Exercise 4. Listening from Guide to economics, unit 10 – “Positive externalities”, track 29)

• What is a positive externality? (repeat or write down the definition)
• Which transactions in the list are mentioned as positive externalities?

1. Buying a new house

2. Fixing up an old home

3. Buying books

4. Paying for a course at a local college

5. Joining a gym

6. Going on holiday

Exercise 5. Summarize each subsection of the text (orally):

1. The Business Cycle
2. Public Goods
3. Externalities
4. Information-Related Problems
5. Monopoly and Market Power
6. Income Redistribution and Merit Goods

 

Exercise 6.

1. Which of the following items of government spending reflect (a) provision of public goods, (b) concern with merit goods, (c) concern with income distribution: (i) police patrols, (ii) old age pensions, (iii) unemployment benefit, (iv) free state primary schools?

2. Which of the following are public goods: (a) clean streets, (b) ambulance services, (c) the postal service? Discuss alternative ways of providing these services.

3. Name the two goods or services you buy from a monopolist. Should the government regulate the price? Does it?

4. Why should the European Commission seek to enforce tough standards reducing pollution of rivers by nitrates used as fertilizers in farming?

Exercise 7.

Compare the content of the two texts by filling in the table:

Government
What does it do?	What should it do?

What conclusions can you draw from this table?

Exercise 8. Write a summary of these texts.

 

Optional: Video (Economics TTC, Lecture 13 “Positive Externalities and Technology”)

 

Taxes

“But in this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin, 1789.

 

Few economic topics excite controversy more easily than taxes. Wile most would agree that neither government nor modern society could survive without them, taxes are more likely to be criticized than praised.

Why Do Governments Collect Taxes? Although the principal purpose of taxes is to pay for the cost of government, it is not the only function taxes serve.

Ø Sometimes taxes are levied to protect selected industries. For a number of years a tariff (a tax on imports) helped to protect American steel manufacturers by making imported steel more costly than it would have been otherwise.

Ø Taxes have also been used to discourage activities the government believes to be harmful. For example, taxes on cigarettes and liquor, so called “sin taxes”, have been levied both to raise money and to discourage people from smoking and drinking.

Ø Taxes have been used to encourage certain activities. In the 1980’s, for example, the government wanted to encourage business to modernize plants and increase productivity. It did so, in part, by offering to reduce taxes of firms that purchased new machinery and equipment.

Ø The federal government can use its ability to tax to regulate the level of economic activity. The size of the economy is directly related to consumer and business spending. By increasing or decreasing taxes, government can directly affect the amount of money available to be spent.

 

Evaluating taxes. Most people would agree that some taxation is necessary, but the question of which taxes and in what amounts can lead to considerable disagreement. In comparing the merits of one tax to another, it is convenient to focus on the following questions:

Who ought to pay taxes?

What types of taxes are being considered?

Who will actually pay the taxes?

 

Who Ought to Pay Taxes?

The benefits-received principle of taxation states that those who benefit from a government program are the ones who ought to pay for it. Consider, for example, the case of a highway tunnel or bridge. In keeping with the benefits-received principle, motorists using these should have to pay for a toll.

Benefits-received works just fine when it comes to things like bridge and tunnel tolls or admission to a public beach, but it has its limitations. For example, is it fair to ask low-income families or the disabled to bear the cost of the programs designed to help them?

The ability-to-pay principle states that taxes ought to be paid by those who can best afford them, regardless of the benefits they receive. In arguing in favor of the ability-to-pay principle, economists often cite Engel’s Law. It states that as income increases, the proportion spent on luxuries increases, while that spent on necessities decreases. It follows that taxing higher-income groups may deny them certain luxuries, but taxing the poor reduces their ability to buy necessities.

Also, some benefits are indirect. If Mr. and Mrs. Jones have children in the public school, they can see the direct benefit of their school taxes. But Mr. and Mrs. Smith may feel they get no benefit from the school because they have no children.

We all benefit from having an educated workforce, however. Thanks to education, the nation’s productivity is higher, and we can all share in the additional output that results from it. If the Smiths own a business, they benefit from having workers who have been trained to read, write and solve mathematical problems.

 

Types of Taxes: Progressive, Proportional and Regressive

Most taxes can be classified as progressive, proportionate or regressive. A progressive tax takes a larger percentage of a higher income and a smaller percentage of a lower income. The federal income tax is the best known example of a progressive tax.

A proportionate tax takes the same percentage of all incomes, regardless of size. So, for example, a proportionate income tax of 10 percent would cost a person with a $10,000 income $1,000 in taxes, and a person with a $100,000 income $10,000 in taxes.

A regressive tax is one that takes a higher percentage of a low income and a lower percentage of a higher income. Although they are not based on a person’s income, sales taxes have a regressive effect because they take a larger share of earnings from a low-income taxpayer than from a high-income taxpayer. For example, a low-income family and a high-income family buy $500 refrigerators with a sales tax of eight percent. They would both pay a $40 sales tax. But the $40 represents a higher percentage of the low-income family’s total income than that of the high-income family.

Which tax is the fairest?

Few would argue that a regressive tax is fair. Those who favor the ability-to-pay principle would support a progressive tax, and possibly the proportionate tax. There are some, however, who argue that the proportional tax is not fair.

The proportional tax seems to be fair because everyone pays the same rate. Miss Rich, with her income of $100,000 pays 10 times as much as Mr. Poor who has an income of $10,000. Mr. Poor, however, can barely get by on $10,000; he needs every penny he earns. Miss Rich, on the other hand, can pay a tax of $10,000 and still have $90,000 left over – a very substantial sum! She can pay for all of her basic needs, enjoy main luxuries and still have money left to save or invest. Although her tax was 10 times as large as Mr. Poor’s, she didn’t suffer as much in laying it.

In analyzing the impact of taxes on individuals, economists often concentrate on discretionary income – the amount that a person has left buying necessities (food, clothing, shelter, medical care, transportation, etc.). Let’s assume that Mr. Poor has $1,000 left after having met all his needs. By levying a tax of $1,000, the government has taken 100 percent of Poor’s discretionary income. What about Miss Rich? Let’s say that she needs $50,000 to meet all of her needs (as she defines “needs”), and that she has $50,000 left as her discretionary income. The government takes $10,000 of this, or only 20 percent. She still has $40,000 left for luxuries, savings and investments. If we look at the discretionary incomes of Mr. Poor and Miss Rich, we find that the proportional tax is really a regressive tax!

 

Who really Pays the Tax?

In evaluating a tax it is important to know who will really have to pay it, or, as economists put it, the incidence of tax. The burden of paying a tax can be avoided if one responsible for writing the check for taxes to the government can pass the cost to someone else. The process of passing the burden to someone else is known as tax-shifting. Taxes may be passed on to consumers, in which case they are said to be shifted forward. Similarly, taxes may be shifted backward as when suppliers or the workers who produced the products are forced to assume the burden.

Whether taxes are shifted forward, backward or not at all will depend upon the elasticity of demand and supply. When demand is relatively inelastic, it is easier for sellers to shift taxes to buyers. When supply is relatively elastic, the seller is more likely to assume the burden of taxes.

Suppose cigarettes cost £1 a packet in the absence of a cigarette tax and the government imposes a tax of 50p per packet. Do cigarette smokers end up paying the tax or is it borne by manufacturers of cigarettes? It all depends on how much of the tax cigarette producers can pass on to the consumer. We now show that this depends on the slopes of the supply and demand curve.

In parts (a) and (b) of the figure we plot the (after-tax) price to the consumer on the vertical axis. DD' shows the demand curve, which depends on the price to cigarette smokers (consumers). Since the price received by the producer is the consumer price minus the 50p tax per packet, the effect of levying the tax is to shift the supply curve from SS to SS" in both diagrams. Each possible quantity supplied depends on the price received by the producer, which will be the same as before only if consumer prices are 50p higher; that is why we must shift the supply curve up by 50p.

(a) Steep demand, flat supply

Q, Q₂

Quantity

 

In part (a), with a flat supply curve and steep demand curve, the tax is borne mainly by cigarette consumers. Point В is nearly 50p higher than point A. Since demand is inelastic, producers can pass on most of the tax in higher prices. Supply is elastic, so any significant drop in the price received by producers would lead to a large drop in the quantity produced. Consumers pay £1.45 and producers get £0.95 a packet. In part (b), with a flat demand curve and a steep supply curve, most of the tax is borne by cigarette producers. Demand is elastic, so attempts to pass on the tax in higher prices quickly lead lo a drop in the quantity of cigarettes sold. Supply is inelastic, and firms produce nearly as many cigarettes even though the price they receive (after tax) has fallen nearly 50p from point A lo point C. Consumers pay £1.05 and producers get £0.55 a packet.

(b) Flat demand, steep supply

Q, Q₂

Quantity

 

Incidence refers to the individual or business that will bear the burden of a tax. For example, in many localities businesses have to pay a sales tax on their gross receipts. If, for example, your community charged a 5 percent sales tax, a store with $1,000 in sales would have to pay $50 in taxes. But sales taxes are normally added on to the selling price of a good or service. In other words, the incidence of a sales tax falls upon consumers.

 

 

Exercise 1. Answer the following questions:

1. When the government increases the sales tax on a product, who pays this tax?

2. Give an example of a good where the tax is mainly passed on to the consumer, and a good where it is largely borne by the producer. Why is this?

Exercise 2. Describe and compare parts (a) and (b) of the figure. Explain the possible influence of the tax increase on the demand for and the supply of cigarettes.