Taxes and Regulation in Economics

These are my notes and thoughts on taxes and regulation in Economics.

Government regulation can be a double edged sword. Well-designed regulation can improve societal outcomes but poorly designed regulation stifles economic efficiency. 


In the US, governments tax citizens to correct market failures and externalities, raise revenues, redistribute funds, and finance operations. 


Through direct regulation and price controls, governments can intervene to influence market outcomes.


Although government intervention sometimes creates inefficiencies, it often results in improving social well being.


Weighing the trade-offs between equity and efficiency is one task of an economist.


It is up to each individual to decide when and where government intervention makes the most sense. 


When government tax revenues fall below spending. The government runs a budget deficit. When the converse happens and tax revenues exceed spending, the government is running a budget surplus. Total government spending and tax revenues have increased over the past several decades. 


The largest component of federal government revenues comes from the individual income tax, followed by social insurance tax receipts. Corporate income tax, excise taxes, and other sources of income make up a smaller percentage of federal receipts.


Individual income taxes represent the largest portion, around 47% in 2013.


Payroll taxes represent about a third of the federal government’s receipts. A payroll tax, also known as social insurance tax, is a tax on your wages that employers are required to withhold from employees’ pay. On your paystub, these are often listed as Federal Insurance Contribution Act, or FICA taxes.


Corporate income tax provides 10 percent of the overall pie. Corporate income tax is generated from taxing profits earned by corporations.


All other taxes make up the remaining 9 percent. This includes excise taxes, which are taxes paid when purchasing specific goods such as alcohol, tobacco, and gasoline.


State and local governments receive a much smaller fraction of their tax revenues from individual incomes taxes than does the federal government. Instead, property taxes, income taxes, and transfers from the federal government account for the bulk of their revenues.


Four main factors influence government taxation and spending decisions:

  1. Raising revenues
  2. Redistributing funds via transfer payments
  3. Financing operations
  4. Correcting market failures and externalities


Most taxation in our economy is intended to raise revenues for the funding of public goods such as national defense, public education, police protection, and infrastructure projects. The federal government spends most of its money on national defense and social security. The two biggest items of spending for state governments are education and public welfare. 


The second major objective of government taxation and spending is redistribution. Market outcomes can be quite inequitable, with high levels of inequality and poverty coexisting alongside huge fortunes for a few. Governments in all advanced economies use transfer payments and the tax system to limit the extent of such inequality and the economic hardships that poorer households in the society suffer.  Transfer payments refer to payments from the government to certain groups, such as the elderly or the unemployed. Social security is the largest transfer program and was introduced by Roosevelt in 1935 to provide economic security to the elderly, disabled, widows, and fatherless children. Medicare, introduced by Lynbdon Johnson in 1965, provides health insurance to Americans aged 65 and older and makes up another l;arge part of federal spending. 


Public welfare makes up a significant part of state and local budgets. This consists of transfer and vendor payments made to private purveyors for medical, burials, and other services provided under welfare programs.


A progressive tax system is one in which tax rates increase with taxable base incomes, so that the rich pay higher tax rates than the less well to do. To understand this system more precisely, we need to distinguish between average and marginal tax rates. The average tax rate faced by a household is the total tax paid divided by total income earned. The marginal tax rate refers to how much of the last dollar earned the household pays in taxes. 


The alternatives to the progressive tax system are the proportional and regressive tax systems. In a proportional tax system, households pay the same percentage of their incomes in taxes regardless of their income level. In a regressive tax system, the marginal tax and average tax rates decline with income so that low income households pay a greater percentage of income in taxes than do high income households. 


As a result of transfer programs and progressive taxation, the post tax income distribution in the US is more equal than the pre tax income distribution. 


Governments also tax to pay for their own operations, including the salaries of presidents, members of congress, and other politicians, and for the sizable bureaucracy in charge of the day to day running of government operations and services. 


The government sometimes imposes taxes to correct market failures or externalities. Though important in principle, this use of taxation is far less prevalent than the three reasons discussed above.


The term tax incidence refers to how the burden of the tax is distributed across various agents in the economy. The incidence on producers is the portion of tax revenue that lies above the pre-tax equilibrium price, is given by the same green triangle. 


The deadweight loss of taxation is the loss in total surplus or the decline in consumer and producer surpluses not made up by the increase in tax revenues. The deadweight losses of taxation imply that for every dollar of tax raised, the cost is greater than a dollar. 


In competitive markets, tax incidence and equilibrium prices and quantities are independent of whether the tax is imposed on consumers or producers. 


The fact that the incidence of the tax is identical for buyers and sellers in the examples above is due to how we drew the market demand and market supply curves. So, that means buyers and sellers are equally sensitive to price changes at the original equilibrium. 


Externalities and various market failures can have significant social costs. The main tool that governments use to deal with externalities and other sources of market failures is regulation. Regulation refers to actions by the federal or local government directed at influencing market outcomes, such as the quantity traded of a good or service, its price, or its quality of safety. 


A common form of government intervention in markets is direct regulation. Direct regulation refers to direct actions by the government to control the amount of a certain activity. 


A price ceiling is a cap on the price of a market good or service. One important example is rent control. A price ceiling causes a shortage.


Sometimes the government steps in to impose a minimum price on a  product or service. The result is a price floor, which represents a lower limit on the price of the product or service. A good example of a price floor is the minimum wage.  A price floor causes a surplus. 


Every government program needs bureaucrats to monitor its implementation and these people have to be paid. However, they are taken out of productive sectors of the economy. In this way, the allocation of time and talent of individuals to bureaucracy is an important cost of government. This cost is increased by the fact that bureaucracies don’t function efficiently. 


Equally as important as the deadweight losses associated with government intervention and the inefficiencies of bureaucracies is the corruption that large governments engender. Corruption refers to the misuse of public funds or the distortion of the allocation of resources for personal gain. 


The underground economy, or black market, includes activities where income taxes are not paid, as well as illegal activities such as drug dealing and prostitution. In modern economies, black markets cover an array of activities and are generally found in areas where the benefits of such activities are the highest. 


Problems of an underground economy are:

  1. When it involves goods and services that have been legally banned, the underground economy undermines the ban.
  2. When underground transactions occur in markets for legal goods and services in order to avoid taxes or regulation, they put legitimate businesses at a disadvantage. 
  3. To compensate for the lost revenue, governments must levy higher taxes
  4. Criminals spend vast resources trying to evade the law, which are not effective uses of society’s resources.


The equity-efficiency-trade-off refers to the balance between ensuring an equitable allocation of resources and increasing social surplus or total output. Most would agree that equity and efficiency are the two most important goals for government policy. 


The trade-off between equity and efficiency represents the nub of the conflict between those who support big government and those who call for smaller government. The government can often achieve greater social equality but only at the expense of greater inefficiencies. When social inequality is very high, there may be no conflict between equity and efficiency. 


Equity and efficiency are two opposites. To have one means you lose the other. 


All developed nations seek to achieve some degree of equality in their society. The welfare state refers to the set of insurance, regulation, and transfer programs utilized to create a safety net, reduce poverty, and redistribute income from the rich to the poor. The welfare state is even more expansive in Europe. Despite deadweight losses associated with their systems, many European nations choose to promote some degree of equality in income. 


Consumer sovereignty is the view that choices made by a consumer reflect his or her true preferences, and outsiders, including the government, should not interfere with these choices. 


At the other end of the spectrum is paternalism. Paternalism is the view that consumers do not always know what is best for them, and the government should encourage or induce them to change their actions. This approach gives the government an active hand in designing choices to help individuals make the right decision. 


The social security system in the US, which forces individuals to save for old age, was born out of paternalism. Laws that ban substance abuse are also motivated by paternalism. 


As we have shown, a major efficiency loss of taxation is deadweight loss. So, the debate on the reach of the government should hinge on the effect of its actions, the larger the deadweight loss, the worse the policy.  


The government typically operates in a slow moving manner. A significant drag on the economy can result if regulators cannot move swiftly in response to changing market conditions. 


Governments can play an important role in ensuring that markets are competitive, efficient, and equitable. Key roles of the government include taxation to raise funds to provide public goods, such as national defense, policing, and infrastructure investments that would not be provided adequately by the market. The use of tax and transfer programs to achieve a more equitable distribution of resources in society and the use of taxes and subsidies as well as regulation to correct market failures. 


The costs of government interventions must be compared carefully with their benefits. Economics is most useful not as a value judgment on whether the government is good or bad, but for understanding what sorts of activities require government intervention. 

The primary types of tax systems are:

  1. Progressive
  2. Proportional
  3. Regressive

An example of a progressive tax is the:

  1. Income tax

An example of a regressive tax is the:

  1. Social security tax

An example of a proportional tax is the:

  1. Medicare tax


Tax incidence refers to:

  1. Who bears the burden of a tax

Is the entire burden of the tax always borne by those on whom is is imposed?:

  1. Not necessarily, since the burden of the tax depends on price elasticity. Tax incidence depends on the relative elasticities of market supply and demand


The following table gives the federal income tax rates for a single individual. The total tax payable for an individual who earns 500,000 a year is:

  1. 8925*10% +
  2. (36250-8925)*15% +
  3. (87850-36250)*25% +
  4. (183250-87850)*28% +
  5. (398350-183250)*33% +
  6. (400000-398350)*35% +
  7. (500000-400000)*39.6& +
  8. = 155763.75

The marginal tax rate is:

  1. The marginal tax rate refers to how much of a household’s marginal dollar earned is paid out in tax. Since the last dollar earned is 500000, the individual’s marginal tax rate is 39.60%

The average tax rate is:

  1. 31.15 % or 155763.75 / 500000 = 31.15 percent


Many people have argued that an income tax should be marriage neutral, that is, two people should pay the same total tax whether they are married or they are single. Suppose Amanda earns nothing, Ben earns 60000, and Cathy and Dylan each earn 30000. They are all single.

Amanda pays no taxes because she has no income. If they all live in a country that has a progressive income tax, which will be higher: the tax that Ben pays or the sum of the taxes Cathy and Dylan pay?

  1. The tax that Ben pays because high-income individuals pay higher income taxes

Amanda marries Ben and Cathy marries Dylan. This country taxes married couples based on a family’s total income.

Amanda and Ben will pay the same tax as Cathy and Dylan because

  1. The couple have the same family income

Is the income tax in this country marriage neutral?

  1. No, because Cathy and Dylan pay higher taxes when married than before marriage.


Which of the following is a cost associated with government intervention in an economic system?

  1. Corruption

Given that there are costs involved with government intervention in an economy, governments still choose to intervene in markets to:

  1. Reduce poverty


How would you depict the trade-off between equity and efficiency on a graph?

  1. Inequality on one axis and social surplus on the other with a positively-shaped function

A government would want to be on this curve when:

  1. There is no correct answer to this question, as the answer depends on a government’s value judgments. 


Paternalism is the view that:

  1. People do not always know what is best for them, and government should encourage them to make the right choices

Consumer sovereignty suggests that:

  1. Government should not interfere with consumer choices


Why are there two different views on the effect of taxation on labor supply in the US?

  1. All of the above
  2. The effect of a tax on labor supply depends on the amount of deadweight loss created by the tax
  3. It depends on normative questions such as how much to tax or how much government intervention is necessary
  4. The effect of a tax on labor supply depends on the elasticity of labor supply


Suppose a government generates its revenue using a lump sum income tax of 10000 per person regardless of income. Calculate the average and marginal income tax rates for individuals with each income level shown in the table below

50,000 20.00% 0%

75,000 13.33% 0

100,000 10.00% 0

125,000 8.00% 0

150,000 6.67% 0

This lump sum income tax is a regressive tax


The two most important goals for government policy involve a trade-off between:

  1. Equity and efficiency


The graph shows the market for good A. The equilibrium price and quantity is P_m and Q respectively. Suppose the government imposes a price control that reduces producer surplus. Determine the type of price control and show it on the graph.

  1. The price control is a price ceiling

Draw a price control and label is price control

  1. Draw horizontal line below equilibrium point

There is a possibility of forming a black market by the seller, if there is a:

  1. Price control

If a price floor is set below the free market equilibrium price, then the quantity demanded:

  1. Remains unaffected

Which of the following are examples of inefficiencies created by government intervention?

  1. Creating a large workforce of professionals who review whether the financial reports of companies are true and fair
  2. An increase in the price of alcohol due to higher taxes imposed by the government
  3. Quality deterioration in a market after government implements a price control

Which of the following is not a result of corruption?

  1. Selling goods at a price that does not include taxes