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Chapter 17/Taxation and Resource Allocation
CHAPTER 17
TAXATION AND RESOURCE ALLOCATION
TEST YOURSELF
1. Using the following hypothetical income-tax table, compute the marginal and average
tax rates. Is the tax progressive, proportional, or regressive?
Income Income Tax
$20,000 $2,000
30,000 2,700
40,000 3,200
50,000 3,500
The tax is regressive, since the average tax rate falls as income rises:
Tax Rate
Income Tax Marginal Average
$20,000 $2,000 .10 .10
2. Which concept of tax equity, if any, seems to be served by each of the following?
a. The progressive income tax
b. The excise tax on cigarettes
c. The gasoline tax
The answers to these questions are not obvious, and students may be able to argue
various points of view.
(a) The progressive income tax promotes vertical equity, if one believes that income
differentials should be reduced. It promotes horizontal equity, unless one thinks that
3. Suppose the supply-and-demand schedules for cigarettes are as follows:
Price per Carton Quantity Demanded Quantity Supplied
$3.00 360 160
3.25 330 180
3.50 300 200
3.75 270 220
4.00 240 240
4.25 210 260
4.50 180 280
4.75 150 300
5.00 120 320
NOTE: Quantity is in millions of cartons per year.
a. What are the equilibrium price and equilibrium quantity?
b. Now the government levies a $1.25 per carton excise tax on cigarettes. What are the
new equilibrium price paid by consumers, the price received by producers, and the
quantity?
c. Explain why it makes no difference whether Congress levies the $1.25 tax on the
consumer or the producer. (Relate your answer to the discussion of the payroll tax in
the text.)
d. Suppose the tax is levied on the producers. How much of the tax are producers able
to shift onto consumers? Explain how they manage to do so.
e. Will there be any excess burden from this tax? Why? Who bears this excess burden?
f. By how much has cigarette consumption declined on account of the tax? Why might
the government be happy about this outcome, despite the excess burden?
(a) Before the tax is imposed, the equilibrium price is $4.00 and the equilibrium quantity
is 240 million cartons.
(b) After the tax is imposed, the supply curve shifts up by the amount of the tax to:
Price Price Quantity Quantity
(including tax) (excluding tax) Demanded Supplied
$4.25 $3.00 210 160
(c) Regardless of who pay it, the tax is a wedge of $1.25 between the price paid by the
consumer and the price received by the seller. In the situation described in part (b),
the seller may list the price at $3.25, and then require the buyer to pay a tax of $1.25
Chapter 17/Taxation and Resource Allocation
(e) There is excess burden borne by both buyers and sellers. The buyers’ excess burden
4. Now suppose the supply schedule is instead as follows:
Price per Carton Quantity
Supplied
$3.00
60
3.25
105
3.50
150
3.75
195
4.00
240
4.25
285
4.50
330
4.75
375
5.00 420
NOTE: Quantity is in millions of cartons per year.
a. What are the equilibrium price and equilibrium quantity in the absence of a tax?
b. What are the equilibrium price and equilibrium quantity in the presence of a $1.25 per
carton excise tax?
c. Explain why your answer to part b differs from your answer to part b of the previous
question, and relate this difference to the discussion of the incidence of an excise tax in
this chapter.
(a) Without the tax, the equilibrium is still a price of $4.00 and a quantity of 240.
5. The country of Taxmania produces only two commodities: rice and caviar. The poor
spend all their income on rice, whereas the rich purchase both goods. Both demand for
and supply of rice are quite inelastic. In the caviar market, both supply and demand are
quite elastic. Which good would be heavily taxed if Taxmanians cared mostly about
efficiency? What if they cared mostly about vertical equity?
If Taxmanians care mostly about efficiency, they will tax rice most heavily. Since the
elasticities of supply and demand are both low, there will be little reduction in the
DISCUSSION QUESTIONS
1. “Americans are overtaxed. The federal government should continue cutting taxes.”
Comment.
Federal tax revenues have increased, but only in proportion to the increase in national
2. Soon after taking office in 2001, President George W. Bush proposed a series of large
tax cuts, including upper-bracket rates and repeal of the estate tax. Critics, including
President Barack Obama, have argued that these tax cuts were excessive in magnitude
and regressive in their distributional impact. Why did they say that? Do you agree more
with President Bush or with President Obama?
Critics opposed President Bush’s tax cuts for many reasons. Some argued that tax cuts
would eliminate the federal government’s budget surplus and possibly lead to a future
3. Use the example of Mr. Figg (see the box, “The American Way of Tax”) to explain the
concepts of efficient taxes and excess burden.
The taxes that the government tried to levy on Mr. Figg led to inefficiencies, because
4. Think of some tax that you personally pay. What steps have you taken or could you take
to reduce your tax payments? Is there an excess burden on you? Why or why not?
Students could take steps to avoid taxes (legally) by buying fewer consumer goods,
5. Discuss President Reagan’s statement on taxes quoted at the beginning of this chapter.
Do you agree with him?
Students may or may not agree with the former president. Most taxes are in fact levied
only for the purpose of raising revenue. If they lead to behavior changes, these create
6. Use the criteria of equity and efficiency in taxation to evaluate the idea of taxing capital
gains at a lower rate than other sources of income.
Many would argue that on both horizontal and vertical equity grounds, the proposal to
reduce capital gains taxation is a bad idea. From a horizontal perspective, it would mean
