The Basics of Taxes

In the two of the previous articles, we went over some of the forces that affect supply and demand. I left two of the forces – taxes and subsidies – out, because their effects are often misunderstood. This article focuses on one of those forces – taxes.

Before getting into the graphs – what exactly are taxes? Think of taxes as punishments. If you go to the store and want to buy cereal, but have to pay a sales tax – you are being punished for your action. When you are punished for doing something, you will not take the action as often as you did before the punishment. So, when you have to pay a sales tax, you will buy less of the good.

Let’s look at the first graph below.

This graph shows the supply and demand curves for PlayStation 3s. The equilibrium price is $260 and 460 thousand consoles – the point at which the demand curve and the original supply curve intersect. But then, there is a tax of $80 dollars on the supplier. This means that the supplier must pay $80 to the government for each console that they produce. What happens now?

Now, that there is an $80 dollar tax on each console produced, suppliers will be less willing to produce consoles at every price. Therefore, there is not just a movement along the supply curve – there is a change in supply altogether. The new curve is labeled as “Supply + Tax”.

Due to the change in supply, there is a new equilibrium point with lessened output and increased price. The price of a console is now $300. Since the price has been increased, consumers are going to pay more for the console. This $40 increase in price is a burden on the consumer. So, even though the tax was originally on the suppliers, consumers pay a portion of the tax. At this higher price, eighty dollars is taken out and given to the government. So, suppliers get $40 less than the previous equilibrium price – this represents the burden placed upon the sellers.

At the previous equilibrium point, there were 460 thousand consoles sold, but at the higher price, there are only 400 thousand consoles sold. So, there are 60 thousand fewer consoles sold. People will only trade voluntarily if they gain from it. The consoles that are no longer sold are gains from trade no longer made, or dead weight loss. This is represented by the blue area on the graph.

The key point to see on this graph is that consumers and suppliers are both being burdened by the tax on the suppliers. Consumers have to indirectly pay through higher prices while sellers have to pay directly through the tax. When people want to stop taxing the Average Joe and put the burden on Big Business – that is still going to increase the burden on Average Joe.

Most people agree that the government should tax its citizens and residents – how else will it run? But what should the optimal tax rate be? 70%? 20% 100%? The Laffer Curve can help shed a little bit of light on this.

The Laffer Curve is a thought experiment showing us the government’s revenue at different tax rates. Obviously, at a tax rate of 0%, the government has no revenue. However, note that a tax rate of 100% also has no revenue. This seems a bit odd – you would expect a tax rate of 100% to give the government quite a bit of revenue!

Let’s run our own thought experiment. Your name is Jim. I drug you and put a self-destruction device into your heart, which only I know how to turn off. I then tell you that you must give me all your income at the end of the year, or I will not turn off the device. I don’t care how much money you make. I just care that you give me all the money that you do make.

Tell me, what is your incentive to make any money at all? If you produce, you have to give it all away. You won’t produce anything.

The Laffer Curve’s lesson is that increasing the tax rate doesn’t necessarily increase government’s revenue. At some points along the curve, it likely does increase revenue. But there is some point  (t*) at which the government maximizes revenue. This point isn’t necessarily a 50% tax rate – I just put t* in the middle to make the graph prettier.

In the 1980s, the Reagan government used the Laffer Curve to justify tax cuts of the highest tax bracket – but there is debate over whether Reaganomics really did much to increase tax revenue. If you are interested in this, check out the wikipedia articles on the Laffer Curve and Reaganomics.

In the next article, we go over the basics of subsidies. Get ready for more!