Chapter 7: Taxes

Welcome to Last Minute Lecture.

This free chapter overview is designed to help students review and understand key concepts.

These summaries supplement not replaced the original textbook and may not be redistributed or resold.

For complete coverage, always consult the official text.

Welcome to the Deep Dive.

Today we're diving into something that affects pretty much

taxes and to really grasp their impact.

Let's jump back to, believe it or not, 1794,

Western Pennsylvania.

Yeah, it sounds dramatic, doesn't it?

You had farmers organizing, protesting.

There were even shots fired, people killed.

You'd almost think it was the French Revolution playing out in America.

Exactly.

But this was the Whiskey Rebellion, a really pivotal moment actually challenging the brand new US government and President George Washington.

And it all started, as these things often do, with the tax.

Right.

The country was basically broke after the War of Independence.

So Alexander Hamilton, Treasury Secretary, comes up with this idea in 1791, tax whiskey distillers.

Whiskey was super popular, seemed like a good way to raise money.

It did, on paper.

But the way the tax was set up caused huge problems.

How so?

Well, it just felt deeply unfair to a lot of people, especially on the frontier.

Big distillers, wealthy ones, could pay a flat fee for the year, which meant per gallon they actually paid less tax.

But the small guys, often farmers just turning extra grain into whiskey to make ends meat, maybe supplement their income.

They had to pay tax on every single gallon produced.

So a much bigger chunk there.

A much bigger chunk.

And remember out there, cash was really hard to come by.

Whiskey itself was often used like money for trade.

So this tax wasn't just money.

It was kind of strangling their local economy.

Wow.

So that history really hammers home how explosive taxes can be.

Washington eventually had to lead troops to put the rebellion down.

But politically, it was a game changer.

The Federalist Party, Hamilton's party, they never really recovered from it.

That's right.

And it paved the way for Thomas Jefferson's party, which got rid of the tax in 1800.

So this whole episode, this whiskey rebellion, it leaves us with a couple of big takeaways, doesn't it?

It really does.

Two key things I think they're still relevant.

First, governments need taxes for defense, for roads, parks, schools,

you name it.

Services cost money.

But, and this is the crucial part,

taxes always have a cost that goes beyond the dollars collected.

They change people's behavior.

They distort incentives, sometimes stopping good economic activity from happening at all.

And the second lesson.

Making tax policy is just incredibly difficult and politically risky.

As the Federalists found out the hard way, you're always balancing competing interests.

So for you listening, maybe you're studying economics, maybe you just want to understand the news better.

This is why we're doing this deep dive.

We're going to explore how taxes affect supply demand prices.

Who really ends up paying?

The hidden costs, the benefits,

different types of taxes.

And that constant balancing act between making taxes efficient and making them fair, economics gives us the tools to analyze these tradeoffs.

Okay, let's start simple with the type of tax called an excise tax.

Good place to start.

It's just a tax on each unit of a good or service sold.

I think gasoline, cigarettes, hotel rooms.

They're straightforward, but they show us a lot about how all taxes work fundamentally.

So let's imagine a town, Potterville, they have hotels.

Before any tax, maybe the price settles at $80 a night and folks rent 10 ,000 rooms.

Standard supply and demand Right.

You've got your downward slipping demand curve, upward slipping supply curve meeting at that point,

$80, $10 ,000 rooms.

Now, Potterville decides to slap a $40 per night tax on the hotel owners.

What happens?

Well, for the owners, it's suddenly $40 more expensive to provide that room.

To be willing to supply the same number of rooms as before, they'd need to receive $40 more per room to cover the tax.

So their costs effectively go up.

Exactly.

So that supply curve, it shifts upwards vertically by the amount of the tax $40.

And the market finds a new balance.

It does.

The new intersection point shows that the price consumers actually pay jumps up, say, to $100, but fewer rooms are rented now, maybe only $5 ,000.

Okay.

So consumers pay $100,

but the hotel owners have to give $40 of that to the city.

Precisely.

So the owners are only effectively receiving $60 per room, which is $20 less than before the tax.

So wait, the tax was $40 on the owners, but the price only went up $20 for consumers and the owner's take home went down by $20.

It looks like they split the burden 50 -50.

In this particular example, yes, which leads to a really common question.

Does it actually matter who officially pays the tax?

Like if Potterville tax the guests $40 instead of the owners, would it be different?

Great question.

And the economic answer is, surprisingly, no, it doesn't matter who legally hands over the money.

Really?

How does that work?

An excise tax creates what economists call a wedge.

It's the difference between the price consumers pay and the price producers receive.

That $40 wedge exists regardless.

Okay.

So if you tax the guests $40, their willingness to pay any given sticker price drops by $40 because they know they have to pay the tax on top.

This shifts the demand curve downward by $40.

So demand shifts instead of supply this time.

Right.

The market price, the sticker price hotel owners receive will actually fall maybe to $60, but the guests have to pay that $60 plus the $40 tax.

Meaning they're still paying $100 total?

Exactly.

And the owners are still receiving $60 and the number of rooms rented still falls to $5 ,000.

The economic outcome, the final prices paid and received, the quantity, it's identical.

Who really bears the burden, what we call the tax incidence, is the same.

Okay.

That's counterintuitive.

So if it's not about who officially pays, what actually determines who bears more of the burden?

You said it was split 50 -50 in the hotel example, but is it always?

No, definitely not always 50 -50.

The real key, the determinant of tax incidence is price elasticity, specifically the price elasticity of supply and the price elasticity of demand.

Elasticity.

Refresh my memory on that.

Sure.

Elasticity just measures how much buyers or sellers change their behavior in response to a price change.

If they change a lot, we say their demand or supply is elastic.

If they don't change much, it's inelastic.

Got it.

So how do elasticities decide who pays the tax?

Let's use an example.

Think about gasoline taxes.

Federal taxes, what, 18 cents a gallon?

States add more.

Right, it adds up.

No.

Think about your demand for gas.

If the price goes up a bit, do you immediately stop driving?

Probably not much, right?

You still need to commute, run errands.

There aren't many easy, quick substitutes for most people.

True.

My driving doesn't change that much day to day based on gas prices.

So your demand is relatively inelastic, but what about the suppliers, the oil companies?

They have some flexibility.

They can adjust production levels, maybe shift crude oil to make other products if gasoline isn't profitable enough.

Their supply is generally more elastic than consumer demand.

Inelastic demand, elastic supply for gas.

So imagine a new $1 per gallon tax, because consumers don't really change their behavior much inelastic demand,

and producers can adjust elastic supply.

Producers can pass most of that tax on to you, the consumer.

Yeah, so if the pre -tax price was $2, maybe the post -tax price jumps to $2 .95.

You're paying 95 cents more.

The producers, they only effectively receive $1 .95, just 5 cents less than before.

The burden falls almost entirely on the consumer.

Because we're kind of stuck buying it, relatively speaking.

Exactly.

That's the general principle.

When demand is less elastic than supply, the burden falls mainly on consumers.

This applies to things like cigarettes, alcohol, two goods, where demand tends to be inelastic.

Okay, makes sense.

So what about the other way around?

When do producers get stuck with most of the bill?

Let's think about, say, a tax on downtown parking spaces.

Imagine a $5 per day tax.

Okay.

Now, as a driver, you probably have lots of options, right?

Park further away and walk, take a bus, maybe use a rideshare, find a different garage.

Your demand for that specific parking is likely quite elastic.

A price increase makes you seriously consider alternatives.

Yeah, I definitely shop around or change my plans if parking jumped $5.

But what about the owner of that parking garage?

What else can they easily do with that big concrete structure?

Not much, right?

Their ability to switch to supplying something else is very limited.

Their supply is very inelastic.

Stuck with a parking garage?

Pretty much.

So you have elastic demand, consumers can easily walk away, and inelastic supply, producers are stuck.

Who bears the burden of that $5 tax?

The producers.

Mostly, yes.

The price consumers pay might only go up a little, say from $6 to $6 .50, an increase of just $0 .50.

But the garage owner, after paying the $5 tax, they're only taking home $1 .50 effectively.

That's $4 .50 less than before.

They absorbed almost the entire tax.

Wow, big difference.

It really is.

So the other general principle.

When supply is less elastic than demand, the burden falls mainly on producers.

Think about taxes on selling an existing house.

Sellers often need to sell inelastic supply, while buyers have choices elastic demand.

Sellers often end up eating a large chunk of transaction taxes.

So the rule is, whoever is less flexible, less able to change their behavior in response to the price change caused by the tax, they're the ones who bear more of the burden.

That's the Okay, this has huge real -world implications.

What about something like the FICA tax, the payroll tax for Social Security and Medicare?

The law says it's split 50 -50 between workers and employers.

Right, that's what your pay stub looks like.

Half seems to come from you, half from your employer.

But based on what you just said,

is it really 50 -50?

Most economists would say no, probably not even close.

The consensus is that workers actually most, if not practically all, of the FICA tax burden.

How?

Apply the elasticity rule for us.

Think about the demand for labor that's firms hiring workers.

Is it elastic or inelastic?

Well, firms have options.

If labor costs, including their share of FICA, get too high, they can invest in machines, hire fewer people, maybe outsource.

So the demand for labor is relatively elastic.

Okay, firms have flexibility.

What about the supply of labor as workers?

The supply of labor overall tends to be very inelastic.

Most people need to work a certain amount to live.

Small changes in their take -home pay don't drastically change the total hours people are willing to work across the economy.

Yes, some individuals might adjust hours, but the overall supply curve is steep.

So elastic demand for labor, inelastic supply of labor.

Means the burden falls mainly on the side with the inelastic curve the workers.

Through lower wages than they'd get otherwise.

Exactly.

Even though the employer sends half the payment, the existence of that employer -side tax likely suppresses the wages workers receive in the first place.

The worker effectively pays most of it through a lower starting wage.

That's significant.

Especially since, as you mentioned, FICA is often the biggest tax people pay, right?

For about 70 % of American families, yes.

FICA is 15 .3 % for most workers, up to a cap, and that often outweighs their federal income tax burden.

Understanding the true incidence is pretty important.

Okay, let's shift gears slightly.

We know why governments tax for revenue.

How do we actually figure out how much revenue a tax brings in?

It's pretty straightforward graphically.

Back to Potterville's $40 hotel tax.

The tax reduced the number of rooms rented to 5 ,000.

The revenue is simply the tax rate, $40 times the quantity transacted after the tax, 5 ,000 rooms.

So 40 times $5 ,000, $200 ,000 in revenue for Potterville.

Correct.

You can visualize it as a right -tangle on the graph.

The height is the tax wedge, $40, and the width is the quantity, 5 ,000.

The arrow of that rectangle is the tax revenue.

But here's something tricky.

Does doubling the tax rate always double the revenue?

Ah, good question.

And the answer is no, because raising the tax rate usually shrinks the quantity transacted even further.

Right, fewer hotel rooms rented in our example.

Exactly.

So let's say Potterville considered a $20 tax instead of $40.

Maybe at that lower rate, 7 ,500 rooms would have been rented.

Revenue.

$20 times 7 ,500 is $150 ,000.

Okay, less than the $200 ,000 from the $40 tax.

So higher tax meant more revenue there.

In that range, yes.

But what if they got really aggressive and tried a $60 tax?

The number of rooms rented might plummet to, say, $2 ,500.

So revenue would be $60 times $2 ,500?

Only $150 ,000.

Same as the $20 tax.

Wow.

So raising the tax from $40 to $60 actually decreased total revenue.

Correct.

Because the drop in the number of transactions was so large, it more than offset the higher rate per transaction.

This relationship is often illustrated by the Laffer curve.

The Laffer curve.

I've heard of that.

The idea that if taxes are too high, cutting them could actually increase revenue.

That's the controversial implication, yes.

The curve suggests that revenue is zero at a 0 % tax rate, rises as the rate increases, gets a maximum at some point, and then actually falls back towards zero as the tax rate approaches 100 % because economic activity grinds to a halt.

Are there real examples?

Well, the effects are debated, but you could point to extreme cases.

Like when France proposed that 75 % tax rate on very high earners, reports suggested significant numbers of wealthy individuals made plans to leave the country, potentially reducing France's overall tax base revenue.

It highlights that extremely high rates can indeed backfire by discouraging the taxed activity.

Okay, so revenue is the benefit.

What about the costs of taxation beyond just the money paid?

The biggest hidden cost is what we call deadweight loss.

It's the loss of economic efficiency that occurs because the tax prevents mutually beneficial transactions from happening.

Or transactions that would have happened without the tax.

Exactly.

Remember, our $40 hotel tax reduced room rentals from 10 ,000 to 5 ,000.

That means 5 ,000 potential transactions where a guest was willing to pay a price the owner was willing to accept, somewhere between $60 and $100, never occurred because the tax made them impossible.

And that's a loss.

It's a loss to society.

Before the tax, those transactions would have generated surplus for both the guest, consumer surplus, and the owner, producer surplus.

The tax prevents that creation of value.

The government gets revenue, which is a transfer of surplus, but the deadweight loss is a loss to society.

And the consumer surplus that just vanishes, nobody gets it.

Graphically, how does that look?

You can see it as two triangles on the supply and demand graph, wedged between the old equilibrium quantity and the new lower quantity.

They represent the value of those lost transactions.

The bigger the tax wedge and the more the quantity falls, the larger the deadweight loss triangle becomes.

So taxes cost more than just the revenue they raise because of this loss deficiency.

Usually, yes.

There's a key exception, though.

If a tax doesn't reduce the quantity bought and sold, if demand or supply is perfectly inelastic, then there's no deadweight loss.

The tax just transfers surplus to the government without creating inefficiency.

Are there other costs besides deadweight loss?

Yes.

We also have administrative costs.

These are the real resources used up just in the process of taxing.

Think about the cost of running the IRS, the time you spend filling out tax forms, the money businesses spend on tax accountants, even resources spent on tax evasion.

All that effort could, in theory, be used for something more productive.

So the total inefficiency is deadweight loss plus these administrative costs.

That's right.

So if you're a policymaker trying to be smart about taxes, how do you minimize these costs?

Again, it comes back to elasticity.

Remember how elasticity determines incidence?

It also determines the size of the deadweight loss.

Think about it.

Deadweight loss comes from transactions not happening.

If demand or supply is very elastic, people react strongly to the tax, the quantity transacted falls a lot, and the deadweight loss triangle is large.

If demand or supply is inelastic, people don't change their behavior much, the quantity doesn't fall much, and the deadweight loss is small.

So to minimize inefficiency, you should tax goods with inelastic demand or supply?

Generally, yes.

If your goal is just to raise revenue with the least possible economic distortion, taxing things people will buy anyway regardless of price is the most efficient way.

But what if your goal isn't just revenue?

What if you want to change behavior,

like discourage smoking?

Then you do the opposite.

You tax goods with elastic demand or supply because that will pause the biggest change in quantity consumed, achieving your policy goal more effectively, even if it creates a larger deadweight loss.

Let's apply that to taxing tobacco.

Governments want people to smoke less, but they also want the revenue.

Exactly.

It's a bit of a dual motive.

And what we've seen is that cigarette taxes have gone up a lot.

States like Louisiana, Kansas, Nevada imposed big hikes.

And what happened?

Well, sales did fall, which was part of the goal.

But because the demand for cigarettes is relatively inelastic, smokers don't quit easily just because of price.

The percentage decrease in quantity was smaller than the percentage increase in the tax.

Meaning total tax revenue actually went up.

Significantly, yes.

In pretty much all cases where states raised cigarette taxes substantially, revenues increased.

It shows taxing inelastic goods can be effective for revenue generation, even while nudging behavior slightly.

Okay, we've spent a lot of time on efficiency and costs.

But there's another huge piece of the puzzle.

Tax fairness.

What does that even mean in economics?

It's a crucial concept, but fairness can mean different things.

There are two main principles economists talk about.

First is the benefits principle.

Yeah, the idea that those who benefit from public spending should be the ones who pay the taxes that fund it.

Think of gasoline taxes funding highway construction and repair.

The people using the roads are paying for them.

It links payment to benefit.

Makes sense.

What's the other principle?

The ability to pay principle.

This one says that people with a greater capacity to pay more.

Usually this means higher income individuals should pay more in absolute dollars and often a higher percentage of their income.

Like our modern income tax systems try to do.

Exactly.

And think back to the whiskey rebellion that tax violated the ability to pay principle.

The small distillers who had less ability to pay were tax proportionally more than the large distillers.

That perceived unfairness fueled the revolt.

So we have these two ideas of fairness and we also have the goal of efficiency.

Minimizing deadweight loss.

How do policymakers balance all this?

It seems like they often conflict.

They absolutely do.

That's the fundamental trade off between equity and efficiency and tax design.

It's one of the hardest problems.

Can you give an example?

Sure.

Consider a theoretical lump sum tax.

Imagine the government just charged every single person, say $1 ,000, regardless of their income, their job, what they buy,

anything.

Okay, a flat fee for everyone.

From an efficiency standpoint, it's perfect because the tax doesn't depend on any action you take.

It doesn't distort any incentives.

You can't avoid it by working less or buying less.

So zero deadweight loss, maximum efficiency.

That sounds incredibly unfair.

A billionaire pays the same thousand dollars as someone struggling to get by.

Precisely.

It completely violates the ability to pay principle.

So while it's perfectly efficient, it's widely seen as extremely inequitable.

So the trade off is if you want a tax system that feels fairer according to ability to pay, you generally have to accept some inefficiency, some deadweight loss.

That's usually the case.

Taxes based on income or consumption, which feel fairer to many, inevitably distort decisions about working, saving or spending, creating deadweight loss.

Finding the right balance between fairness and efficiency is really a political and social choice, not purely an economic one.

Okay, let's bring this home.

How do these principles play out in the actual US tax system?

Well, first we need a few terms.

Every tax has a tax base.

That's what is being taxed.

Income, payroll, sales, profits, property, wealth, and a tax structure.

How the tax depends on the base.

And that structure can be different types, right?

Right.

A proportional tax or flat tax takes the same percentage of the base from everyone.

A progressive tax takes a larger percentage from high income earners than low income earners.

And a regressive tax takes a smaller percentage from high income earners.

So progressive means the rich pay a higher rate, regressive means the poor pay a higher rate proportionally.

Essentially, yes, as a percentage of their income or base.

Now, highly progressive taxes might seem fairest under the ability to pay principle, but they can also create incentive problems if the marginal tax rate gets too high.

Marginal tax rate.

That's a tax rate on an additional dollar of income.

If your marginal rate is, say, it means for every extra dollar you earn, the government takes 75 cents.

That can really discourage working extra hours or taking investment risks.

Historically, the US actually had top marginal rates over 90 % back in the 1950s and 60s.

Wow.

OK, so what does the current US system look like?

Progressive.

Regressive.

It's a mix, really.

The federal personal income tax is definitely progressive.

Higher incomes fall into higher tax brackets and things like the earned income tax credit, actually a result in negative tax rates for some very low income families.

It strongly reflects the ability to pay principle.

OK, income tax is progressive.

What about that FICA payroll tax we talked about?

FICA is generally considered somewhat regressive.

Remember, it's meant to fund social security and Medicare, sort of aligning with the benefits principle.

But the social security part is capped.

You only pay it on income up to a certain limit each year.

Meaning billionaires pay the same dollar amount for social security tax as someone earning, say, $160 ,000.

Exactly.

Which means as a percentage of their total income, high earners pay much less in social security tax.

So overall, FICA takes a smaller share from the very wealthy than from middle income earners.

OK.

What about sales taxes?

Sales taxes, typically levied by states, are generally regressive because lower income households tend to spend a larger proportion of their income on goods and services subject to sales tax, while higher income households save more or spend on untaxed services.

And state and local taxes generally.

They tend to be less progressive, sometimes regressive too.

Think flat fees for car registration or property taxes that might not perfectly align with income.

So income tax progressive,

payroll and sales taxes leaning regressive.

What's the overall picture?

When you add it all up, federal, state, local, the overall U .S.

tax system is progressive.

Data consistently shows that higher income households pay a significantly higher percentage of their income in total taxes than lower income households.

But it's less progressive than the federal income tax alone might suggest because of those other taxes.

How does the U .S.

compare globally?

Are we a high tax or low tax country?

Compared to other wealthy developed nations, especially in Europe, the U .S.

is actually near the bottom in terms of taxes as a share of the economy, as a share of GDP.

European countries often have tax burdens 40, 50, even 70 % higher.

Why is that?

Largely because their governments provide much more extensive social benefits, universal health care, more generous pensions, widespread subsidized child care, things like that.

More government spending requires higher taxes.

So why is the U .S.

system such a mix of progressive and regressive elements?

Two main reasons stand out.

One is the different levels of government.

State and local governments worry about tax competition.

If they make their taxes too progressive, wealthy residents or businesses might just move to a state with lower taxes.

The federal government doesn't face that same pressure.

So states might lean towards less progressive taxes to stay competitive?

Potentially, yes.

The second reason is that different taxes are often justified by different principles.

The federal income tax is largely built on ability to pay.

The payroll tax is more linked to the benefits principle, funding specific programs like social security and Medicare.

Sales taxes are primarily for state revenue, so you end up with this patchwork system reflecting different goals and constraints.

This also touches on that debate about taxing income versus taxing consumption, doesn't it?

It does.

Taxing income, especially investment income, can be seen as discouraging saving and investment, maybe slowing economic growth.

A consumption tax, like the value added tax or VAT common in Europe, taxes spending instead of earning.

That might encourage saving.

But VATs are harder to make progressive.

Generally, yes.

It's simpler to tax everyone's consumption at the same rate, which tends to be regressive.

Making a VAT progressive is complex, which is one barrier to adopting it in the US.

And you can really see these different choices playing out when you compare states.

Look at, say, California versus Texas.

Okay.

California has a high state income tax.

Texas has none.

Right.

So you might assume Texas is low tax for everyone.

But if you look at the average tax rate across different income groups, including sales and property taxes, it's interesting.

California's system, with its progressive income tax and credits,

actually results in lower average tax rates for roughly the bottom half of the income distribution compared to Texas.

Really?

Yeah.

But for high income earners, California's rates are much, much higher than Texas's.

It just shows that tax policy isn't one size fits all.

Choices about what to tax and how benefit some groups more than others.

Low tax depends on who you are.

Wow.

Okay.

So wrapping this all up, taxes are clearly essential, but man, they are complicated.

They really are.

The key things to remember seem to be who really pays depends on elasticity, not just who writes the check.

Taxes usually create inefficiency, deadweight loss beyond the revenue collected.

And there's this constant difficult trade -off between making the system efficient and making it fair based on principles like benefits received or ability to pay.

That's a great summary.

And hopefully, understanding these core ideas helps you, the listener, make more sense of economic news, perform better in your courses, and just think more critically about tax policy debates.

Look for the hidden burdens, the trade -offs, the reasons why a tax might be structured a certain way.

And maybe a final thought to leave you with, something a bit different.

Think about companies like Microsoft that have implemented an internal carbon tax.

They charge their own divisions a fee for the carbon emissions they generate.

Right.

They even doubled it recently.

Why would a company do that?

Voluntarily tax itself, potentially reducing short -term profits.

How does that internal tax work like a government tax?

Not just raising revenue internally, but trying to change behavior to incentivize divisions to reduce their carbon footprint to meet a larger company goal.

It's a fascinating parallel.

It shows these principles of using price mechanisms, like taxes,

to influence incentives aren't just for governments.

They apply anywhere you're trying to align individual actions with a broader objective.

Lots to think about there.

Indeed.

Well, thank you for joining us for this deep dive into the economics of taxes.

We hope it clarified these important concepts for you.

Last -minute lecture team,

a warm thank you from the last -minute lecture team.