Chapter 7

Taxation and Efficiency

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Lump-Sum Taxes
 A Lump-sum tax is a fixed tax that is
owed by everyone and is not subject to
anything taxpayers can change.

 It is independent of income,
consumption, or wealth.

 An example is a Head Tax, which is

constant for everyone.

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 Inefficiency in Taxation and the Lump-
Sum Tax
 Inefficiency in taxation results from the ability
to avoid taxes by avoiding a taxed activity.

 Because lump-sum taxes are unavoidable,

they serve as the benchmark by which other
taxes are measured in terms of efficiency.

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 Price Distorting Taxes

 A price distorting tax alters the relative

price of goods.

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 Figure 11.1 A Price Distorting Tax Versus
A Lump-Sum Tax
A

T
Expenditure on Other Goods

Y* L
per Year (Dollars)

T
YT
E' E
Y1
E''

U1 U2 U3

B' L' B
0 Q T QL Q1
Gasoline per Year (Gallons)
5
Individual Excess Burden of a Tax

The individual excess burden of a tax

is the loss in well-being when a
taxpayer pays taxes under a price-
distorting tax instead of under a lump-
sum tax.

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Community Charges in the U.K.
 The Thatcher government replaced local
property taxes with a form of lump-sum tax
called “the community charge.’’

 The tax was set by each local council and

charged a fixed amount per adult taxpayer.

 Despite its efficiency, the lump-sum tax was

viewed as so unfair by many taxpayers that
they refused to pay it.

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Unit Taxes

 A unit tax adds to the price by a fixed

amount. Examples include the 32 cents
per pack of cigarettes and 24 cents per
gallon of gasoline in federal taxes.

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Tax Terms

 The Gross Price (PG) is the price paid

by consumers.

 The Net Price (PN) is the price received

by producers after the tax is paid.

 PN = PG – T

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 Figure 11.2 Impact of A Unit Tax on
Market Equilibrium
ST = MSC +$0.25
S = MSC
Tax Revenue
C
Price (Dollars)

1.15 = PG Excess Burden

1.00 B
0.90 = PN A

T = $0.25

Q D = MSB

0 Q1 Q*
Gasoline per Year (Gallons) 10
Excess Burden of a Unit Tax

DWL = 1/2TQ
=1/2 ×T2 × (Q*/P*) × (ESED)/(ES – ED)

(A Step-by-step algebraic derivation is in the appendix to

Chapter 11)

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 Implication of the DWL Calculation

 A doubling of the per-unit tax

quadruples the Deadweight Loss.

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 Figure 11.3 Excess Burden When Demand or
Supply is Perfectly Inelastic

A Supply B
Demand Supply
after Tax

Supply

Price
Price

Demand
Net Price
after Tax

0 q 0 q
Quantity per Month Quantity per Month

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Efficiency Loss Ratio of a Tax

 The Efficiency Loss Ratio is the

deadweight loss per dollar of revenue
raised DWL/R .

 Estimates of U.S. tax system place

ELR at between 25 and 40 cents per
dollar of tax revenue raised.

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 Incidence of a Tax
 The Legal Incidence is the burden of a tax
as determined by those who are legally
obligated to pay the tax. 

 The Economic Incidence is the burden of a

tax as determined by how much the
parties are affected in terms of paying
higher prices, or receiving lower prices.

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Shifting of Taxes
 Forward Shifting is the transfer of the
burden of a tax from the seller, who is
legally obligated to pay it, to a buyer. 

 Backward Shifting is the transfer of the

burden of a tax from the buyer, who is
legally obligated to pay it, to a seller.

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Ad-Valorem Taxes

 Ad-Valorem Taxes add a fixed

percentage to the price of a good.

 The primary example is sales taxes.

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 Incidence of an Ad-valorem tax

DWL = 1/2 TQ

T = tPG

= 1/2 t2PG2(Q*/P*) × (ESED)/(ES – ED)

if t is very small, then this is

approximately
= 1/2 t2P*Q*(ESED)/(ES – ED) 18
 Figure 11.5 Incidence of a Tax Collected From Buyers

S = MSC

PG + T =1.15 C
Price (Dollars)

1.00 B
PG = 0.90 A

D = MSB
D' = MSB – T

0 Q1 Q*
Price per Year (Gallons) 19
 Figure 11.6 The More Inelastic the Demand, the
Greater the Portion of a Tax Borne by Buyers
S = MC + $0.25
S = MC
E
1.20 C
1.15
Price (Dollars)

1.00 B
.95
.90 A

D’
Q’ D
Q’

0 Q1 Q2 Q*
Gasoline per Year (Gallons) 20
 Figure 11.7 Impact of a Tax on a Good with
a Perfectly Elastic Supply
Price (Cents)

E'
60 MC + T = S'
E
50 MC = S'

0 Q1 Q*
Housing per Month Square Feet
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 Figure 11.8 Tax Incidence When
Market Supply is Perfectly Inelastic
S
Wages (Dollars)

WG* E
tw*G
F
WN= WG*(1-t)

D=W
WN= WG*(1-t)

0 Q*
Labor Hours per Year 22
Government Taxes and Expenditures and
the Distribution of Income
 The Tax Incidence is who bears the burden of a tax. 

 The Expenditure Incidence is who receives the

benefits of a government program.

 The Budget Incidence is the net analysis of a

program’s tax and expenditure incidence.

 The Differential Tax Incidence is the change in the tax

incidence that results from substituting one equal
yield tax for another.

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The Lorenz Curve

 The Lorenz Curve maps the cumulative

percentage of households against their
cumulative percentage of income.

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 Figure 11.12 A Lorenz Curve
100 E
Percentage of Real Income Line of Equal Distribution

75
60 y
50
Area A

25
20 Area B
10
5 x
3 D
0 10 25 50 75 100
Percentage of Households
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The Gini Coefficient
 The Gini Coefficient is the ratio of the
area between the Lorenz curve and the
perfect equality line (Area A in the
previous slide) to the area under the
perfect equality line (Areas A and B).

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