TAXATION AND INCOME DISTRIBUTION Chapter 14 ©2016 by McGraw-Hill Education Limited.

Learning Objectives Distinguish between the statutory incidence and the economic incidence of tax. Illustrate the difference between a marginal tax rate and an average tax rate. Describe two ways of measuring tax progressiveness. Relate the incidence of tax to the elasticities of supply and demand.

Learning Objectives (cont) Explain why a tax on economic profits cannot be shifted onto consumers. Give examples of tax equivalence relations in general equilibrium models. Analyze the output effect and the substitution effect of a partial factor tax.

Vocabulary Statutory Incidence Economic Incidence Tax Shifting LO1 Statutory Incidence Economic Incidence Tax Shifting Tax Analysis – use of economic theory to analyze impact of taxes Equity and Efficiency – how do taxes affect the distribution of income, how do taxes affect economic efficiency Statutory Incidence - who is legally responsible for tax (who writes the check) Economic Incidence – whose purchasing power is reduced by the tax Tax Shifting – extent that statutory and economic incidence differ

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

Tax Progressiveness Can Be Measured in Several Ways LO2, LO3 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 5,000 400 0.08 10,000 1,400 0.14 30,000 5,400 0.18 Tax scheme depicted – Tax = 0.20*(Income - $3,000) Table 14.1

Measuring the Degree of Progressive of a Tax System

Partial Equilibrium Models Models that look only at the market in which the tax is imposed and ignore the ramifications in other markets

Unit Taxes on Commodities Economic incidence does not depend on whether it is levied on consumers or producers Economic incidence depends on elasticities of supply and demand

Unit Taxes on Commodities Price and Quantity Before Taxation Price per litre of wine a Pa Sw u b P0 m Pc u n Dw Qa Q0 Qc Litres of wine per year Figure 14.1

LO4 Unit Taxes on Commodities Incidence of a Unit Tax Imposed on the Demand Side Price per litre of wine Sw Tax wedge = fh Tax Revenue = kfhn Price paid by consumers k f Pg g m Original price P0 Pn n Price received by producers h u Dw D’w Q1 Q0 Litres of wine per year Figure 14.2

LO4 Unit Taxes on Commodities Incidence of a Unit Tax Imposed on the Supply Side Price per litre of wine S’w j Sw u Price paid by consumers P’g Pi Original price P0 P’n Price received by producers Dw Q’1 Q0 Q1 Litres of wine per year Figure 14.3

LO4 Unit Taxes on Commodities Tax Incidence when Supply is Perfectly Inelastic SX Price per litre of X Price received by suppliers falls by the full amount of the tax Pg=P0 u Pn Dx D’x X per year Figure 14.4

LO4 Unit Taxes on Commodities Tax Incidence when Supply is Perfectly Elastic Price per litre of Z Price paid by consumers increases by the full amount of the tax Pg u Pn=P0 Sz Dz D’z Z1 Z0 Z per year Figure 14.5

Ad Valorem Taxes Sc Price per unit of clothing r Pr s P0 m Pm n Dc Qr Qm Units of clothing Figure 14.6

Ad Valorem Taxes Incidence of an Ad Valorem Tax S’c Sc Price per unit of clothing Pg P0 Pn Dc D’c Q1 Q0 Units of clothing Figure 14.7

Taxes on Factors The payroll Tax Capital taxation in a global economy Tax on labor used to finance the Canada Pension Plan (CPP) Capital taxation in a global economy

The Payroll Tax LO4 SL Wage rate per hour Pr wg = w0 wn DL DL’ L0 = L1 Hours per year Figure 14.8

Commodity Taxation with 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

Equilibrium of a Monopolist $ Economic Profits MXX c a P0 ATCX d b ATC0 DX MRX X per year X0 Figure 14.9

Imposition of a Unit Tax on a Monopolist $ Economic Profits MXX c a P0 ATCX Economic Profits after unit tax Pn i f d h g b ATC0 DX DX’ MRX X per year X1 X0 MRX’ Figure 14.10

Taxes on Profits Economic profit Perfect competition Monopoly LO5 Taxes on Profits Economic profit Perfect competition Monopoly Measuring economic profit

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

General Equilibrium Models Show how various markets are interrelated Consider a 2-commodity, 2-factor economy resulting in the following 9 possible ad valorem taxes tKF = 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

Tax Equivalence Relations LO6 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 tKM tLM tM are equivalent to tK tL t Source: Charles E. McLure, Jr., “The Theory of Tax Incidence with Imperfect Factor Mobility,” Finanzarchiv 30 (1971): 29. Table 14.2 14-25

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

Analysis of Various Taxes LO7 Analysis of Various Taxes Commodity tax (tF) Income tax (t) General tax on labor (tL) Partial factor tax (tKM) Output effect Factor substitution effect

Incidence of a Partial Factor Tax (tKM) in a General Equilibrium Model Figure 14.11

Some Qualifications Differences in individuals’ tastes Immobile factors Variable factor supplies

Applied Incidence Studies Average Tax Rate, Total Taxes, by Broad Income, Canada, 1990 to 2005 Figure 14.12

Applied Incidence Studies Decile Cut-offs, 1990 and 2005 (in constant 2010 dollars) Table 14.3

Applied Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005 Figure 14.13

Applied Incidence Studies Average Tax Rate, by Revenue Source, Broad Income, Standard Case, Canada, 2005 Figure 14.14

Chapter 14 Summary Statutory incidence refers to the legal liability for a tax, while economic incidence shows the actual sacrifice of income due to the tax. Economic incidence is determined by the way price changes when a tax is imposed; the incidence of a tax ultimately falls on individuals via both their sources and uses of income. In partial equilibrium competitive models, tax incidence depends on the elasticities of supply and demand. Due to capitalization, the burden of taxes may be borne by current owners of an inelastically supplied durable commodity, such as land.

Chapter 14 Summary (cont) General equilibrium incidence analysis is often conducted using a two-sector, two-factor model. Taxing a single factor in its use only in a particular sector changes relative factor prices and the distribution of income. The particular outcome depends on factor intensities, ease of substitution of products, mobility of factors, and elasticities of demand for outputs. Applied incidence studies indicate the Canadian system is progressive up to the middle of the income distribution, then modestly regressive thereafter.