TAXATION AND INCOME DISTRIBUTION

Chapter 14

Vocabulary

• Statutory Incidence • Economic Incidence• Tax Shifting• Partial Equilibrium Models

14-2

Tax Incidence: General Remarks

• Only people can bear taxes– Functional distribution of income– Size distribution of income

• Both sources and uses of income should be considered• Incidence depends on how prices are determined• Incidence depends on the disposition of tax revenues– Balanced-Budget tax incidence– Differential tax incidence– Lump-sum tax– Absolute tax incidence

14-3

Tax Progressiveness Can Be Measured in Several Ways

• Average tax rate versus marginal tax rate

• Proportional tax system• Progressive tax system• Regressive tax system

Tax Liabilities under a hypothetical tax system

Income Tax Liability

Average Tax Rate

Marginal Tax Rate

$2,000 -$200 -0.10 0.2 3,000 0 0 0.25,000 400 0.08 0.2

10,000 1,400 0.14 0.230,000 5,400 0.18 0.2

14-4

Measuring How Progressive a Tax System Is

vI I

TI

TI

11 0

1

1

0

0

vT TT

I II

2

1 0

0

1 0

0

14-5

Measuring How Progressive a Tax System is – A Numerical Example

vI I

TI

TI

11 0

1

1

0

0

v

T TT

I II

2

1 0

0

1 0

0

.000251000 800

3001000

200800

.00031000 800

3601000

240800

2 0300 200200

1000 800800

.

2 0360 240240

1000 800800

.

14-6

Partial Equilibrium Models

• Models that study only one market and ignore possible spillover effects on other markets

• Economic incidence depends on:– Elasticities of Supply and Demand– Tax Salience: the extent to which a tax rate is made

prominent to a taxpayer

• Economic incidence does not depend on whether it is levied on Consumers or Producers.

14-7

Before Tax

After Tax

Consumers Pay

Suppliers Receive

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

2.60

0 1 2 3 4 5 6 7 8

$1.40

$1.00

$1.20

$1.20

D0

S0

D1

S1

Quantity

14-8

Unit Tax on Commodities

0.6

0.8

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

0 1 2 3 4 5 6 7 8

DX

S

SX

DX’

PerfectlyInelasticSupply

Quantity

14-9

0.6

0.8

1

1.2

1.4

1.6

1.8

2

2.2

2.4

2.6

0 1 2 3 4 5 6 7 8

DX

S

SX

DX’

PerfectlyElasticSupply

Quantity

14-10

Ad Valorem Taxes

Pounds of food per year

Pric

e pe

r Pou

nd o

f foo

d

Df

Sf

Q0 QmQr

P0

Pm

Pr

Df’

14-11

Taxes on FactorsStatutory vs. Economic Incidence

• The Payroll Tax– Tax on labor that finances Social Security

• Tax on Capital in a Global Economy

14-12

The Payroll Tax

Hours per year

Wag

e ra

te p

er h

our

DL

SL

L0 = L1

wg = w0

Pr

DL’

wn

14-13

Commodity Taxation without Competition

• Monopoly– Despite market power a monopolist is generally

made worse off • QD does down• Price paid by consumers goes up• Price received by the monopolist goes down• Profits go down

• Oligopoly– Can result in higher or lower profits

14-14

Monopoly

X per year

$

DX

MRX

ATCX

MXX

X0

P0

ATC0

a

b

c

d

DX’

MRX’

Pn igf

h

X114-15

Economic Profits

Economic Profits

after unit tax

Profits Taxes

• Economic profit• Perfect competition• Monopoly• Measuring economic profit

14-16

Tax Incidence and Capitalization

• PR = $R0 + $R1/(1 + r) + $R2/(1 + r)2 + … + $RT/(1 + r)T

• PR' = $(R0 – u0) + $(R1 – u1)/(1 + r) + $(R2 – u2)/(1 + r)2 + … + $(RT – uT)/(1 + r)

• u0 + u1/(1 + r) + u2/(1 + r)2 + … + uT/(1 + r)T

• Capitalization: A stream of tax liabilities becomes incorporated into the price of an asset

14-17

General Equilibrium Models

• Show how various markets are interrelated• Consider a 2-commodity, 2-factor economy resulting in the following

9 possible ad valorem taxestKF = a tax on capital used in the production of food

tKM = a tax on capital used in the production of manufactures

tLF = a tax on labor used in the production of food

tLM = a tax on labor used in the production of manufactures

tF = a tax on the consumption of food

tM = a tax on consumption of manufactures

tK = a tax on capital in both sectors

tL = a tax on labor in both sectors

t = a general income tax

14-18

Tax Equivalence Relations• Partial factor tax: tax levied on an input in only some of its

uses. – tKF, tLF, tKM, tLM

• Tax Equivalence: any two sets of taxes that generate the same changes in relative prices.

tKF and tLF are equivalent to tF

and and and

tKM and tLM are equivalent to tM

are are are

equivalent equivalent equivalent

to to to

tK and tL are equivalent to tSource: McLure [1971].

14-19

The Harberger Model

• Assumptions– Technology

• Elasticity of substitution• Capital intensive• Labor intensive

– Behavior of factor suppliers– Market structure– Total factor supplies– Consumer preferences– Tax incidence framework

14-20

Analysis of Various Taxes

• Commodity tax (tF)

• Income tax (t)• General tax on labor (tL)

• Partial factor tax (tKM)– Output effect– Factor substitution effect

14-21

Some Qualifications

• Differences in individuals’ tastes• Immobile factors• Variable factor supplies

14-22

An Applied Incidence Study

Average Federal Tax Rates and Share of Federal Taxesby Income Quintile (2009)

Income Category Average Federal Tax Rate Share of Federal TaxesLowest Quintile 1.0% 0.3%Second Quintile 6.8% 3.8%Third Quintile 11.1% 9.4%Fourth Quintile 15.1% 18.3%Highest Quintile 23.2% 67.9%All Quintiles 17.4% 100.0%Top 1% 28.9% 22.3%Source: Congressional Budget Office (2012a)

14-23

Chapter 14 Summary

• Who bears the burden of a tax? It depends on price changes, which, in turn, depend on:– Time frame– Disposition of tax revenue– Market structure– Elasticities of supply and demand– Mobility of factors of production– Tax salience

• Partial equilibrium incidence and general equilibrium incidence analyses are used to determine burdens of unit and ad-valorem taxes

14-24