Bryan Caplan  

Tax Cuts Under Price Controls

My Ongoing Frustration... Two Dismal Books...

Yesterday I was explaining Singapore's clever approach to fiscal stimulus to Russ Roberts at lunch. During the explanation, I realized that I should probably back up and explain how tax cuts works in markets with price controls. But since I was feeling a bit sick, I didn't have the energy.

Hopefully Russ will consider this a make-up assignment. Here goes:

With flexible prices, of course, we have the standard result that de jure responsibility for a tax has nothing to do with de facto incidence. Inelastic factors reap the benefits of tax cuts; elastic factors don't.

But what if a market has a persistent surplus due to a price floor? Then de jure responsibility matters a lot. If you cut the tax paid by suppliers, the surplus actually gets bigger. Getting the legal minimum with low taxes is even better than getting the legal minimum with high taxes.

In contrast, if you cut the tax paid by demanders, the surplus gets smaller. Paying the legal minimum plus low taxes is less onerous than paying the legal minimum plus higher taxes. If you cut the tax enough, you might be able to eliminate the surplus entirely.

You could object: "What does this have to do with unemployment in Singapore? They don't have an economy-wide wage floor, do they?" Of course not. But unless Singaporeans are psychologically very different from almost everyone else on earth, they resent nominal wage cuts. And the analysis above does not fundamentally change if the "price control" stems from psychology rather than an act of government. If workers are unemployed due to excessive wages, and if for some reason wages do not fall, you can get around the problem by cutting the taxes paid by employers. Which is precisely what Singapore does.

How's that, Russ?

Comments and Sharing

COMMENTS (3 to date)
mjh writes:

Normally, this blog does a great job of explaining economics in bits that are easily consumed by non-professional economists (e.g. me).

Is there any chance that this homework assignment meant for Russ Roberts could be translated into something closer to the normal fair for this blog?

No? Ok. Just thought I'd ask.

Rich writes:

Brilliant! And of course completely unrelated, I assume, to today's post regarding democracy.

liberty writes:

"If you cut the tax enough, you might be able to eliminate the surplus entirely."

If the surplus is due to a wage (or price) floor, I don't see how cutting out an additional tax should eliminate the surplus entirely.

But given that we are so used to having to pay taxes in addition, it could seem pretty close.

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