pub econ lecture 19 tax incidence

8/3/2019 Pub Econ Lecture 19 Tax Incidence

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Public Finance

Dr. Katie Sauer

Tax Incidence


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3 Rules of Tax Incidence

1. The statutory burden of a tax does not describe

economic burden of the tax.

2. Whether the tax is levied on consumers or producers

does not impact the distribution of the tax burden.

3. Elasticity determines the distribution of the tax burden.


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Taxes on Goods or Services

Taxes on goods and services are typically levied on

sellers.

- ease of collection

Just because the seller is the one responsible for sending

in the tax money doesnt mean they are the one paying

the tax.- passed on to consumers


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A. How a Tax on a Good Works (levied on seller)

Price

Quantity

Supply

Demand

Q

P

Because the seller isresponsible for

payment of the tax, a

tax on a good

shifts the supplycurve to the left.

Consumers pay a

higher price andpurchase a lower

quantity.

Supply + tax

tax

Pt

Qt


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Price

Quantity

Supply

Demand

Q

P

But sellers dont get

to keep all of that

higher price.

They get to keep

Pt tax = Pp

Buyers pay a higher

price per item,

sellers keep a lower

price, thegovernment collects

the difference (the

tax).

Supply + tax

tax

Pt

Qt

Pp


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The total amount of

tax revenue that the

government collectsis:

(tax)(Qt)

The burden that fallson consumers is

(Qt)(Pt P)

The burden that falls

on producers is

(Qt)(P Pp)

Price

Quantity

Supply

Demand

Q

P

Supply + tax

tax

Pt

Qt

Pp


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Elasticity will determine how the tax incidence is split

between buyers and sellers.

quantity

price

quantity

price

D

D

demand more inelastic supply more inelasticthan supply than demand

Pt

P

Pt

P

Qt Q QQt

S

S + tax

S + tax

PpPp

S


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When demand is more inelastic than supply, consumers

pay more of the tax.- not as responsive to price

- easier for producers to pass on the tax

When supply is more inelastic than demand, producers

pay more of the tax.

- demand more elastic

- consumers are responsive to price changes

- harder for producers to pass on the tax


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B. How a tax levied on buyers works

- buyers would purchase the item, then send the govt a

check for the tax

Price

Quantity

Supply

Demand

Q

P

Because the buyer is

responsible for payment

of the tax, a tax on a good

shifts the demand curve to

the left.- less income

Consumers pay Pp at the

store and then send the tax

to the government.

Ultimately they end up

paying Pt.Demand + tax

tax

Pt

Qt

Pp


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Price

Quantity

Supply

Demand

Q

P

Demand + tax

tax

Pt

Qt

Pp

Because the true price

to consumers is higher,

the quantity purchasedis lower.

Even though the buyer

is paying the taxdirectly, sellers still

face some of the

burden.

The tax decreased

demand, lowering

market price.


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Notice: the results are the same whether the tax is

levied on buyers or sellers.

- consumers pay a higher price

- producers receive a lower price- a lower quantity is exchanged

- the government collects revenue

- the tax burden will be shared by sellers and

buyers according to their relative elasticities


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Factor markets are no different


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with one exception.

- impediments to free wage adjustment

ex: minimum wage


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Suppose there is a minimum wage at $7.25.

$1 tax on Labor: - decrease labor supply

- gross wage (market wage)

rises

- minimum wage is non-

binding price floor

- hours worked falls

- after-tax wage falls (wage

received by the party paying

the tax)


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$1 tax on firms: - demand for labor falls

- gross wage falls (marketwage)

- minimum wage is binding

- hours worked falls

- after-tax wage rises (wage

paid by the firm)- workers get $7.25

- workers cost the firm

$8.25


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What if the market is not competitive?

Monopoly Market

P

P*

Q

MC

Q*

D

MR


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P

P*

Q

MC

ATC

Q*

DMR DMR

Q*

P*

Suppose the tax is levied on

buyers.

-demand decreases

- MR decreases

- new Q* (lower)

- new P* (lower)

Since P* is lower, themonopolist bears part of the

tax burden.


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General Equilibrium Tax Incidence

Effects of a restaurant tax: $1 tax per meal

Demand for restaurant meals tends to be quite elastic.

restaurant bears the

full burden of the tax


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But how exactly does the restaurant bear the tax?

A restaurant is really just a combination of factors of

production.

- the labor and capital actually bear the tax


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Labor supply for an

individual restaurant

tends to be fairly elastic.

Labor demand for an

individual restaurant is

downward sloping.

Labor demand falls

because each worker is

worth less (WTP for anhour of work falls b/c

firm is taxed on the fruits

of that labor).


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Hours worked decreases.

The wage does not fall.

Workers bear none of this

tax.


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In the short run, the supply

capital is fixed.

- tables, stove, etc

So, the supply of capital is

fairly inelastic.

The demand for capital isdownward sloping.


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Since the restaurant is

bearing the full burden ofthe tax, its demand for

capital falls.

The firm will demandcapital only from those

willing to charge a lower

rate of return.

Capital owners bear the

burden of this tax.


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GEAnalysis is a game of follow the tax burden.


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Issues to Consider

1. Time Period matters- elasticities vary in short run vs long run

2. Tax Scope

- tax on one citys restaurants vs tax on onestates restaurants

3. Spillovers

When consumers pay a higher price:- may buy less in general (income effect)

- may buy substitutes (substitution effect)

- may buy less complements


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These assumptions are consistent with theory andempirical evidence.


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Table

19-1


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The US has a fairly progressive tax system overall.


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Table 19-2

pub econ lecture 19 tax incidence

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