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Chapter 10The Government in the Economy: Taxation and Regulation

Questions1. When does a government run a budget surplus?

Answer: When the government’s tax revenues exceed its spending in a time period (for example, a year), the government is said to be running a budget surplus.

2. Consider Exhibit 10.1. What can you say about the reach of government in the United States in the stated period? What about the budget deficit?

Answer: This exhibit shows that government spending has grown over time, except the spikes in the mid-1940s and 2009, which shows substantial increase in government spending due to World War II and the global financial crisis. Tax revenues have grown in tandem as well. However, we cannot tell if there is a constant budget deficit, because this depends on how much tax revenue the government earned compared to how much it spent during this period.

3. How does the federal government raise revenue? What is the largest source of revenue for the federal government? Do state governments also raise revenue from the same sources as the federal government?

Answer: The government raises revenues by collecting taxes. The federal government’s largest source of revenue is the individual income tax. The other major federal taxes are the payroll tax, the corporate income tax, and excise taxes.

The sources of revenue for state and local governments are quite different from that of the federal government. The largest source of revenue for state and local governments are miscellaneous taxes and fees that state and local governments collect. These include tolls on roads, public transportation, ticket sales, vehicle licenses, hunting and fishing licenses, etc. States rely on the sales tax, individual income tax, and corporate tax. Local governments rely heavily on the property tax. State and local governments also receive funds from the federal government.

4. What are the tools commonly used by the government to intervene in the market?

Answer: The tools commonly used by the government to intervene in a market include taxes, direct regulations, and price controls.

5. How do governments use spending and taxation to reduce inequality and poverty in an economy?

Answer: The government uses progressive taxation and transfer payments in order to reduce inequality and poverty in the economy. Transfer payments refer to payments from the government to certain individual groups, such as the elderly or the unemployed. Social security, Medicare, and Supplemental Security Income are all examples of transfer payments. A progressive tax system is one in which marginal tax rates increase as incomes increase, so that the rich face higher marginal tax rates than the less well-to-do.

6. What are the different types of tax systems? Give one example of each type of tax.

©2018 Pearson Education Ltd.

Chapter 10 | The Government in the Economy: Taxation and Regulation 108

Answer: In progressive tax systems, higher income levels face higher average tax rates. In a proportional tax system, households pay the same percentage of their incomes in taxes regardless of their income level; in other words, the average tax rate does not vary with income. In a regressive tax system, the average tax rate declines with income so that low-income households pay a greater percentage of income in taxes than do high-income households. In the United States, income taxes (except flat-rate state and local income taxes) are progressive. Social Security and sales taxes are regressive.

7. How does a higher unit tax affect the size of the deadweight loss? Explain your answer.

Answer: A higher unit tax causes a smaller quantity to be transacted in the market. As the quantity transacted moves away from the equilibrium quantity due to higher unit tax, the social surplus decreases and the deadweight loss increases.

8. If the demand for a good is more elastic than its supply, how will the tax burden be distributed between buyers and sellers?

Answer: If the demand for a good is more elastic than the supply of it, the tax burden borne by the sellers will be larger than that borne by the buyers.

9. How does a binding price floor affect the consumer surplus, produce surplus, and social surplus?

Answer: If a binding price floor is set above the equilibrium price, the consumer surplus will decrease and the producer surplus will increase. If the decrease in consumer surplus is greater than the increase in producer surplus, the social surplus will decrease and there will be a deadweight loss. However, the social surplus will increase if the increase in producer surplus is greater than the decrease in consumer surplus.

10. If a price ceiling is set above the equilibrium price in the oil market, how does it affect the oil price and quantity?

Answer: If a price ceiling is set above the equilibrium price in the oil market, the price ceiling will not be binding, and there will be no changes in the equilibrium oil price and the quantity transacted.

11. How can you define corruption? Explain your answers with examples of corrupt activities.

Answer: Corruption refers to the misuse of public funds or the misallocation of resources for personal gain. Corruption is said to be linked to heavy bureaucracy, because the greater the regulatory burden is, the more corrupt the country is perceived to be. The regulatory burden (ranging from customs procedures, licensing requirements, procurement policies and so on) create bureaucracy, bureaucracy creates interaction with high officials/politicians and leads to corruption. Examples of corrupt actions: bribery, donation of campaigning money in return for benefits from politicians, embezzlement, extortion, business networking that gives unfair advantage.

12. Look at Exhibit 10.17 in the chapter that shows the tradeoff between equity and efficiency. Is it possible for the government to improve equity and efficiency at the same time? Explain.

Answer: If the society is somewhere above point A in Exhibit 10.17, decreasing government intervention can move the society toward point A and improve both equity and efficiency.

13. Explain the terms “paternalism” and “consumer sovereignty.”

Answer: 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, even if there is evidence that these choices might ultimately have negative consequences for the consumer. 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.

14. What is the effect of increasing taxes by the U.S. government on high-income innovators? What will happen if all advanced countries increase their top tax brackets?



Answer: The high-income innovators are more likely to move to other countries in response to high taxes, with direct implications on innovation activities. Thus, high taxes increase the number of domestic innovators emigrating from the United States and reduce the number of foreign innovators immigrating to the United States. This poses additional costs to increased taxation, as it creates losses in revenues because of the flight of domestic innovators. In addition, the country misses the new technologies that these individuals would have otherwise created domestically. If all advanced countries increase their taxes in tandem with the U.S. government, then no country would become relatively more attractive for these high innovators.

15. If your goal is to minimize the deadweight loss from a tax, would you tax goods for which demand is elastic or goods for which demand is inelastic, everything else being equal? Explain using a diagram.

Answer: For fixed tax wedge, the change in quantity is much lower when the demand is less elastic (more vertical). This generates a smaller deadweight loss (DWL) triangle, as shown.

Problems1. The following table gives the 2017 federal income tax rates for a head of the household.

Taxable income bracket Rate$0 to $13,350 10%$13,350 to $50,800 15%$50,800 to $131,200 25%$131,200 to $212,500 28%$212,500 to $416,700 33%$416,700 to $444,550 35%$444,550 + 39.60%

a. Calculate the total tax owed for the head of a household who earns $25,000 a month.

b. What is the marginal tax rate?

c. Calculate the average tax rate.

Answer:

a. If the head of the household earns $25,000 a month, this means $300,000 a year. The total tax owed is $117,103.5:



b. (13,350 – 0) × 10% + (50,800 – 13,350) × 15% + (131,200 – 50,800) × 25% + (212,500 – 131,200) × 28% + (416,400 – 212,500) × 33% = 1,335 + 5,617.5 + 20,100 + 22,764 + 67,287 = 117,103.5

c. His marginal tax rate is 33%, so he is in the 33% tax bracket.

d. His average tax rate is: $117,103.5 ÷ $300,000 = 39.03%

2. Britain taxed windows from 1696 until 1851. Under the 1747-57 tax rates, you would pay no tax if your home had 0 – 9 windows but if your home had 10 – 14 windows you would pay a tax of 6 pence per window for every window in your home.

a. In what way is the window tax similar to the U.S. income tax?

b. In what way is the window tax different from the U.S. income tax?

c. Do you think from 1747–1757 the number of new homes with 9 or fewer windows increased from the pre-1747 days? Explain.

Answer:

a. The income tax and the window tax are both progressive. United States taxpayers with higher incomes pay higher marginal tax rates on their income. Property owners in 18th century Britain with more windows paid higher marginal tax rates on their windows.

b. When United States taxpayers earn more income and move into a higher tax bracket, they pay a higher marginal tax rate on additional income but the tax rate on their other income is unchanged. Consider Exhibit 10.6 in the text. Someone who earned $8,926 would pay 10% of her first $8,925 of income and 15% of her last dollar in taxes. Property owners in Britain faced a very different situation. If they purchased a 10th window, they would pay the 6 pence tax on that 10th window and a 6 pence tax on their first nine windows as well. Economists say that tax systems like the United States income tax have “kinks” in the tax schedule; tax systems like the window tax have “notches.”

c. You should expect to find that more houses with nine or fewer windows were built after the imposition of the window tax. Starting in 1747, the 10th window was very expensive. A homeowner would pay no tax with nine windows but a tax of 60 pence (which was equal to five shillings) if the home had 10.

3. Suppose there are three families with different annual incomes. The Smiths have an income of $20,000, the Johnsons have an income of $70,000, and the Kleins have an income of $210,000. Based on the following table, answer the questions:

Progressive TaxSmiths $20,000 15%Johnsons $70,000 25%Kleins $210,000 28%

Proportional TaxSmiths $20,000 25%Johnsons $70,000 25%Kleins $210,000 25%

Regressive TaxSmiths $20,000 25%Johnsons $70,000 15%Kleins $210,000 10%

a. What is the amount of tax paid by each family under each of the tax systems?



b. If the government changes the progressive tax system to a proportional tax system, will the families be better off or worse off? Why?

c. Do you think that the change of the tax system reduces or increases inequality? Why?

Answers:

a.

Progressive TaxSmiths $20,000 15% $3,000

Johnsons $70,000 25% $17,500Kleins $210,000 28% $58,800

Proportional TaxSmiths $20,000 25% $5,000

Johnsons $70,000 25% $17,500Kleins $210,000 25% $52,500

Regressive TaxSmiths $20,000 25% $5,000

Johnsons $70,000 20% $14,000Kleins $210,000 15% $31,500

b. If the country applies a proportional tax system, then the Smiths are worse off, as they will pay more than in a progressive tax system. The Johnsons are not affected by the tax system, as their tax rate does not change. The Kleins are better off, because their tax rate decreases.

c. The change of the tax system does not reduce inequalities, because the family with the lowest income pays more in the new tax system and the family with the highest income pays less than in the old system.

4. Consider the following graph, which shows the equilibrium price and quantity in the plastic boxes market in country X. Suppose the government imposes a tax of 5% on the production of plastic boxes.

a. What is the new equilibrium price and quantity?

b. What is the amount of tax revenue earned by the government?

c. What is the deadweight loss of this tax?



Answer:

a. The imposed tax is 5%, so the tax supply curve shifts by the amount of the tax to ST. The price of a plastic box rises to $3.5, while the quantity falls to 2 million pieces.

b. The tax revenue earned by the government is 2 million × ($3.5 – $1.5) = $4 million

c. The deadweight loss of this tax is ½ × ($3.5 – $1.5) × 2 million = $2 million.



5.

6. The following diagram shows the effect of a $4 tax.

a. Complete the table using the letters to denote the area of each region.

b. Based on this calculation, what is the deadweight loss of the tax? This is the difference in social surplus between the two columns.

c. Redraw a similar diagram, except with a perfectly inelastic (vertical) supply curve. Explain why the deadweight loss is zero in this case.

No Tax With Tax

Consumer Surplus

Producer Surplus

Government Tax Revenue 0 B + C

Social (Total) Surplus

Answer:

a. See table.

b. The deadweight loss is the difference in social surplus: E + F. This represents unrealized gains from trade.

c. See graph. The deadweight loss triangle has collapsed to zero. There is no deadweight loss because the tax has not distorted the market in any way: There are still 6 exchanges because the quantity supplied is fixed at 6, regardless of price. Therefore, there is only a transfer from sellers to the government, but there is no market distortion. If you want to relate this to the table, all areas except for A, C, and D are now zero.

No Subsidy With Tax



Consumer Surplus A + B + E A

Producer Surplus C + D + F D

Government Tax Revenue 0 B + C

Social (Total) Surplus A + B + C + D + E + F A + B + C + D

7. This chapter has focused on the effect of taxes. Let’s consider the effect of subsidies, which also generate deadweight loss. A subsidy creates a gap between the price received by sellers and the price paid by buyers.

a. Complete the table using the letters to denote the area of each region. The government “revenue” is negative as a subsidy requires a payment by the government.

b. Based on this calculation, what is the deadweight loss of the subsidy? This is the difference between the social surplus.



c. Describe why a subsidy creates deadweight loss. Try to use your answer to the previous part as a guide.

No Subsidy With Subsidy

Consumer Surplus

Producer Surplus

Government “Revenue” 0 - (B + C + D + E + G)

Social (Total) Surplus

Answers:

a. Consumer surplus is always the area between the demand and the price paid by buyers while producer surplus is the area between the supply and the price received by sellers. Notice that both consumer surplus and producer surplus increase. However, this does not overcome the cost of the subsidy borne by the government.

No Subsidy With Subsidy

Consumer Surplus A + B A + B + D + E

Producer Surplus D + F B + C + D + F

Government “Revenue” 0 - (B + C + D + E + G)

Social (Total) Surplus A + B + D + F A + B + D + F - G

b. With the subsidy, the total is lower by the value of G; this is the deadweight loss. No subsidy is the free-market outcome and thus A + B + D + F is the maximum possible total surplus. With the subsidy the surplus is lower.

c. The area G is the loss in surplus from too much trade. The optimal quantity of Q = 3 (as drawn in the graph) exhausts all gains from trade. The additional trade induced by the subsidy allows for consumption by buyers who value the good at below marginal cost. The area of G is the summation of the negative effect of costs that are greater than benefits.



8. Suppose the supply and demand schedules for cell phones are as follows:

Price Demand Supply$2 10 0$3 9 0$4 8 0$5 7 1$6 6 2$7 5 3$8 4 4$9 3 5$10 2 6$11 1 7$12 0 8

a. Make a sketch of supply and demand

b. Find equilibrium price and quantity in the cell phone market.

c. Suppose the government sets a maximum price (that is, a price ceiling) of $6. How many cell phones are traded? Add the price ceiling to your sketch.

d. Suppose the government sets a minimum price (that is, a price floor) of $10. How many cell phones are traded? Add the price floor to your sketch.

Answer:

a. See sketch.

b. The equilibrium price is $8 since quantity supplied equals quantity demanded at that price. Equilibrium quantity is 4.



c. Only 2 cell phones will be supplied (even though quantity demanded will be 6) and so at most 2 cell phones will be traded.

d. Only 2 cell phones will be demanded (even though quantity supplied will be 6) and so at most 2 cell phones will be traded.

9. Some government agricultural policies involve price controls. Other agricultural policies, however, involve quantity controls.

a. The equilibrium price of wheat is $5 and the equilibrium quantity is 100. Draw a supply and demand diagram that shows the equilibrium in the wheat market.

b. Suppose the government institutes a policy that prohibits wheat farmers from growing more than 80 bushels of wheat in total. How would this policy change the supply curve for wheat?

c. Use your supply and demand diagram to show that the government policy in part (b) would raise the equilibrium price and lower the equilibrium quantity of wheat.

d. Show that the policy in part (b) will lead to a deadweight loss in the wheat market.

Answer:

a. The supply curve in the wheat market is S1, the initial equilibrium price is $5.00, and the initial equilibrium quantity is 100 bushels.

b. The new government policy will have no effect on supply for quantities below 80 bushels. Supply becomes perfectly inelastic at 80 bushels since farmers are not allowed to grow more than 80 bushels regardless of how high the price rises. The new supply curve is therefore S2 and consists of two parts: the old supply curve until we reach 80 bushels and then a vertical line.

c. The new equilibrium is at the intersection of the new supply curve and demand. The new equilibrium quantity is 80 bushels and the new equilibrium price is above $5.00. We do not have enough information to find the new price (but we do know that it is above $5.00); in the diagram above it is $7.00.



d. The quantity control leads to a deadweight loss of C + F.

No Quantity Control Quantity Control ChangeConsumer Surplus A + B + C A – B – CProducer Surplus E + F B + E B – FTotal Surplus A + B + C + E + F A + B + E – C – F

10. Create a sketch that shows the trade-off between equity and efficiency. Highlight the portion of the curve where there is a fundamental trade-off between equity and efficiency. In this region, what is the cost of moving to up the curve? What is the cost of moving down the curve?

Answer: The bottom (bolded) portion of the curve represents the region in which there is a fundamental trade-off with no easy answers. Moving up the curve increases social surplus, but at the cost of increased inequality. Moving down the curve decreases inequality but at the cost of lower overall surplus.

11. New York raises the price of a pack of cigarettes from $10.50 to $13, adding additional pressure on what is already the costliest cigarette market in the country. However, the sales of bootleg cigarettes from other states allow smokers in New York to bypass taxes and buy cigarettes for a price of $7 or $8 per pack. Does this mean that the black market is flourishing in New York? Explain your arguments.

Answer:

Some black markets involve illegal efforts to evade taxation. New York has the highest cigarette price in the country pushing up the price of a pack of cigarettes. Black marketers are likely to find it profitable to smuggle cigarettes from states where the price is lower and then re-sell them in New York. Since the price is so high, it is still profitable to buy a pack in some other US state and sell it in New York at a price that is lower than the perceived price.

For further reference, see: https://www.usatoday.com/story/news/2017/04/19/nyc-moves-raise-cost-cigarettes-nations-highest/100672190/

12. The Sensible Estate Tax Act of 2016 slashes the estate tax exemption to $3.5 million and raises the estate tax rate to 45%. Small and family businesses can be particularly hard hit. Family Business Defense Council calculated an effective death tax rate of 57%, and with state inheritance taxes, the combined tax could be as high as 68%. What do you think are the implications on equity and efficiency of imposing these high taxes?



Answers:

An estate tax is levied to try to ensure a more level playing field between those who inherit wealth and those who do not. This, however, does entail some inefficiencies. Wealth that is left to the next generation is part of an economy’s savings. These savings are usually used to fund investment or set up businesses. Levying a tax on estates could induce wealthy individuals to move their wealth to places where taxes are lower or to save less while they are alive. This takes away from investment in the domestic economy. Governments, however, continue to tax inherited wealth. One of the arguments in favor of an inheritance tax is based on the idea of fairness. The estate tax reduces wealth inequality. By reducing the advantage that heirs have by inheriting wealth, equality of opportunity increases since everyone starts closer to the same level. Given this tradeoff between what is considered fair and what is considered efficient, the decision to levy an estate tax is a normative one.

See https://www.forbes.com/sites/robertwood/2017/02/23/trump-vows-estate-tax-repeal-but-california-plans-its-own-40-estate-tax/#6abfe9a01e2d


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