Taxes and markets. Most of the discussion will focus on: Excise taxes: taxes on specific goods, like gasoline, cigarettes, and alcoholic beverages. When the government levies a tax on a good, who bears the burden of taxation (buyers or sellers)? This is a question about tax incidence (the study of who bears the burden of taxation).

We will see that: The one who “pays” the tax (the one who is required to give payment to the government) is not necessarily the one who “pays” the tax (the one who bears the burden of taxation). Usually, it’s the seller who is required to give payment to the government. But we will consider the other case as well: buyer gives payment to government.

Let’s suppose the government levies a $0.50/unit tax on the market for widgets and buyers are required to send payment to the government. (For every widget you buy, you have to send a check for $0.50 to the government.) In supply and demand graphs, let’s interpret “price” (plotted on vertical axis) as the amount, per unit sold, that changes hands between buyer and seller. How will tax affect supply and demand graph?

When tax goes into effect, demand will shift down by $0.50/unit. D1D1 Demand curve D 1 to start. Consider one particular point on D 1 Q 1 p1p1 Before tax, when buyers have to give p 1 $/widget, they demand Q 1 widgets/day. Same will be true after tax goes into effect. But (!) -- after tax is in effect, if buyers are to give up p 1 $/widget in total, amount paid to seller must be p $/widget. Original point shifts down by 0.50 $/widget. p Same story for each point on D 1 -- demand shifts down by D2D2 ($/widget) widgets/day

Now let’s look at a $0.50/unit tax on widgets with sellers required to send payment to the government. (For every widget a seller sells, she has to send a check to the government for $0.50.) Remember, “price” plotted on vertical axis is the amount, per unit, that changes hands between buyer and seller.

When tax goes into effect, supply will shift up by $0.50/unit. ($/widget) widgets/day S1S1 Supply curve S 1 to start. Consider one particular point on S 1 p1p1 Q 1 Before tax, when sellers “pocket” p 1 $/widget, they supply Q 1 widgets/day. Same will be true after tax goes into effect. But (!) -- after tax is in effect, if sellers are to “pocket” p 1 $/widget, amount received from buyer must be p $/widget. Original point shifts up by 0.50 $/widget. p Same story for each point on S 1 -- supply shifts up by 0.50 S2S2

Recap: If the buyers are required to send tax payment to government: Demand shifts down by amount of tax. (Demand decreases.) If sellers are required to send tax payment to government: Supply shifts up by amount of tax. (Supply decreases -- even though it’s an upward shift.) What about the effects on market equilibrium?

Consider a t $/unit tax on widgets -- and buyers are required to send payment to government. Then the tax goes into effect... p s * New “equilibrium price” is a sellers’ price: p s * Buyers’ price is t $/widget higher: p b * = p s * + t t $/widget... shifting demand down by t $/widget. D2D2 ($/widget) To start: D 1, S 1, p 1 *, Q 1 * S1S1 D1D1 Q 1 * (widgets/day) p 1 * Q 2 * Equilibrium quantity goes down: Q 1 * to Q 2 * p b *

Consider same t $/widget tax -- but this time, sellers are required to send payment to government. Then the tax goes into effect... p b * New “equilibrium price” is a buyers’ price: p b *... shifting supply up by t $/widget. t $/widget S2S2 To start: Same D 1, S 1, p 1 *, Q 1 * as before. S1S1 D1D1 ($/widget) Q 1 * (widgets/day) p 1 * p s * Sellers’ price is t $/widget lower: p s * = p b * - t Q 2 * Equilibrium quantity goes down: Q 1 * to Q 2 *

What difference does it make if buyers “pay” the tax, or sellers “pay” the tax? Let’s bring in the graph from the “buyers ‘pay’” analysis. Now let’s overlay the graph for the “sellers ‘pay’” case. No difference! S1S1 D1D1 Q 1 * (widgets/day) p 1 * D2D2 p s * p b * Q 2 * ($/widget) S1S1 D1D1 Q 1 * (widgets/day) p 1 * S2S2 p s * p b * Q 2 *

The effects of an excise tax are independent of whether buyers or sellers are required to send the tax payment to the government. With no tax, “buyers’ price” (the amount buyers pay out, per unit) is the same as “sellers’ price” (the amount sellers “pocket,” per unit). The fundamental effect of a tax is to introduce a gap, or “tax wedge” between the buyers’ and sellers’ prices. This observation gives us another way to do the analysis.

Let’s go back to the original (before-tax-is-introduced) demand and supply curves again. The tax introduces a tax wedge of t $/widget between buyers’ and sellers’ prices. Take a vertical bar of height t $/widget and see where it “fits” between supply and demand to the left of equil. tax wedge This determines p b *, p s *, Q 2 *. S1S1 D1D1 ($/widget) Q 1 * (widgets/day) p 1 * p s * Q 2 * p b *

Again, the effects of the tax are independent of who “pays the tax” (sends the check to the government). But what are the effects? From the graph, we see: Equilibrium quantity falls (from Q 1 * to Q 2 *). The price buyers pay increases (from p 1 * to p b *). The price sellers “pocket” decreases (from p 1 * to p s *).

Notice: In general, the burden of the tax is “shared” between buyers and sellers buyers’ price goes up some,... and sellers’ price goes down some. Often we hear: “When an excise tax is levied on a good, sellers will ‘pass the tax along’ to buyers.”

What if they tried to “pass the tax along” (mark up the original price by full amount of tax)?... and sellers’ price would be p 1 * so quantity supplied is Q 1 *. Excess supply -- price must fall to the level of p b * from previous graphs. S1S1 D1D1 ($/widget) Q 1 * (widgets/day) p 1 * p 1 * + t Q 3 At a buyers’ price of p 1 * + t, quantity demanded is Q 3...

We’ve seen that the effects of a tax are independent of who “pays” the tax (... independent of who is required to give payment to government). But this basic lesson isn’t understood by everyone! FICA (Federal Insurance Contribution Act) payroll taxes. -- pays for Social Security and Medicare. -- takes about 15.3% of (before-tax) earnings for typical worker (in 2008). -- Congress mandated a division. (More on FICA: But the “mandated division” is irrelevant!

Recent news on payroll tax: The tax bill passed in “lame-duck” session of Congress cuts the employee’s share in 2011 from 6.2% to 4.2% of earnings. (

But then, what does determine how the burden of a tax is distributed? (Now coming back to the tax incidence question.) In the graphs we’ve drawn, it looks like an approximately split: -- buyers’ price goes up by about half of the tax. -- sellers’ price goes down by the other half. Does it always work out this way?

Suppose that supply is more elastic than demand: Demand Supply Tax incidence and elasticity ($/widget) (widgets/day) For a given “tax wedge” buyers’ price rises more than sellers’ price falls. Tax incidence falls more heavily on buyers (the ones with the less elastic price-quantity relation). tax wedge p1*p1* ps*ps* pb*pb*

Now suppose that demand is more elastic than supply. ($/widget) (widgets/day) Demand Supply... and the same “tax wedge” as before sellers’ price falls more than buyers’ price rises. Tax incidence falls more heavily on sellers (the ones with the less elastic price-quantity relation). tax wedge With the same initial equilibrium price as before... p1*p1* pb*pb* ps*ps*

Cigarettes are subject to significant (state and federal) excise taxes. The demand for cigarettes is relatively inelastic. (One study by Craig Gallet and John List in Health Economics, 2003, reports that own price elasticity estimates average ) ( ) Elasticity of supply? -- most likely higher than So the incidence of cigarette excise taxes falls more heavily on buyers than sellers.

Cigarette excise tax rates. Federal: $1.01/pack Iowa: $1.36/pack. The five highest: NY ($4.35/pack), RI (3.46) WA (3.025), CT (3.00), HI (3.00) The five lowest: MO ($0.17/pack), VA (0.30), LA (0.36), GA (0.37), AL (0.425) ( )