6. Economic Policy

6. Economic Policy

Main types of government policies

• Price Control:

price ceiling: a legal maximum on the price at which a good can be sold.

price floor: a legal minimum on the price at which a good can be sold.

• Taxes (direct & indirect)

  —> Specific taxes (specific sum per unit of consumption)

  —> Ad valorem taxes (% of consumption value) - mainly VAT = Mst.

• Subsidies

Price Ceiling

If the Price Ceiling is above the equilibrium point, the Price Ceiling has no effect on the market. Thus, It is not binding. If, however, the Price Ceiling is below the equilibrium point, then it is binding. We call this a shortage. The demand for cheap rentals is high, but, landlords are not willing to rent at low rents, development companies are not willing to build and the quality of the product deteriorates.

Shortage leads to a reduction of consumer and producer surplus.

Price Floor

When the equilibrium price is above the floor, the price floor is not binding. Market forces move the economy to the equilibrium, and the price floor has no effect.

When the the equilibrium price is below the floor, the price floor is a binding constraint on the market. At this floor, the quantity of alcohol supplied, 6 million units, exceeds the quantity demanded (3 million units), thus, a binding price floor causes a surplus.

indirect tax = a tax levied on the sale of goods and services (Taxes on expenditure)

In both of these scenarios, the effective consumer price is higher than the effective producer price.

• Steeper Supply Curve

• impact is similar to specific tax, but it is larger for high levels of demand than for low levels of demand

• Shift in the supply curve is not parallel, because with higher prices the seller has to give more to the government, since Ad valorem taxes are based on given percentages on the products price. So, with higher prices, the taxes increase.

When supply is more elastic than demand, the incidence of the tax falls more heavily on consumers than on producerers.

When demand is more elastic than supply, the incidence of the tax falls more heavily on producers than on consumers.

In general, a tax burden falls more heavily on the side of the market that is less price elastic.

Implications of taxes

• Taxes result in a change in market equilibrium. Taxes discourage market activity.

• Buyers pay more and sellers receive less, regardless of whom the tax is levied on. Buyers and sellers share the tax burden.

• Tax incidence is the manner in which the burden of a tax is shared among market participants.

• The way the burden of the tax divided depends on the price elasticity of demand and the price elasticity of supply. In general, a tax burden falls more heavily on the side of the market that is less price elastic.

Subsidies

• A subsidy is the opposite to a tax (“negative tax”).

• A subsidy is a payment to buyers and sellers to supplement income or lower costs and which thus encourages consumption or provides an advantage to the recipient.

• A subsidy effectively shifts the supply curve down, lowers the price to buyers and increases the quantities

• However:

• Subsidies are often payed from tax revenues.

• Subsidies can also result in overproduction (e.g. food production).

We already know that:

• It does not matter who a tax is levied on; buyers and sellers will share in the burden of the tax.

• A tax on a product means:

• The price that a buyer pays will be greater than the price the seller receives. • Therefore, there is a tax wedge between the two prices.

• The quantity sold will be smaller if there was no tax.

Deadweight loss —> the fall in total surplus that results from a market disortion, such as tax.

• For the small tax, tax revenue is small.

• As the size of the tax rises, tax revenue grows.

• But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market.

Administrative costs of taxes

• Complying with tax laws creates additional losses:

• Taxpayers spend time and money documenting, computing, and filling tax forms.

• These are additional administrative costs they incur, over and above the actual taxes they pay.

• The administrative burden of any tax system is part of the inefficiency it creates.

Adam Smith‘s Principles of Taxation

• 1. Equality

• Each person should pay taxes according to their ability to pay.

• 2. Certainty

• Taxpayers need to know what taxes they owe, and governments should have some certainty in how much they are able to collect in taxes.

• 3. Convenience

• Paying taxes should be made as easy as possible

• 4. Economic

• The cost of collecting and administering taxes must be less than the amount collected.

Two more principles of taxation

• The benefits principle is the idea that people should pay taxes based on

the benefits they receive from government services.

• The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden.

The difficulty in formulating tax policy is balancing the often- conflicting goals of efficiency and equity.