0. Tax Incidence (Chapter7)
Unit IV
Tax Incidence (Chapter7)

1. In this chapter, look for the answers to these questions:
How do taxes affect market outcomes? How does the outcome depend on whether the tax is imposed on buyers or sellers?
What is the incidence of a tax? What determines the incidence?
How does a tax affect consumer surplus, producer surplus, and total surplus?
What is the deadweight loss of a tax?

2. In this chapter, look for the answers to these questions:
What factors determine the size of this deadweight loss?
How does tax revenue depend on the size of the tax?
What are the efficiency costs of taxes?
How can we evaluate the equity of a tax system?

3. Government Policies That Alter the Private Market Outcome
Price controls
Price ceiling: a legal maximum on the price of a good or service. Example: rent control.
Price floor: a legal minimum on the price of a good or service. Example: minimum wage.
Taxes
The govt can make buyers or sellers pay a specific amount on each unit bought/sold.
We will use the supply/demand model to see how tax policy affects the market outcome (the price buyers pay, the price sellers receive, and eq’m quantity).

4. Taxes
The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.
The govt can make buyers or sellers pay the tax.
The tax can be a percentage of the good’s price, or a specific amount for each unit sold.
For simplicity, we analyze per-unit taxes only.

5. EXAMPLE 1: The Market for PizzaQ D1 S1
Eq’m w/o tax
$10.00
500

6. Effects of a $1.50 per unit tax on buyers
A Tax on Buyers
A tax on buyers shifts the D curve down by the amount of the tax.
Effects of a $1.50 per unit tax on buyers P Q D1 S1
$11.00
PB = D2
Tax
430
$10.00
500
$9.50
PS =
The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

7. The Incidence of a Tax:
how the burden of a tax is shared among market participants P Q D1
Because of the tax, buyers pay $1.00 more,
sellers get $0.50 less. S1
$11.00
PB = D2
Tax
430
$10.00
500
$9.50
PS =

8. Effects of a $1.50 per unit tax on sellers
A Tax on Sellers
A tax on sellers shifts the S curve up by the amount of the tax.
Effects of a $1.50 per unit tax on sellers P Q S2 D1 S1
$11.00
PB =
Tax
430
$10.00
500
$9.50
PS =
The price buyers pay rises, the price sellers receive falls, eq’m Q falls.

9. The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! P Q D1
What matters is this:
A tax drives a wedge between the price buyers pay and the price sellers receive. S1
PB =
$11.00
Tax
$10.00
500
PS =
$9.50
430

10. A C T I V E L E A R N I N G 1: Effects of a taxQ P S
The market for hotel rooms D
Suppose govt imposes a tax on buyers of $30 per room.
Find new Q, PB, PS, and incidence of tax.

11. A C T I V E L E A R N I N G 1: AnswersQ P S
The market for hotel rooms D
PB = $110
PB =
Q = 80
Tax
PS = $80
PS =
Incidence
buyers: $10
sellers: $20

12. Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand P Q
In this case, buyers bear most of the burden of the tax. D PB S
Buyers’ share of tax burden
Tax
Price if no tax
Sellers’ share of tax burden PS

13. Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply P Q
In this case, sellers bear most of the burden of the tax. S D
Buyers’ share of tax burden PB
Tax
Price if no tax
Sellers’ share of tax burden PS

14. Elasticity and Tax Incidence
If buyers’ price elasticity > sellers’ price elasticity, buyers can more easily leave the market when the tax is imposed, so buyers will bear a smaller share of the burden of the tax than sellers.
If sellers’ price elasticity > buyers’ price elasticity, the reverse is true.

15. CASE STUDY: Who Pays the Luxury Tax?
1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc.
Goal of the tax: to raise revenue from those who could most easily afford to pay – wealthy consumers.
But who really pays this tax?

16. CASE STUDY: Who Pays the Luxury Tax?
Demand is price-elastic.
The market for yachts P Q S
In the short run, supply is inelastic. D
Buyers’ share of tax burden PB
Tax
Hence, companies that build yachts pay most of the tax.
Sellers’ share of tax burden PS

17. So, what do we know so far?
A tax is a wedge between the price buyers pay and the price sellers receive.
A tax raises the price buyers pay and lowers the price sellers receive.
A tax reduces the quantity bought & sold.

18. The Effects of a Tax P Q D S
With no tax, eq’m price is PE and quantity is QE .
Size of tax = $T
Govt imposes a tax of $T per unit. PB QT PE QE
The price buyers pay is PB , PS
the price sellers receive is PS ,
and quantity is QT .

19. The Effects of a Tax The tax generates revenue equal to $T x QT .P Q
The tax generates revenue equal to $T x QT .
Size of tax = $T S PB PE PS D QT QE

20. The Effects of a Tax
Next, we use the tools of welfare economics to measure the gains and losses from a tax.
We will determine consumer surplus (CS), producer surplus (PS), tax revenue, and total surplus with and without the tax.
Tax revenue is included in total surplus, because tax revenue can be used to provide services such as roads, police, public education, etc.

21. The Effects of a Tax Without a tax, CS = A + B + C PS = D + E + FQ D S
Without a tax,
CS = A + B + C
PS = D + E + F A
Tax revenue = 0 B C
Total surplus = CS + PS
= A + B + C D + E + F PE QE E D F QT

22. The Effects of a Tax With the tax, CS = A PS = F Tax revenue = B + DQ
With the tax,
CS = A
PS = F A
Tax revenue = B + D S PB B C
Total surplus = A + B + D + F E D PS D F
The tax causes total surplus to fall by C + E QT QE

23. The Effects of a Tax P Q
C + E is called the deadweight loss (DWL) of the tax, the fall in total surplus that results from a market distortion, such as a tax. A S PB B C E D PS D F QT QE

24. About the Deadweight LossP Q
Because of the tax, the units between QT and QE are not sold.
So, the tax has prevented some mutually beneficial trades. S PB PS D QT QE

25. A C T I V E L E A R N I N G 2: Analysis of tax
The market for airplane tickets P Q $
A. Compute CS, PS, and total surplus without a tax.
B. If $100 tax per ticket, compute CS, PS, tax revenue, total surplus, and DWL. D S

26. A C T I V E L E A R N I N G 2: Answers to A
The market for airplane tickets P Q $ CS
= ½ x $200 x 100
= $10,000 D S PS
= ½ x $200 x 100
= $10,000
P =
total surplus
= $10,000 + $10,000
= $20,000

27. A C T I V E L E A R N I N G 2: Answers to B
A $100 tax on airplane tickets P Q $ CS
= ½ x $150 x 75
= $5,625 D S
PS = $5,625
PB =
tax revenue
= $100 x 75
= $7,500
PS =
total surplus = $18,750
DWL = $1,250

28. What Determines the Size of the DWL?
The govt needs tax revenue to finance roads, schools, police, etc., so it must tax some goods and services.
Which ones? One answer is that govt should tax the goods or services with the smallest DWL.
So when is the DWL small vs. large? Turns out it depends on the elasticities of supply and demand.
Recall: The price elasticity of demand (or supply) measures how much quantity demanded (or supplied) changes when the price changes.

29. DWL and the Elasticity of Supply
When supply is inelastic, P Q S D
the DWL of a tax is small.
Size of tax

30. DWL and the Elasticity of SupplyQ D
The more elastic supply, S
Size of tax
the larger the DWL.

31. DWL and the Elasticity of Supply
When demand is inelastic, P Q D S
the DWL of a tax is small.
Size of tax

32. DWL and the Elasticity of SupplyQ S D
The more elastic the demand,
Size of tax
the larger the DWL.

33. Why Elasticity Affects the Size of DWL
A tax distorts the market outcome: consumers buy less and producers sell less, so eq’m Q is below the surplus-maximizing quantity.
Elasticity measures how much buyers and sellers respond to changes in price,
and therefore determines how much the tax distorts the market outcome.

34. A C T I V E L E A R N I N G 3: Elasticity and DWL of a tax
Would the DWL of a tax be larger if the tax were on
A. Rice Krispies or sunscreen?
B. Gasoline in the Short Run vs. Gasoline in the Long Run
C. Insulin vs. Caribbean Cruises

35. A C T I V E L E A R N I N G 3: Answers
A. Rice Krispies or sunscreen
From Chapter 6: Rice Krispies has many more close substitutes than sunscreen, so demand for Rice Krispies is more price-elastic than demand for sunscreen.
So, a tax on Rice Krispies would cause a larger DWL than a tax on sunscreen.

36. A C T I V E L E A R N I N G 3: Answers
B. Gasoline in the short run or long run
From Chapter 6: The price elasticities of demand and supply for gasolline are larger in the long run than in the short run.
So, a tax on gasoline would cause a larger DWL in the long run than in the short run.

37. A C T I V E L E A R N I N G 3: Answers
C. Insulin vs. Caribbean Cruises
From Chapter 6: Insulin is a necessity and therefore less price-elastic than a Caribbean Cruise
So, a tax on a Caribbean Cruise would cause a larger DWL than a tax on insulin.

38. A C T I V E L E A R N I N G 3: Discussion question
The government must raise tax revenue to pay for schools, police, etc. To do this, it can either tax groceries or meals at fancy restaurants.
Which should it tax?

39. The Effects of Changing the Size of the Tax
Policymakers often change taxes, raising some and lowering others.
What happens to DWL and tax revenue when taxes change? We explore this next….

40. DWL and the Size of the TaxP Q D S
Initially, the tax is T per unit.
new DWL
Doubling the tax 2T Q2
causes the DWL to more than double. T Q1
initial DWL

41. DWL and the Size of the TaxP Q D S
new DWL
Initially, the tax is T per unit. 3T Q3
Tripling the tax
causes the DWL to more than triple. Q1 T
initial DWL

42. DWL and the Size of the Tax
Implication
When tax rates are low, raising them doesn’t cause much harm, and lowering them doesn’t bring much benefit.
When tax rates are high, raising them is very harmful, and cutting them is very beneficial.
Summary
When a tax increases, DWL rises even more.
DWL
Tax size

43. Revenue and the Size of the Tax
When the tax is small, increasing it causes tax revenue to rise. P Q D S PB Q2 2T PB Q1 T PS PS

44. Revenue and the Size of the Tax
Revenue and the Size of the Tax P Q D S PB Q3 3T PB Q2
When the tax is larger, increasing it causes tax revenue to fall. 2T PS PS

45. Revenue and the Size of the Tax
Revenue and the Size of the Tax
The Laffer curve shows the relationship between the size of the tax and tax revenue.
The Laffer curve
Tax size
Tax revenue

46. Taxes and Efficiency
One tax system is more efficient than another if it raises the same amount of revenue at a smaller cost to taxpayers.
The costs to taxpayers include:
the tax payment itself
deadweight losses
administrative burden

47. Administrative Burden
includes the time and money people spend to comply with tax laws
encourages the expenditure of resources on legal tax avoidance
e.g., hiring accountants to exploit “loopholes” to reduce one’s tax burden
is a type of deadweight loss
could be reduced if the tax code were simplified but would require removing loopholes, politically difficult

48. Marginal vs. Average Tax Rates
Marginal vs. Average Tax Rates
average tax rate
total taxes paid divided by total income
measures the sacrifice a taxpayer makes
marginal tax rate
the extra taxes paid on an additional dollar of income
measures the incentive effects of taxes on work effort, saving, etc.

49. Lump-Sum Taxes income $20,000 20% 0% $40,000 10% 0%
A lump-sum tax is the same for every person
Example: lump-sum tax = $4000/person
marginal tax rate
average tax rate
income
$20,000
20% 0%
$40,000
10% 0%

50. Taxes and Equity
Another goal of tax policy: equity – distributing the burden of taxes “fairly.”
Agreeing on what is “fair” is much harder than agreeing on what is “efficient.”
Yet, there are several principles people apply to evaluate the equity of a tax system.

51. The Benefits Principle
The Benefits Principle
Benefits principle: the idea that people should pay taxes based on the benefits they receive from govt services
Tries to make public goods similar to private goods – the more you use, the more you pay.
Example: Gasoline taxes
the more you drive on public roads, the more gas you buy, so the more gas tax you pay

52. The Ability-To-Pay Principle
Ability-to-pay principle: the idea that taxes should be levied on a person according to how well that person can shoulder the burden
suggests that all taxpayers should make an “equal sacrifice” to support govt
recognizes that the magnitude of the sacrifice depends not just on the tax payment, but on the person’s income and other circumstances
a $10,000 tax bill is a bigger sacrifice for a poor person than a rich person

53. Three Tax Systems
Proportional tax: taxpayers pay the same fraction of income, regardless of income
Regressive tax: high-income taxpayers pay a smaller fraction of their income than low-income taxpayers
Progressive tax: high-income taxpayers pay a larger fraction of their income than low-income taxpayers

54. Examples of the Three Tax Systems
20%
$40,000
25%
$25,000
30%
$15,000
regressive
25%
$50,000
$25,000
$12,500
proportional
30%
$60,000
25%
$25,000
20%
$10,000
progressive
income
tax
tax
% of income
tax
% of income
% of income
$50,000
$100,000
$200,000

55. U.S. Federal Income Tax Rates: 2010 (Married Filing Jointly)
On taxable income…
the tax rate is…
0 – $16,750
10%
$16,750 - $68,000
15%
$68,000 - $137,300
25%
$137,300 - $209,250
28%
$209,250 - $373,650
33%
Over $373,650
35%
The U.S. has a progressive income tax.

56. CHAPTER SUMMARY
A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq’m quantity to fall, whether the tax is imposed on buyers or sellers.
The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers.
The incidence of the tax depends on the price elasticities of supply and demand.
Policymakers often face a tradeoff between the goals of efficiency and equity in the tax system. Much of the debate over tax policy arises because people give different weights to these two goals.

57. CHAPTER SUMMARY
The efficiency of a tax system refers to the costs it imposes on taxpayers beyond their tax payments. One cost is the deadweight loss caused by the distortion of incentives from taxes. Another is the administrative burden of complying with tax laws.
The equity of a tax system refers to its fairness. The benefits principle suggests that it is fair for people to be taxed based on the amount of government benefits they receive. The ability-to-pay principle suggests that it is fair for people to pay taxes based on their ability to handle the burden.
The U.S. has a progressive tax system, in which high income taxpayers face a higher average tax rate than low income taxpayers.