Chapter 7: Tax Incidence and Inefficiency Chapter 7 Tax Incidence and Inefficiency Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Chapter 7: Tax Incidence and Inefficiency Introduction Incidence: Who bears the burden People, not firms, ultimately bear all tax burdens A tax on capital income Inefficiency A tax on wage income The efficiency loss from a tax on a good The efficiency loss from a tax on wage income The efficiency loss from a tax on capital income

Chapter 7: Tax Incidence and Inefficiency People, Not Firms, Ultimately Bear all Tax Burdens People, in their roles as Two examples consumers workers stockholders and managers …will ultimately bear the burden of taxes levied on business firms. Tax on gasoline Payroll tax

Chapter 7: Tax Incidence and Inefficiency P D S Q S’ 100 $3.30 $2.50 $ $1 Figure 7.1A Who bears the burden of a $1 tax? In this case, Supply is elastic Demand is inelastic It depends on relative elasticities So the consumers bear more of a burden. The Distribution of the Burden Depends on the Relative Elasticities A tax on gasoline Tax is levied on producers.

Chapter 7: Tax Incidence and Inefficiency $2.70 $2.50 $1.70 P D S Q S’ 100QTQT $1 Figure 7.1B In this case, Supply is inelastic Demand is elastic So the producers bear more of a burden. The Distribution of the Burden Depends on the Relative Elasticities A tax on gasoline Elasticity In the short run In the long run Tax is levied on producers.

Chapter 7: Tax Incidence and Inefficiency P D S Q D’ 100 $3.30 $2.50 $ $1 Figure 7.1C The Distribution of the Burden Doesn’t Depend on Who Writes the Check Who bears the burden of a $1 tax? In this case, the consumer writes the check… It doesn’t depend on who writes the check And the outcome is the same as if the producer wrote the check. Tax is levied on consumers.

Chapter 7: Tax Incidence and Inefficiency P D S Q 100 $3.30 $2.50 $ A B Figure 7.1D The Distribution of the Burden Doesn’t Depend on Who Writes the Check The tax wedge short cut Tax revenue Equal to the amount of the tax = BA Equal to the tax per unit multiplied by the number of units

Chapter 7: Tax Incidence and Inefficiency P D S Q S’ $106 $101 $100 6% Figure 7.2 QTQT QNQN The Distribution of the Burden Doesn’t Depend on Who Writes the Check A sales tax Is an ad valorem tax Who bears the burden of a sales tax? Again, it depends on relative elasticities Tax is levied on producers.

Chapter 7: Tax Incidence and Inefficiency A Tax on Wage Income $16 $15 $12 W D S L S’ $4 Figure 7.3A A wage tax S = employees D = employers Who bears the burden of a wage tax? Again, it depends on relative elasticities Tax is levied on employees.

Chapter 7: Tax Incidence and Inefficiency D S D’ Figure 7.3B $16 $15 $12 W $4 L A Tax on Wage Income Who bears the burden of a wage tax? Tax is levied on employers. A wage tax The outcome is the same as if the tax was levied on the employees.

Chapter 7: Tax Incidence and Inefficiency D S Figure 7.3C $16 $15 $12 W L The tax wedge short cut A Tax on Wage Income The employee’s share of total tax revenue The employer’s share of total tax revenue

Chapter 7: Tax Incidence and Inefficiency D S Figure 7.4 $ $ $93.80 W L LTLT LNLN $ The payroll tax for Social Security Split between employees and employers Use the tax wedge short cut to identify who bears the burden of a payroll tax A Tax on Wage Income The employee’s share of total tax revenue The employer’s share of total tax revenue

Chapter 7: Tax Incidence and Inefficiency How elastic is labor supply? The substitution effect The income effect How do you measure employees’ responses to changing taxes? A Tax on Wage Income Time series data and analysis Cross-section data and analysis Primary earners Secondary earners Important to distinguish the type of earner Estimates?

Chapter 7: Tax Incidence and Inefficiency A Tax on Capital Income r D S Saving S’ 5% 4% 3% Figure 7.5 STST SNSN A capital income tax S = lenders D = borrowers Substitution effect Income effect How elastic is saving supply? The tax is levied on capital income which lenders earn.

Chapter 7: Tax Incidence and Inefficiency General Equilibrium Tax Incidence D S Figure 7.6 W L LTLT LNLN D’ The impact of a capital income tax on the wage If the tax reduces the capital stock, employees’ productivity decreases Employees bear some burden from a capital income tax

Chapter 7: Tax Incidence and Inefficiency D S S’ $30 Figure 7.7AFigure 7.7B WHWH High-Skilled Labor O F D S S’ $10 WLWL O G D’ Low-Skilled Labor General Equilibrium Tax Incidence The impact of a capital income tax on the wage

Chapter 7: Tax Incidence and Inefficiency Inefficiency A tax usually causes an efficiency loss by causing an unfavorable change in the mix of goods. Deadweight loss Welfare loss Welfare cost Excess burden Inefficiency resulting from a tax is also called: Efficiency, along with fairness and ease of administration, are criteria for judging taxes.

Chapter 7: Tax Incidence and Inefficiency The Efficiency Loss from a Tax on a Good P D S Q $20 $16 $4 Figure 7.8 (MC) (MB) A B D Efficiency loss = (1/2)T(∆Q) = BAD e ≡ (% ∆ Q) /(%∆ P) L = (1/2)t 2 ePQ L/R = (1/2)te Efficiency loss depends on the elasticity of demand.

Chapter 7: Tax Incidence and Inefficiency Optimal Commodity Taxation Varying price elasticities for goods leads to different efficiency losses. Elasticity is difficult to determine May encourage wasteful lobbying Would raise compliance and administrative costs Citizens may find this unfair Four drawbacks Ramsey inverse elasticity rule

Chapter 7: Tax Incidence and Inefficiency The Efficiency Loss from a Tax on Wage Income P D S L (Annual Hours) $20 $16 Figure 7.9 (MRPL) 22,00020,000 A B D Wage = MRPL = (1/2)T(∆H) Efficiency loss = BAD ε ≡ (%∆H)/(%∆W) L = (1/2)t 2 εWH L/R = (1/2)tε Efficiency loss depends on the elasticity of labor supply.

Chapter 7: Tax Incidence and Inefficiency r D S Saving 5% 3% Figure 7.10 $120,000$100,000 A B D The Efficiency Loss from a Tax on Capital Income Efficiency loss = BAD Again, efficiency loss depends on the elasticity.

Chapter 7: Tax Incidence and Inefficiency A Lump-Sum Tax and the Marginal Tax Rate A lump-sum tax is a tax where the amount owed doesn’t vary with the taxpayer's behavior. Importance of average tax rates (ATR) and marginal tax rates (MTR) to determine inefficiency There is no efficiency loss with lump-sum taxes.

Chapter 7: Tax Incidence and Inefficiency The Revenue-Rate Curve Tax Revenue Tax Rate Figure % tMtM There is some tax rate between 0% and 100% which maximizes tax revenue Laffer’s hypothesis The location of t M depends on your economic perspective

Chapter 7: Tax Incidence and Inefficiency Summary Incidence: Who bears the burden People, not firms, ultimately bear all tax burdens A tax on capital income Inefficiency A tax on wage income The efficiency loss from a tax on a good The efficiency loss from a tax on wage income The efficiency loss from a tax on capital income

Chapter 7: Tax Incidence and Inefficiency Preview of Chapter 8: Mechanics of the U.S. income tax Concepts underlying the income tax Issues in taxing labor income Issues in taxing capital income Income Taxes