Taxes

All governments—from the federal government in Washington, D.C., to the local governments in small towns—use taxes to raise revenue for public projects, such as roads, schools, and natkvial defense. Because taxes are such an important policy instrument, and because they affect our lives in many ways, we return to the study of taxes several times throughout this book. In this section, we begin our study of how taxes affect the economy.

To set the stage for our analysis, imagine that a local government deckles to hokl an annua) icc-cream celebration—with a parade, fireworks, ami speeches by town officials. To raise revenue to pay for the event, the town decides to place a $0.50 tax on the sale of ice-cream cones. When the plan is announced, our two lobbying groups swing into action. The American Association of Ice-Cream Eaters claims that consumers of ice cream are having trouble making ends meet, and it argues that seller» of ice cream should pay the tax. The National Organisation of lee-Cream Makers claims that its members are struggling to survive in a competitive market, and it argues that buyer* of icc cream should pay the tax. The town mayor, hoping to reach a compromise, suggests that half the tax be paid by the buyers and half be paid by the sellers.

To analyze these proposals, we need to address a simple but subtle question: When the government levies a tax on a good, who actually bears the burden of the tax? The people buying the good? The people selling the good? Or if buyers and sellers share the tax burden, what determines how the burden is divided? Can the government simply legislate the division of the burden, as the mayor is suggesting, or is the division determined by more fundamental market forces? The term lax incidence refers to how the burden of a tax is distributed among the various people who make up the economy. As we will see, some surprising lessons about tax incidence can be learned by applying the tools of supply and demand.

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