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2. Tax Incidence An Application of Supply and Demand uA sales tax is a tax on a wide variety of goods. uAn excise tax is a tax on a specific good. uAn ad valorem tax is expressed as a percentage of a good’s price or value. uA unit tax is a fixed amount per unit of a good.

3. uStatutory tax incidence is concerned with who is legally required to pay a tax. uEconomic tax incidence is concerned with who ultimately bears the burden of a tax. The introduction of a tax often results in changes in market prices, which in turn results in the economic incidence of the tax differing from the statutory incidence.

4. 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 102030 40 5060708090 P $ per gallon Q (millions of gallons) S S’ A tax on sellers of $0.60 per gallon will shift the supply curve upward by $0.60. Unit Tax (statutorily) Imposed on Sellers Consider a $0.60 per gallon tax on the sellers of gasoline.

5. 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 102030 40 5060708090 P $ per gallon Q (millions of gallons) S D S’ $0.60 Here a $0.60 tax per unit causes the (gross) price of gas paid by buyers to increase by $0.40 and the (net) price received by sellers to fall by $0.20. Changes in market prices typically result in the ultimate burden of a tax (i.e., the economic incidence) being at least partially shifted away from those statutorily required to pay the tax.

6. 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 102030 40 5060708090 P $ per gallon Q (millions of gallons) D D’ A tax on buyers of $0.60 per gallon will cause the demand curve to shift down by $0.60. Unit Tax (statutorily) Imposed on Buyers

7. D 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 102030 40 5060708090 P $ per gallon Q (millions of gallons) S Here a $0.60 tax per gallon of gas causes the (gross) price of gas paid by buyers to increase by $0.40 and the (net) price received by sellers to fall by $0.20. D’ $0.60

8. The economic incidence is the same whether buyers or sellers are statutorily liable for the tax. 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 102030 40 5060708090 P $ per gallon Q (millions of gallons) S D S’ $0.60 D 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 102030 40 5060708090 P $ per gallon Q (millions of gallons) S D’ $0.60

9. P Q D S P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 S’ u (P g 1 - P 0 ) + (P 0 - P n 1 ) = P g 1 - P n 1 = u The increase in the gross price paid by buyers plus the decrease in the net price received by sellers equals the tax per unit of the good.

10. P Q D S P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 S’ u tax revenue: R = u Q 1

11. P Q D S P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 S’ u tax revenue: R = u Q 1 (P g 1 - P 0 ) Q 1 (P 0 - P n 1 ) Q 1 Buyers’ share of the tax burden: Sellers’ share of the tax burden:

12. Who bears the burden of a tax crucially depends upon the price elasticities of demand and supply.

13. P Q S P0P0 Q0Q0 D2D2 S’ Pg2Pg2 Pn2Pn2 Q2Q2 P Q D1D1 S P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 P Q D1D1 S P0P0 Q0Q0 D2D2 Pg1Pg1 Pn1Pn1 Q1Q1 Pg2Pg2 Pn2Pn2 Q2Q2

14. P Q D1D1 S P0P0 Q0Q0 D2D2 Pg1Pg1 Pn1Pn1 Q1Q1 Pg2Pg2 Pn2Pn2 Q2Q2 The share of the tax burden borne by buyers will be larger (and the share borne by sellers will be smaller) as demand is less elastic with respect to price. With the less elastic demand (D 2 ), the gross price paid by buyers is higher. With the less elastic demand (D 2 ), the net price received by sellers is higher.

15. P Q D S1S1 P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 D’ P Q D P0P0 Q0Q0 S2S2 Q2Q2 Pg2Pg2 Pn2Pn2 P Q D S1S1 P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 S2S2 Q2Q2 Pg2Pg2 Pn2Pn2

16. P Q D S1S1 P0P0 Q0Q0 Pg1Pg1 Pn1Pn1 Q1Q1 S2S2 Q2Q2 Pg2Pg2 Pn2Pn2 The share of the tax burden borne by buyers will be larger (and the share borne by sellers will be smaller) as supply is more elastic with respect to price. With the more elastic supply (S 1 ), the gross price paid by buyers is higher. With the more elastic supply (S 1 ), the net price received by sellers is higher.

17. The portion of a unit tax borne by buyers, K B, can be shown to equal. The portion of a unit tax borne by sellers, K S, can be shown to equal. Thus, the economic incidence of a tax depends upon the magnitude of E d relative to the magnitude of E s, as the ratio E d / E s determines the shares of the tax burden borne by buyers and sellers.

18. As E d / E s is smaller,... the portion of a tax borne by buyers will be larger and the portion of a tax borne by sellers will be smaller. As E d / E s is larger,... the portion of a tax borne by buyers will be smaller and the portion of a tax borne by sellers will be larger.

19. Price Ceilings & Price Floors Price Ceiling uA legally established maximum price at which a good can be sold. Price Floor uA legally established minimum price at which a good can be sold.

20. Price Ceilings Two outcomes are possible when the government imposes a price ceiling:  The price ceiling is not binding if set above the equilibrium price.  The price ceiling is binding if set below the equilibrium price, leading to a shortage.

21. A Price Ceiling That Is Not Binding... $4 3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply Price ceiling Equilibrium price 100 Equilibrium quantity Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

22. A Price Ceiling That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 2 Demand Supply Equilibrium price Price ceiling Shortage 125 Quantity demanded 75 Quantity supplied Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

23. Rent Control uRent controls are ceilings placed on the rents that landlords may charge their tenants. uThe goal of rent control policy is to help the poor by making housing more affordable. uOne economist called rent control “the best way to destroy a city, other than bombing.”

24. Rent Control in the Short Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic

25. Rent Control in the Long Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... …rent control causes a large shortage