Economics in Minutes

by Niall Kishtainy

  Tax incidence

  Tax incidence is the study of who ultimately bears the burden of a tax; this can be different from who formally pays the tax authorities. When people talk about companies passing on taxes to customers through higher prices, this is what they are referring to (see Taxing corporations). Suppose the government levies a tax on paint – the tax acts like a production cost, so it causes manufacturers to supply less paint. Lower supply in turn leads to a higher price, so both the buyer and the seller lose out: the seller doesn’t sell as much and the buyers pay more. Suppose now that buyers are fairly insensitive to price changes, perhaps because there are few alternatives to using paint. If they are less sensitive to prices changes than the suppliers, they will be willing to bear more of the burden of the tax, so a larger share of the tax can be passed onto them without affecting demand too much. Conversely, if buyers are sensitive to price rises – perhaps they are willing to buy wallpaper instead of paint – then the seller will have to bear most of the tax impact.

  Direct and indirect taxation

  A direct tax is imposed on particular individuals or companies who pay the tax authorities directly – you typically have no choice about whether to pay it. For example, workers pay income tax and companies pay taxes on their profits. Indirect taxes, meanwhile, aren’t imposed on particular individuals. They are typically collected by intermediaries like a shop and then passed onto the government. The most common form of an indirect tax is a tax on transactions such as a sales tax, and by refraining from a purchase one wouldn’t pay the tax.

  It is sometimes argued that indirect taxes such as sales taxes are preferable to income taxes because taxes on labour discourage people from working. But even indirect taxes reduce real income by increasing prices, and taxes on some products rather than others distort the relative prices of goods, making markets work less efficiently. Indirect taxes are also criticized as ‘regressive’: lower income groups end up paying relatively more in tax as a share of their income.

  The deadweight loss of taxation

  The benefits of taxation come with a cost, in terms of their interference with the market mechanism. Taxes on goods increase the prices of some goods relative to others, and income tax reduces workers’ take-home wages, leading to so-called ‘deadweight losses’.

  Suppose that the government increases the income tax rate. This will reduce workers’ disposable incomes, but increase the revenue for spending on public services. The higher rate makes some people work less, reducing their welfare, and the government doesn’t gain any extra revenue to offset these lower hours. This is the deadweight loss to the economy. Incentive effects come from the marginal tax rate: this is the rate on an extra hour of work. When high, it may not be worth working more. Marginal rates tend to be lower at low income levels, so at high levels the average rate of tax – the share of total income that goes on tax – is often much less than the marginal rate.

  Lump-sum taxes

  The UK government’s introduction of a lump-sum tax in 1989–90 (dubbed the Poll Tax) sparked widespread protests at its perceived unfairness.

  Economists view taxation as a necessary evil: people need governments, but taxes have incentive effects that hamper markets – income tax might make people work less, for example. Lump-sum taxes are fixed amounts to be paid by everyone regardless of income: they are an important kind of tax because they have no incentive effects. Because work decisions have no impact on my tax bill, I ignore the tax when deciding how much to work: the marginal tax – the rate of tax on extra work – for a lump-sum tax is zero.

  In this sense, lump-sum taxes don’t interfere with market incentives. However, the average rate – the share of total income paid in tax – for a lump-sum tax is higher at lower income levels, making them ‘regressive’ taxes. At an income of £10,000, a £1,000 lump-sum tax would imply an average rate of 10 per cent. At £1,000 income, the rate would be 100 per cent. The poor pay proportionately more, so although lump-sum taxes are efficient, many believe them to be unfair.

  Redistributive taxation

  In order to provide schools and hospitals, the government has to tax its population, but how should the burden of taxation be distributed? Economists often focus on the impact of taxation on economic efficiency: a fixed £500 tax on everyone is efficient because it doesn’t influence how much people work, but such a tax might be considered unfair. Many argue that those with a greater ability to pay should contribute more.

  All taxes redistribute income in some way, but redistributive taxation, as well as raising revenue also has a goal of making income distribution fairer. Progressive tax systems place a higher rate of tax on the rich, fulfilling the principle that those with greater ability to pay should contribute more, and also making distribution of income more equal. Under proportional systems, all taxpayers contribute the same fraction of income. Under regressive tax systems, even though the rich may pay more in absolute terms, they pay a lower fraction of their income than the poor.

  United Kingdom taxpayers and revenue shares, 2009–10

  The welfare state

  People inevitably lose jobs, get ill and become too old to work. To deal with these situations, governments fund health care and provide social security, paying a basic income to individuals who are unable to support themselves. Why can’t private markets do the job by insuring people against ill health or unemployment? Economists now understand how imbalances of information between buyers and sellers mean that insurance markets often don’t work very well. For example, because distinguishing between healthy and unhealthy people is difficult, insurers will take the very fact that a person asks for health insurance as an indication that he is unhealthy. This raises premiums and means that some people don’t get insured. One rationale for social insurance or state provision of health care is to get around these market failures. The downside of such a ‘welfare state’ is that it may lead to adverse incentives. If health care is paid for, people might be less careful about their health, and the debate continues about the extent to which unemployment benefits encourage people to stay out of work.

  Pensions

  Economists think about an individual’s earning, saving and consumption in terms of a life cycle: people earn and save when young, and use up their savings when old (see The life cycle and permanent income). One way in which people save for their old age is through pensions. Governments provide a basic retirement income to the elderly – the state gets involved here in order to deal with problems inherent in the market provision of retirement incomes. On their own, individuals may find it difficult to plan income streams for decades ahead. It might be hard to get the necessary information and to know what to do with it.

  Furthermore, private pension provision faces the problem that people may end up living for a long time, and individuals buying pensions are likely to be those who expect to live for a long time. Since this would cause a loss to the seller, private markets will tend to undersupply, suggesting another reason for state provision. Recently in the West, provision of pensions by employers, alongside the state, has become more common.

  Price controls and subsidies

  Governments sometimes restrict prices in key markets. Minimum wage laws place a floor on pay, while rent controls impose a ceiling on accommodation costs. Much of this is aimed at helping the poor, but by tinkering with demand-and supply-determined prices, controls have costs.

  Suppose that a rent of £600 a month brings the supply of flats into line with demand: at £600 everyone demanding a flat can rent one. The government, however, then sets a rent ceiling of £500. Demand for flats rises and supply falls, so not everyone who wants a flat can get one. So flats have to be distributed by non-market means: perhaps those who are willing to wait the longest, or those with favourable personal connections obtain one. As time goes on, fewer new flats get built and the shortfall becomes even greater. The rent control helps those with flats, but shuts others out. Price floors have the opposite effect, leading to s
urpluses. Advocates of price controls argue that their social benefits outweigh these sorts of costs.

  How rent ceilings create excess demand

  Minimum wages

  Since 1999 the United Kingdom has enforced a legal minimum wage. What are the arguments for and against such a measure? A minimum wage interferes with the normal functioning of the labour market, in which wages are determined by the supply and demand of labour. Legal minimum wages are usually a fraction of the average wage, so in most segments of the labour market they have no impact.

  In low-wage sectors, however, the minimum wage bites. Where the imposition of a legal minimum does raise the wage, the supply of labour increases and the demand for it falls. Because more people are seeking work than offering it, unemployment results, and the wage is not allowed to adjust downwards to bring supply back into line with demand. For this reason, some economists criticize the use of minimum wages. Others argue that the the unemployment effect of the minimum wage is limited, and that any disadvantages from this are outweighed by the improved living standards of low-income workers.

  Competition policy

  Standard economics sees competition as leading to an efficient allocation of resources: when firms compete, they supply what consumers want at low prices. But often markets deviate from this ideal. The aim of competition (or anti-trust) policy is to ensure market competition. Suppose that Dairy Foods is contemplating a merger with Farmhouse Produce. Both are major suppliers of butter and if combined they would control 75 per cent of the butter market. The question for the competition authorities is whether this large market share would allow the merged firm to act like a monopoly and raise prices – if so, then it might forbid the merger. If there were products that consumers considered to be substitutes for butter – margarine perhaps – then the 75 per cent butter share would imply a lower degree of market power. Other anti-competitive practices that competition policy tries to counter include collusion between firms to fix prices in cartels (see Cartels), and the predatory use of very low prices to drive competitors from the market (see Predation).

  Regulation

  Utilities such as the water supply are natural monopolies, and are therefore a good target for government regulation.

  Even in market economies, governments regulate businesses where competition is absent. ‘Natural monopolies’, such as water suppliers, have average costs that decline as output rises because of large set-up investments. One large firm is cheaper than several firms operating different networks, but how do you stop the monopolist from charging high prices? The most efficient amount of water production is that for which the price – the value consumers place on the last unit of water – is equal to the cost of producing it (the marginal cost). To boost profits, monopolists produce less, charging more. The regulator could compel the water company to produce until price equals marginal cost. But at this high level of production, price becomes so low that the natural monopolist no longer covers average costs and makes a loss. One response to this problem is to subsidize the monopolist; an alternative is to set a price cap that allows the firm to remain viable. All of these solutions have drawbacks, so regulation is complex and often politically contentious.

  Taxing pollution

  When the slurry by-product from a group of mines reduces the fertility of the surrounding soil so that adjacent nurseries produce less flowers, we have an ‘externality’ (see Externalities). The slurry is a cost to society because it lowers flower production and the profit of the nurseries. However, the mines don’t take this into account: they end up producing ‘too much’ coal and pollution. The government could compel the mines to produce less pollution. Alternatively, they could tax pollution, charging the mines for every tonne of slurry produced.

  Such a pollution tax is set at a level that takes into account all the costs and benefits to society. It makes the mines face the social cost of their activities where market prices didn’t, in a sense ‘internalizing’ the externality. Taxes allow the polluters to respond in various ways: some may find it easy to pollute less, but for others this could prove very costly, so they reduce it less and pay more tax. Overall, this can lead to an efficient distribution of pollution-reduction efforts among the mines.

  Valuing human life

  Should a council hire an extra lifeguard for its swimming pool? To decide, the council has to compare the salary costs with the benefits in terms of lives saved. But how can one express the value of a life in money – surely life is priceless? Because resources are scarce, putting an infinite value on life leads to an absurdity: it might require the council to spend unlimited amounts on safety, to hire hundreds of lifeguards, install advanced CCTV cameras and build a poolside medical centre. Eventually resources would be taken away from schools, hospitals and rubbish collection. In reality, pools are staffed only to reduce risks to a reasonable level.

  Economists argue that there must be an implicit value placed on lives to determine how much safety is worthwhile. They compute life values by seeing how much people are willing to pay to eliminate risks. One way is to look at the difference in wages between risky and less risky jobs. Some studies have estimated the value of life in the US at around US$7 million.

  Comparative advantage

  Britain has a comparative advantage in beer, France in cheese.

  Suppose that France is better at making cheese, England at beer. If France specializes in cheese and England in beer and the two countries trade, then both gain: the French get cheaper beer, the English cheaper cheese. The theory of comparative advantage shows that even if England was worse at both goods, there are still gains from specialization and trade. Suppose that to make an extra keg of beer, England has to give up two wheels of cheese output, while France would have to give up three wheels of cheese to make an extra keg. England has a comparative advantage in beer production because the ‘cost’ of extra beer in terms of cheese is less than for France. This can be the case even if in absolute terms France is better at making both goods. Both countries can still gain if England specializes in beer and France in cheese. What determines countries’ comparative advantage? The availability of capital and labour in a country is one factor, although how countries build up comparative advantage in the longer term is a more complex story.

  The balance of payments

  A country’s balance of payments is a record of payments and receipts between its firms and individuals and those of other countries. The balance of payments always balances: total payments equal total receipts, and only components of the overall balance of payments can be in deficit or surplus. For example, if the US exports £10 million worth of mobile phones to Britain and Britain sells nothing to the US, then Britain has a ‘trade deficit’ of £10 million, but US businesses now hold an extra £10 million of British assets, representing a surplus on the ‘capital account’ – the segment of the balance of payments that records capital flows between countries.

  People often worry about trade deficits: they can arise if domestic goods are not internationally competitive due to the low productivity of domestic firms. However, there are many reasons for trade deficits, and not all of them are bad: for instance, a country might be growing fast, building lots of roads and so importing large volumes of tarmac and steel.

  Free trade

  While the Corn Laws protected British famers from foreign competition, they also limited supply and kept prices high, forcing working people to spend a substantial amount of their income on staples. Huge rallies were held as part of the campaign for abolition.

  Free trade happens when countries open up their markets to foreign goods through the removal of tariffs and quotas on imports or the repeal of laws and regulations that hinder trade. Most economists welcome free trade, since it brings the expansion of markets and competition.

  An early step towards free trade was taken by Britain in 1846 when it abolished the ‘Corn Laws’ protecting British farmers from foreign competition. Since then, free trade has waxed and wan
ed, retreating between the wars, advancing again in the latter part of the 20th century. Sometimes free trade is served through bilateral agreements between countries, sometimes through multilateral treaties such as those of the World Trade Organization. Some economists question the consensus that free trade is always a good thing, pointing out that it can hurt some groups of workers, and that countries at early stages of development might need some protection from foreign competition to expand their industries.

  Protectionism and trade wars

  Major global trading blocs

  AL: Arab League

  ASEAN: Association of Southeast Asian Nations

  AU: African Union

  CAIS: Central American Integration System

  EU: European Union

  NAFTA: North American Free Trade Agreement

  PIF: Pacific Islands Forum

  SAARC: South Asian Association for Regional Cooperation

  SCO: Shanghai Cooperation Organization

  UNASUR: Union of South American Nations