McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 14 TAXATION AND INCOME DISTRIBUTION

14-2 Vocabulary  Statutory Incidence  Economic Incidence  Tax Shifting  Partial Equilibrium Models

14-3 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

14-4 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 IncomeTax Liability Average Tax Rate Marginal Tax Rate $2,000-$ , , ,0001, ,0005,

14-5 Measuring How Progressive a Tax System is

14-6 Measuring How Progressive a Tax System is – A Numerical Example

14-7 Before TaxAfter Tax Consumers Pay Suppliers Receive $1.40 $1.00 $1.20 D0D0 S0S0 D1D1 S1S1 Partial Equilibrium Models Quantity $

14-8 DXDX S SXSX DX’DX’ Perfectly Inelastic Supply Quantity $

14-9 DXDX S SXSX DX’DX’ Perfectly Elastic Supply Quantity $

14-10 Ad Valorem Taxes Pounds of food per year Price per Pound of food DfDf SfSf Q0Q0 QmQm QrQr P0P0 PmPm PrPr Df’Df’

14-11 Taxes on Factors  The Payroll Tax The Payroll Tax  Capital Taxation in a Global Economy

14-12 Commodity Taxation without Competition  Monopoly Monopoly  Oligopoly

14-13 Profits Taxes  Economic profit  Perfect competition  Monopoly  Measuring economic profit

14-14 Tax Incidence and Capitalization P R = $R 0 + $R 1 /(1 + r) + $R 2 /(1 + r) 2 + … + $R T /(1 + r) T P R ’ = $(R 0 – u 0 ) + $(R 1 – u 1 )/(1 + r) + $(R 2 – u 2 )/(1 + r) 2 + … + $(R T – u T )/(1 + r) u 0 + u 1 /(1 + r) + u 2 /(1 + r) 2 + … + u T /(1 + r) T Capitalization

14-15 General Equilibrium Models  Partial equilibrium  General equilibrium

14-16 Tax Equivalence Relations t KF = a tax on capital used in the production of food t KM = a tax on capital used in the production of manufactures t LF = a tax on labor used in the production of food t LM = a tax on labor used in the production of manufactures t F = a tax on the consumption of food t M = a tax on consumption of manufactures t K = a tax on capital in both sectors t L = a tax on labor in both sectors t = a general income tax

14-17 Tax Equivalence Relations  Partial factor taxes t KF andt LF are equivalent totFtF and t KM andt LM are equivalent totMtM are equivalent to tKtK andtLtL are equivalent tot Source: McLure [1971].

14-18 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

14-19 Analysis of Various Taxes  Commodity tax (t F )  Income tax (t)  General tax on labor (t L )  Partial factor tax (t KM ) Output effect Factor substitution effect

14-20 Some Qualifications  Differences in individuals’ tastes  Immobile factors  Variable factor supplies

14-21 An Applied Incidence Study Income Category Average Federal Tax Rate Share of Federal Taxes Lowest Quintile5.6%1.1% Second Quintile Third Quintile Fourth Quintile Highest Quintile All Quintiles Top 1% Source: Congressional Budget Office [2004]. These figures are based on projections that rely on assumptions about inflation and income growth. They include all tax law as of Table 14.3Average federal tax rates and share of federal taxes by income quintile (2006)

14-22 The Payroll Tax Hours per year Wage rate per hour DLDL SLSL L 0 = L 1 w g = w 0 PrPr DL’DL’ wnwn

14-23 Monopoly X per year $ DXDX MR X ATC X MX X X0X0 P0P0 ATC 0 a b c d Economic Profits DX’DX’ MR X ’ PnPn i g f h X1X1 Economic Profits after unit tax