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Unformatted text preview: Chapter 19 Distortionary Taxes and Subsidies In Chapter 18, we began our discussion of how policies that alter or distort market prices in a competitive market can create dead weight losses. 1 But such policies are not limited to those that explicitly set price floors above the equilibrium price or price ceilings below the equilibrium price. In fact, the most common government policies that distort market prices involve tax and subsidy policies rather than explicit regulatory policies aimed at setting prices directly. With federal, state and local governments funded primarily through taxes, and with all government spending combined making up more than 40 percent of most economies, tax policy then becomes a particularly important area for understanding how price distortions impact welfare. Because of the important role taxes play in most economies, we have already developed many of the concepts that are crucial to understanding tax policy in earlier chapters, particularly in the chapters leading up to and including Chapter 10. We already understand from this development that, on the consumer (or worker or saver) side of markets, taxes result in dead weight losses or inefficiencies to the extent to which they give rise to substitution effects . Now that we have added producers to the model, however, we are able to talk much more explicitly about how taxes affect economic behavior in equilibrium when all sides of the market respond to changes in incentives. This makes it possible to now become explicit about who is affected most by particular taxes who ends up paying taxes in equilibrium, and how this translates to welfare changes for consumers, producers and workers as well as society overall. Again, it is worth noting that, in pointing out the logic behind the emergence of dead weight losses from taxation, the economist is not voicing opposition to taxes per se. Rather, the economist is in the business of identifying costs and benefits leaving it up to others to judge whether particular policies with particular costs and benefits are good or bad. Taxes have hidden costs that policy makers should understand, and some taxes have greater hidden costs than others. Similarly, some taxes may appear to affect one group on the surface while in fact economic analysis suggests that they will actually affect a different group much more. Understanding issues of this kind is the point of this chapter, with later chapters identifying more clearly why we might indeed need to use taxes despite their hidden costs. As in the previous chapter, it is also important to note that the 1 In addition to the usual consumer theory material, this chapter includes material on labor and capital markets material which draws on our development of models in Chapters 3 and 8 as well as the later sections of Chapter 9....
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- Fall '09