the good or service by another person.9.1 PUBLIC GOODSFigure 9.1 shows goodsthat are:Nonrival andnonexcludable (purepublic goods)Excludable and nonrivalNonexcludable andrivalRival and excludable(pure private goods)If it is technologically possible to prevent a personfrom enjoying the benefits of a good or service.9.1 PUBLIC GOODS The Free-Rider ProblemPublic goods create a free-rider problem.Free riderA person who enjoys the benefits of a good or servicewithout paying for it.Because of the free-rider problem, the market wouldprovide too small a quantity of a public good.To produce the efficient quantity, government action isrequired.2

9.1 PUBLIC GOODS The Marginal Benefit of a Public GoodThe benefit a public good provides is the value of itsservices.Because satellite services are nonrival andnonexcludable, they are a public good.9.1 PUBLIC GOODSFigure 9.2 shows how to sum themarginal benefits in the economy inwhich Lisa and max are the onlypeople.Lisa’s marginal benefit curve is MB L.Max’s marginal benefit curve is MB M. Everyone consumes the same quantity of them.To find the economywide value of the satellites, weadd together the marginal benefits of everyone in theeconomy.9.1 PUBLIC GOODS The Marginal Cost of a Public GoodMarginal cost increases as the quantity of satellitesproduced increases—the principle of increasingmarginal cost.So the marginal cost curve of satellites slopes upward.The MB curve for the economy is thevertical sum of the marginal benefitcurves of everyone in the economy.9.1 PUBLIC GOODS The Efficient Quantity of a Public GoodResources are used efficiently if marginal benefit equalsmarginal cost.If marginal benefit exceeds marginal cost, resources canbe used more efficiently by increasing the quantityproduced.If marginal cost exceeds marginal benefit, resources canbe used more efficiently by decreasing the quantityproduced.3

9.1 PUBLIC GOODS9.1 PUBLIC GOODSFigure 9.3 shows the efficientquantity of a public good.3. If MB equals MC, resourceuse is efficient.1. If MB exceeds MC, an increasein the quantity will makeresource use more efficient.4. The efficient quantity is 200satellites.2. If MC exceeds MB, adecrease in the quantity willmake resource use moreefficient.9.1 PUBLIC GOODS Private ProvisionNo one would have an incentive to buy his or hershare of the satellite system—the free-rider problem.So a private firm would not supply satellites. Public Provision9.1 PUBLIC GOODSFigure 9.4(a) shows thepreferences of two politicalparties in an election.1. Doves would like to provide100 satellites.2. The Hawks would like toprovide 300 satellites.The political process determines the quantity of apublic good provided.4

9.1 PUBLIC GOODS9.1 PUBLIC GOODSFigure 9.4(b) shows anefficient political outcome.Principle of Minimum Differentiation3. The political outcome is 200satellites because, unlesseach party proposes 200satellites, the other party canbeat it in the election.The tendency for competitors to make themselvesidentical to appeal to the maximum number of clientsor voters.9.1 PUBLIC GOODS The Role of BureaucratsPrinciple of minimum differentiation9.1 PUBLIC GOODS Why Government Is Large and GrowsBureaucrats translate the choices of politicians intoprograms and control the day-to-day activities thatdeliver public goods.Government grows in part because the demand forsome public goods increases at a faster rate than thedemand for private goods.The behavior of bureaucrats modifies the politicaloutcome.Two possible reasons are: RationalIgnorance Voter preferences Inefficient overprovisionThe decision not to acquire information because themarginal cost of doing so exceeds the expectedmarginal benefit.5

9.1 PUBLIC GOODSVoter PreferencesAs voters’ incomes increase, the demand for manypublic goods increases more quickly than income.These goods include: Highways; air-traffic control systems; publichealth; education; and national defense.Inefficient Overprovision9.1 PUBLIC GOODS Voter BacklashA backlash against government programs might forcepoliticians of all parties to embrace smaller and leanergovernment.Privatization of the production of public goods mightalso counter the tendency for government budgets togrow. The goal of budget maximization combined withvoters’ rational ignorance might explain theexpanding government budgets.9.2 THE TAX SYSTEMTaxes generate financial resources that governmentsus to provide public goods and redistribute income.Governments use five types of taxes: Income taxes Social security taxes9.2 THE TAX SYSTEMFigure 9.5 showsthe sources of taxrevenues:Income taxes 51% (43%personal and 8%corporate) Sales taxesSocial Security taxes22% Property taxesProperty taxes 8% Excise taxExcise taxes 3%6

9.2 THE TAX SYSTEM Income TaxesIn 2000, the personal income tax raised: 1 trillion for the federal government 270 billion for state and local governmentsCorporate profits taxes raised: 207 billion for the federal government9.2 THE TAX SYSTEMPersonal Income TaxTaxable incomeTotal income minus personal exemption and astandard deduction or other allowable deductions.Marginal tax rateThe percentage of an additional dollar of incomethat is paid in tax. 41 billion for the state governments9.2 THE TAX SYSTEMAverage tax rateThe percentage of income that is paid in tax.9.2 THE TAX SYSTEMFigure 9.6 shows U.S.tax rates in 2000.Progressive taxAn increase in the average tax rate as incomeincreases.1. Marginal taxrate increaseswith income.Proportional taxA constant average tax rate at all income levels.Regressive taxA decrease in the average tax rate as incomeincreases.2. Average tax rateincreases withincome, but is lessthan the marginalrate.7

9.2 THE TAX SYSTEM The Effects of Income TaxesTaxes on Labor IncomeTaxes on labor income lead to: Unemployment, which is greater among lowwage workers than among high -wage workers. A deadweight loss, which is larger for high-wageworkers than for low-wage workers.9.2 THE TAX SYSTEMFigure 9.7(b) shows the effect ofa tax on high-wage workers.With a 40% tax:1. The supply of labor decreases,the wage ate rise, and theafter-tax wage rate falls.9.2 THE TAX SYSTEMFigure 9.7(a) shows the effectof a tax on low-wage workers.With a 15% income tax:1. The supply of labordecreases, the wage raterise, and the after-tax wagerate falls.2. The employer pays some ofthe tax.3. The worker pays most of thetax.4. A deadweight loss arises.9.2 THE TAX SYSTEMTaxes on Capital IncomeTaxing the income from capital works like taxing theincome from labor.One crucial difference: capital is internationally mobileand so its supply is highly elastic.2. The employer pays some ofthe tax.3. The worker pays most of thetax.4. A deadweight loss arises.8

9.2 THE TAX SYSTEMTable 9.1 sets outmarginal tax rates forpersonal incomes inthe United States in2000.These tax ratesincorporate allsources of personalincome.9.2 THE TAX SYSTEM9.2 THE TAX SYSTEMFigure 9.8 shows the effect ofa tax on capital income.1. The supply of capital isperfectly elastic.2. With a 40 percent tax oncapital income, the interestrate rises.3. The firm pays the entire tax.4. A large deadweight lossarises.9.2 THE TAX SYSTEMTaxes on Land and Other Unique ResourcesFigure 9.9(a) shows a taxon land.Works in the same way as taxing the income fromother sources except for one crucial difference.1. Supply is perfectly inelastic.The supply of land is highly inelastic.The tax on land income is fully borne by thelandowners and the quantity of land is unaffected bythe tax.With no change in the quantity of land, the tax on landincome creates no deadweight loss or excess burdenand is efficient.2. With a 40 percent tax, thesupply curve is unchangedand the market price isunchanged.3. The landowner pays theentire tax.No deadweight lossarises—the tax is efficient.9

9.2 THE TAX SYSTEM9.2 THE TAX SYSTEMFigure 9.9 (b) shows a high taxrate on Barbara Walter’s income.Why We Have a Progressive Income Tax1. Supply is perfectly inelastic.We have a progressive income tax because a majorityof voters support it and so politicians who support itget elected.2. With a 40 percent tax, thesupply curve is unchanged andthe market price is unchanged.The economic model that predicts progressive incometaxes is called the median voter model.3. Barbara Walters pays theentire tax.No deadweight loss arises andthe tax is efficient.9.2 THE TAX SYSTEMThe median voter modelPolitical parties pursue the policies that are most likelyto attract the support of the median voter. The median voter is the one in the middle of therange of opinion—one half of the voterpopulation lies on one side and one half on theother.9.2 THE TAX SYSTEM Is the Tax System Fair?Whenever political leaders debate tax issues, it isfairness, not efficiency, that looms above all otherconsiderations.There are two conflicting principles of fairness oftaxes: The benefits principle The ability-to-pay principle10

9.2 THE TAX SYSTEM9.2 THE TAX SYSTEMThe Benefits PrincipleThe Ability-to-Pay PrincipleBenefits principleAbility-to-pay principleThe proposition that people should pay taxes equal tothe benefits they receive from public services.The proposition that people should pay taxesaccording to how easily they can bear the burden.This arrangement is fair because it means that thosewho benefit most pay the most.A rich person can more easily bear the burden ofproviding public goods than a poor person can, so therich should pay higher taxes than the poor.But to implement it, we would need an objective wayof measuring each person’s marginal benefit frompublic goods.This principle compares people according to” Horizontal equity Vertical equity9.2 THE TAX SYSTEM9.2 THE TAX SYSTEMHorizontal equityThe Marriage Tax ProblemThe requirement that taxpayers with the sameability to pay pay the same taxes. In the U.S. tax code, a married couple isconsidered a single taxpayer.Vertical equity This arrangement means that if they each earnthe same income as before a marriage, themarried couple might pay more tax than they didbefore marriage.The requirement that taxpayers with a greaterability to pay bear a greater share of the taxes.11

ChapterThe End9Copyright 2002 Addison Wesley12

Taxes generate financial resources that governments us to provide public goods and redistribute income. Governments use five types of taxes: Income taxes Social security taxes Sales taxes Property taxes Excise tax Figure 9.5 shows the sources of tax revenues: Income taxes 51% (43%