ECON 201 SEU The Current Tax System Taxes Peoples Income Case Study

Question Description

I’m trying to study for my Economics course and I need some help to understand this question.

Case Study 

When taxes induce people to change their behavior—such as inducing Jane to buy less pizza—the taxes cause deadweight losses and make the allocation of resources less efficient. As we have already seen, much government revenue comes from the individual income tax in many countries. In a case study in Chapter 8, we discussed how this tax discourages people from working as hard as they otherwise might. Another inefficiency caused by this tax is that it discourages people from saving.
Consider a person 25 years’ old who is considering saving $1,000. If he puts this money in a savings account that earns 8 percent and leaves it there, he would have $21,720 when he retires at age 65. Yet if the government taxes one-fourth of his interest income each year, the effective interest rate is only 6 percent. After 40 years of earning 6 percent, the $1,000 grows to only $10,290, less than half of what it would have been without taxation. Thus, because interest income is taxed, saving is much less attractive.
Some economists advocate eliminating the current tax system’s disincentive toward saving by changing the basis of taxation. Rather than taxing the amount of income that people earn, the government could tax the amount that people spend.
Under this proposal, all income that is saved would not be taxed until the saving is later spent. This alternative system, called a consumption tax, would not distort people’s saving decisions.
Various provisions of the current tax code already make the tax system a bit like a consumption tax. Taxpayers can put a limited amount of their saving into special accounts—such as Individual Retirement Accounts and 401(k) plans—that escape taxation until the money is withdrawn at retirement. For people who do most of their saving through these retirement accounts, their tax bill is, in effect, based on their consumption rather than their income.
European countries tend to rely more on consumption taxes than does the United States. Most of them raise a significant amount of government revenue through a value-added tax, or a VAT. A VAT is like the retail sales tax that many U.S. states use, but rather than collecting all of the tax at the retail level when the consumer buys the final good, the government collects the tax in stages as the good is being produced (that is, as value is added by firms along the chain of production). Various U.S. policymakers have proposed that the tax code move further in direction of taxing consumption rather than income. In 2005, economist Alan Greenspan, then Chairman of the Federal Reserve, offered this advice to a presidential commission on tax reform: “As you know, many economists believe that a consumption tax would be best from the perspective of promoting economic growth—particularly if one were designing a tax system from scratch—because a consumption tax is likely to encourage saving and capital formation. However, getting from the current tax system to a consumption tax raises a challenging set of transition issues.”
Q1: What should be taxed – Personal Income or Personal Consumption and why? Provide your opinion based on the case given below. 
Q2: How may it affect Saudi Economy if an income tax is imposed in KSA?

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N. Gregory Mankiw
Principles of
Macroeconomics
Sixth Edition
9
Application:
International Trade
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Premium
PowerPoint
Slides by
Ron Cronovich
In this chapter,
look for the answers to these questions:
• What determines how much of a good a country
will import or export?
• Who benefits from trade? Who does trade
harm? Do the gains outweigh the losses?
• If policymakers restrict imports, who benefits?
Who is harmed? Do the gains from restricting
imports outweigh the losses?
• What are some common arguments for
restricting trade? Do they have merit?
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Introduction
? Recall from Chapter 3:
A country has a comparative advantage in a
good if it produces the good at lower opportunity
cost than other countries.
Countries can gain from trade if each exports the
goods in which it has a comparative advantage.
? Now we apply the tools of welfare economics
to see where these gains come from and
who gets them.
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2
The World Price and
Comparative Advantage
? PW = the world price of a good,
the price that prevails in world markets
? PD = domestic price without trade
? If PD < PW, ? country has comparative advantage in the good ? under free trade, country exports the good ? If PD > PW,
? country does not have comparative advantage
? under free trade, country imports the good
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3
The Small Economy Assumption
? A small economy is a price taker in world markets:
Its actions have no effect on PW.
? Not always true—especially for the U.S.—but
simplifies the analysis without changing its lessons.
? When a small economy engages in free trade,
PW is the only relevant price:
? No seller would accept less than PW, since
she could sell the good for PW in world markets.
? No buyer would pay more than PW, since
he could buy the good for PW in world markets.
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4
A Country That Exports Soybeans
Without trade,
PD = $4
Q = 500
PW = $6
Under free trade,
? domestic
consumers
demand 300
? domestic producers
supply 750
? exports = 450
Soybeans
P
S
exports
$6
$4
D
300 500 750
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Q
5
A Country That Exports Soybeans
Without trade,
CS = A + B
PS = C
Total surplus
=A+B+C
With trade,
CS = A
PS = B + C + D
Total surplus
=A+B+C+D
Soybeans
P
S
exports
A
$6
B
$4
C
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D
gains
from trade
D
Q
6
ACTIVE LEARNING
1
Analysis of trade
Without trade,
PD = $3000, Q = 400
P
Plasma TVs
S
In world markets,
PW = $1500
Under free trade,
how many TVs
will the country
import or export?
$3000
$1500
Identify CS, PS, and
total surplus without
trade, and with trade.
D
200
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
400
600
Q
ACTIVE LEARNING
Answers
Under free trade,
? domestic
consumers
demand 600
? domestic
producers
supply 200
? imports = 400
1
P
Plasma TVs
S
$3000
$1500
D
imports
200
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
600
Q
ACTIVE LEARNING
Answers
Without trade,
CS = A
PS = B + C
Total surplus
=A+B+C
1
P
Plasma TVs
S
gains
from trade
A
$3000
With trade,
B
CS = A + B + D
$1500
C
PS = C
Total surplus
=A+B+C+D
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D
imports
D
Q
Summary: The Welfare Effects of Trade
PD < P W PD > PW
direction of trade
exports
imports
consumer surplus
falls
rises
producer surplus
rises
falls
total surplus
rises
rises
Whether a good is imported or exported,
trade creates winners and losers.
But the gains exceed the losses.
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10
Other Benefits of International Trade
? Consumers enjoy increased variety of goods.
? Producers sell to a larger market, may achieve
lower costs by producing on a larger scale.
? Competition from abroad may reduce market
power of domestic firms, which would increase
total welfare.
? Trade enhances the flow of ideas, facilitates the
spread of technology around the world.
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11
Then Why All the Opposition to Trade?
? Recall one of the Ten Principles from Chapter 1:
Trade can make everyone better off.
? The winners from trade could compensate the losers
and still be better off.
? Yet, such compensation rarely occurs.
? The losses are often highly concentrated among
a small group of people, who feel them acutely.
The gains are often spread thinly over many people,
who may not see how trade benefits them.
? Hence, the losers have more incentive to organize
and lobby for restrictions on trade.
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12
Tariff: An Example of a Trade Restriction
? Tariff: a tax on imports
? Example: Cotton shirts
PW = $20
Tariff: T = $10/shirt
Consumers must pay $30 for an imported shirt.
So, domestic producers can charge $30 per shirt.
? In general, the price facing domestic buyers &
sellers equals (PW + T ).
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13
Analysis of a Tariff on Cotton Shirts
P
PW = $20
Cotton shirts
Free trade:
buyers demand 80
sellers supply 25
imports = 55
T = $10/shirt
price rises to $30
buyers demand 70
sellers supply 40
imports = 30
S
$30
$20
imports
imports
25
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40
70 80
D
Q
14
Analysis of a Tariff on Cotton Shirts
P
Free trade
CS = A + B + C
+D+E+F
PS = G
Total surplus = A + B
+C+D+E+F+G
Tariff
CS = A + B
PS = C + G
Revenue = E
Total surplus = A + B
+C+E+G
Cotton
shirts
deadweight
loss = D + F
S
A
B
$30
$20
C
D
E
F
G
25
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
70 80
D
Q
15
Analysis of a Tariff on Cotton Shirts
P
D = deadweight loss
from the
overproduction
of shirts
F = deadweight loss
from the underconsumption
of shirts
Cotton
shirts
deadweight
loss = D + F
S
A
B
$30
$20
C
D
E
F
G
25
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
70 80
D
Q
16
Import Quotas:
Another Way to Restrict Trade
? An import quota is a quantitative limit on imports
of a good.
? Mostly has the same effects as a tariff:
? Raises price, reduces quantity of imports.
? Reduces buyers’ welfare.
? Increases sellers’ welfare.
? A tariff creates revenue for the govt. A quota
creates profits for the foreign producers of the
imported goods, who can sell them at higher price.
? Or, govt could auction licenses to import to capture
this profit as revenue. Usually it does not.
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17
Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in industries that compete
with imports.
Economists’ response:
Look at the data to see whether rising imports
cause rising unemployment…
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18
U.S. Imports & Unemployment,
Decade averages, 1961–2010
16%
Imports
(% of GDP)
14%
12%
10%
8%
Unemployment
(% of labor force)
6%
4%
20012010
19912000
19811990
19711980
0%
19611970
2%
Arguments for Restricting Trade
1. The jobs argument
Trade destroys jobs in the industries that compete
against imports.
Economists’ response:
Total unemployment does not rise as imports rise,
because job losses from imports are offset by
job gains in export industries.
Even if all goods could be produced more cheaply
abroad, the country need only have a
comparative advantage to have a viable export
industry and to gain from trade.
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20
Arguments for Restricting Trade
2. The national security argument
An industry vital to national security should be
protected from foreign competition, to prevent
dependence on imports that could be disrupted
during wartime.
Economists’ response:
Fine, as long as we base policy on true security
needs.
But producers may exaggerate their own
importance to national security to obtain
protection from foreign competition.
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21
Arguments for Restricting Trade
3. The infant-industry argument
A new industry argues for temporary protection
until it is mature and can compete with foreign
firms.
Economists’ response:
Difficult for govt to determine which industries
will eventually be able to compete and whether
benefits of establishing these industries exceed
cost to consumers of restricting imports.
Besides, if a firm will be profitable in the long run,
it should be willing to incur temporary losses.
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22
Arguments for Restricting Trade
4. The unfair-competition argument
Producers argue their competitors in another
country have an unfair advantage,
e.g. due to govt subsidies.
Economists’ response:
Great! Then we can import extra-cheap products
subsidized by the other country’s taxpayers.
The gains to our consumers will exceed the
losses to our producers.
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23
Arguments for Restricting Trade
5. The protection-as-bargaining-chip argument
Example: The U.S. can threaten to limit imports
of French wine unless France lifts their quotas
on American beef.
Economists’ response:
Suppose France refuses. Then the U.S. must
choose between two bad options:
A) Restrict imports from France, which reduces
welfare in the U.S.
B) Don’t restrict imports, which reduces U.S.
credibility.
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24
Trade Agreements
? A country can liberalize trade with
? unilateral reductions in trade restrictions
? multilateral agreements with other nations
? Examples of trade agreements:
? North American Free Trade Agreement
(NAFTA), 1993
? General Agreement on Tariffs and Trade
(GATT), ongoing
? World Trade Organization (WTO), est. 1995,
enforces trade agreements, resolves disputes
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25
SU MMA RY
• A country will export a good if the world price of the
good is higher than the domestic price without trade.
Trade raises producer surplus, reduces consumer
surplus, and raises total surplus.
• A country will import a good if the world price
is lower than the domestic price without trade.
Trade lowers producer surplus but raises consumer
and total surplus.
• A tariff benefits producers and generates revenue
for the govt, but the losses to consumers exceed
these gains.
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SU MMA RY
• Common arguments for restricting trade include:
protecting jobs, defending national security,
helping infant industries, preventing unfair
competition, and responding to foreign trade
restrictions.
• Some of these arguments have merit in some
cases, but economists believe free trade is
usually the better policy.
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N. Gregory Mankiw
Principles of
Macroeconomics
Sixth Edition
8
Application:
The Costs of Taxation
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Premium
PowerPoint
Slides by
Ron Cronovich
In this chapter,
look for the answers to these questions:
• How does a tax affect consumer surplus,
producer surplus, and total surplus?
• What is the deadweight loss of a tax?
• What factors determine the size of this
deadweight loss?
• How does tax revenue depend on the size of the
tax?
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Review from Chapter 6
? A tax
? drives a wedge between the price buyers pay
and the price sellers receive.
? raises the price buyers pay and lowers the price
sellers receive.
? reduces the quantity bought & sold.
? These effects are the same whether the tax is
imposed on buyers or sellers, so we do not
make this distinction in this chapter.
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2
The Effects of a Tax
P
Eq’m with no tax:
Price = PE
Quantity = QE
Eq’m with
tax = $T per unit:
Buyers pay PB
Sellers receive PS
Size of tax = $T
S
PB
PE
PS
D
Quantity = QT
QT
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QE
Q
3
The Effects of a Tax
P
Revenue from tax:
$T x QT
Size of tax = $T
S
PB
PE
PS
D
QT
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QE
Q
4
The Effects of a Tax
? Next, we apply welfare economics to measure
the gains and losses from a tax.
? We determine consumer surplus (CS),
producer surplus (PS), tax revenue,
and total surplus with and without the tax.
? Tax revenue can fund beneficial services
(e.g., education, roads, police),
so we include it in total surplus.
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5
The Effects of a Tax
P
Without a tax,
CS = A + B + C
PS = D + E + F
Tax revenue = 0
Total surplus
= CS + PS
=A+B+C
+D+E+F
A
S
B
PE
D
C
E
D
F
QT
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QE
Q
6
The Effects of a Tax
With the tax,
CS = A
PS = F
Tax revenue
=B+D
Total surplus
=A+B
+D+F
P
A
PB
S
B
D
C
E
PS
D
F
The tax reduces
total surplus by
C+E
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QT
QE
Q
7
The Effects of a Tax
P
C + E is called the
deadweight loss
(DWL) of the tax,
the fall in total
surplus that
results from a
market distortion,
such as a tax.
A
PB
S
B
D
C
E
PS
D
F
QT
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
QE
Q
8
About the Deadweight Loss
Because of the tax,
the units between
QT and QE are not
sold.
The value of these
units to buyers is
greater than the cost
of producing them,
P
PB
S
PS
D
so the tax prevents
some mutually
beneficial trades.
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QT
QE
Q
9
ACTIVE LEARNING
Analysis of tax
A. Compute
CS, PS, and
total surplus
without a tax.
B. If $100 tax
per ticket,
compute
CS, PS,
tax revenue,
total surplus,
and DWL.
1
P
The market for
airplane tickets
$ 400
350
300
S
250
200
150
D
100
50
Q
0
0
25
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50
75 100 125
ACTIVE LEARNING
Answers to A
CS
= ½ x $200 x 100
= $10,000
1
P
The market for
airplane tickets
$ 400
350
300
S
250
PS
= ½ x $200 x 100 P = 200
= $10,000
150
D
100
Total surplus
= $10,000 + $10,000 50
= $20,000
0
Q
0
25
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50
75 100 125
ACTIVE LEARNING
Answers to B
CS
= ½ x $150 x 75
= $5,625
1
P
$ 400
350
300
PS = $5,625
PB = 250
Tax revenue
= $100 x 75
= $7,500
200
PS = 150
Total surplus
= $18,750
50
DWL = $1,250
A $100 tax on
airplane tickets
S
D
100
Q
0
0
25
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50
75 100 125
What Determines the Size of the DWL?
? Which goods or services should govt tax
to raise the revenue it needs?
? One answer: those with the smallest DWL.
? When is the DWL small vs. large?
Turns out it depends on the price elasticities
of supply and demand.
? Recall:
The price elasticity of demand (or supply)
measures how much QD (or QS) changes
when P changes.
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13
DWL and the Elasticity of Supply
When supply
is inelastic,
it’s harder for firms
to leave the market
when the tax
reduces PS.
So, the tax only
reduces Q a little,
P
S
Size
of tax
and DWL is small.
D
Q
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14
DWL and the Elasticity of Supply
The more elastic is
supply,
the easier for firms
to leave the market
when the tax
reduces PS,
the greater Q falls
below the surplusmaximizing quantity,
P
S
Size
of tax
the greater the DWL.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
D
Q
15
DWL and the Elasticity of Demand
When demand
is inelastic,
P
S
it’s harder for
consumers to
leave the market
when the tax
raises PB.
Size
of tax
So, the tax only
reduces Q a little,
D
Q
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
and DWL is small.
16
DWL and the Elasticity of Demand
The more elastic is
demand,
P
the easier for buyers
to leave the market
when the tax
increases PB,
S
Size
of tax
the more Q falls
below the surplusmaximizing quantity,
D
Q
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and the greater the
DWL.
17
ACTIVE LEARNING
2
Elasticity and the DWL of a tax
Would the DWL of a tax be larger if the
tax were on:
A. Breakfast cereal or sunscreen?
B. Hotel rooms in the short run or
hotel rooms in the long run?
C. Groceries or meals at fancy restaurants?
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ACTIVE LEARNING
Answers
2
A. Breakfast cereal or sunscreen
From Chapter 5:
Breakfast cereal has more close substitutes
than sunscreen, so demand for breakfast cereal
is more price-elastic than demand for
sunscreen.
So, a tax on breakfast cereal would cause a
larger DWL than a tax on sunscreen.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
Answers
2
B. Hotel rooms in the short run or long run
From Chapter 5:
The price elasticities of demand and supply
for hotel rooms are larger in the long run than
in the short run.
So, a tax on hotel rooms would cause a larger
DWL in the long run than in the short run.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
Answers
2
C. Groceries or meals at fancy restaurants
From Chapter 5:
Groceries are more of a necessity and therefore
less price-elastic than meals at
fancy restaurants.
So, a tax on restaurant meals would cause a
larger DWL than a tax on groceries.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING
3
Discussion question
? The government must raise tax revenue to pay
for schools, police, etc. To do this, it can either
tax groceries or meals at fancy restaurants.
? Which should it tax?
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How Big Should the Government Be?
? A bigger government provides more services,
but requires higher taxes, which cause DWLs.
? The larger the DWL from taxation,
the greater the argument for smaller government.
? The tax on labor income is especially important;
it’s the biggest source of govt revenue.
? For the typical worker, the marginal tax rate
(the tax on the last dollar of earnings) is about 40%.
? How big is the DWL from this tax?
It depends on elasticity….
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23
How Big Should the Government Be?
? If labor supply is inelastic, then this DWL is
small.
? Some economists believe labor supply is
inelastic, arguing that most workers work
full-time regardless of the wage.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
How Big Should the Government Be?
Other economists believe labor taxes are highly
distorting because some groups of workers have
elastic supply and can respond to incentives:
? Many workers can adjust their hours,
e.g., by working overtime.
? Many families