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Lecture 12: Tax Incidence

November 22, 2016


Overview

Course Administration

Ripped From Headlines

Taxation Overview

Three Rules of Tax Incidence

Tax Incidence Extensions

General Equilibrium Tax Incidence

Empirical Incidence of Taxation in the US


Course Administration

1. Problem Sets• PS 11 posted• Returning PS 8• PS 9 answers posted

2. Last year’s final posted

3. Exam 2 review by David• 12/3, 1 to 2:30 pm• Rome 205• bring questions

4. Anything else?


Ripped from the Headlines

Next Week

Afternoon: Done!

Evening

Finder Presenter

Sara Linder Michael HornefferMichael Horneffer Marizabel Cabrera


Taxation Overview


Many Types of Taxation

• Payroll tax

• Income tax

• Corporate tax

• Wealth taxes• Property tax• Estate tax

• Consumption tax• Sales tax• Excise tax – sales tax applied only to certain goods• Value added tax


Type of Taxation Shifted Dramatically in US


Taxation Type Varies Substantially by Country


Key Tax Definitions

• Tax base: that on which the tax is levied• Base for property tax is value of properties• Base for sales tax is value of sales

• Tax rate: rate at which base is taxed• DC’s General tangible property and selected services tax rate is

5.75%• DC’s parking tax rate is 18%


Tax Fairness

• Vertical equity• People with more money should may “more taxes” (total, or

higher rate?) than people with less money

• Horizontal equity• Tax equivalent goods equally• Don’t tax hot dogs and fail to tax sausages• Hard to define in practice


Three Rules

of Tax Incidence


You Levy a Tax – Who Pays?

The US income tax has shifted from a reliance on corporate taxesto income tax. Does this mean workers are paying more? “Whopays?” = tax incidence

Study the three rules of tax incidence

1. Statutory burden of tax 6= economic incidence of tax

2. Side of the market on which tax is imposed is irrelevant todistribution of tax burdens

3. Parties with inelastic supply or demand bear taxes


Types of Taxation

• specific excise tax: per unit tax

• ad valorem tax: tax that is a fixed percentage of the sale price

We will present everything with a specific excise tax. Results areequally applicable to an ad valorem tax.

U.S. excise tax examples

• federal tax on bows, archery equipment and and arrow shafts

• gasoline

• wine, varying by type, highest on “naturally sparkling”


Key Phrases

Incidence ≡ who pays the tax, or who “bears the burden” of thetax.

• Statutory incidence: determined by who pays the tax to thegovernment

• Economic incidence: determined by whose economic resourceschange due to the tax


1. Statutory Incidence 6= Economic IncidenceWhat Happens When you Levy a Tax on the Producer?

price pergallon of gas

quantity of gas in billions of gallons

S

D

Qo

Po


1. Statutory Incidence 6= Economic IncidenceWhat Are the New Equilibrium Price and Quantity?



S

D

S’

tax

Qo

Po


1. Statutory Incidence 6= Economic IncidenceHow Much Extra is the Consumer Paying?



S

D

S’

tax

Qo

Po

Pn

Qn


1. Statutory Incidence 6= Economic IncidenceHow Much Does the Producer Sell for? And What Does He Keep?



S

D

S’

tax

Qo

Po

Pn

Qn

consumer’s burden


1. Statutory Incidence 6= Economic IncidenceProducer and Consumer Share the Burden of the Tax



S

D

S’

tax

Qo

Po

Pn

Qn

consumer’s burden

producer’sburden


Defining Tax Burdens

• a burden is a bad thing for producers or consumers

• burden is expressed as a positive number

• think of it as the net effect of positive and negative pricechanges from the tax

• from the producer and consumer viewpoint separately

• producer and consumer tax burden sum to the amount of thetax


Defining Tax Burdens, Tax on Producer

• consumer tax burden= (post-tax price - pre-tax price) + per-unit tax payment byconsumer= benefit/loss in price change to consumer + per-unit taxpayment by consumer= (Pn − Po)+ per-unit tax payments by consumers= Pn − Po

• producer tax burden= (pre-tax price - post-tax price) + per-unit tax payment byproducer= per-unit tax payment by producer + benefit/loss in pricechange to producer= per-unit tax payments by producers −(Pn − Po)= tax− (Pn − Po)


Writing the New Supply Curve, 1 of 3

• Suppose that the supply curve before the tax is Q = 2P + 2.

• How does the supplier perceive a tax of $2/unit?

• Note that the price with taxes on the new supply curve is 2higher than the old supply curve: Pt = Pnt + 2



Method 1 of 2 for getting to the same answer, or writing the newsupply curve Recognize that you can plug Pt = Pnt + 2 into thenew supply curve

Q = 2Pt + 2

Q = 2(Pnt − 2) + 2

Q = 2Pnt − 4 + 2

Q = 2P − 2



Method 2 of 2 for getting to the same answer, or writing the newsupply curve

• Recognize that the new supply curve has a y-intercept twounits higher than the old one

• Re-write the original supply curve in terms of P

Pt = Pnt + 2

Pt =Q − 2

2+ 2

Pt =Q + 2

2Q = 2P − 2


Two Tax Price Terms

Gross Price

• price paid by or received by party not paying the tax to thegovernment

• same as the market price

After-tax Price

• price paid by or received by the party paying tax to thegovernment

• lower by the amount of the tax if the producer pays the tax

• higher by the amount of the tax if the consumer pays the tax


2. Side of the Market on Which Tax is Imposed Irrelevantto Distribution of Tax Burden

• Suppose that the gasoline tax is levied on the consumer, notthe producer

• This means you buy some gas and send a check to thegovernment


Consumer Pays TaxWhat Happens When you Levy a Tax on the Consumer?



S

D

Qo

Po


Consumer Pays TaxWhat Are the New Equilibrium Price and Quantity?



S

Dt

Qo

Po

D’


Consumer Pays TaxHow Much Lower Price Does the Producer Suffer?



S

Dt

Qo

PoPn

Qn

D’


Consumer Pays TaxHow Much Does the Consumer Pay?



S

Dt

Qo

PoPn

Qn

producer’sburden

D’


Consumer Pays TaxProducer and Consumer Share the Burden of the Tax



S

Dt

Qo

PoPn

Qn

consumer’s burden

D’

producer’sburden


Consider Burdens

• When tax is levied on consumers• consumer burden

= t − (Po − Pn)• producer burden = Po − Pn

• When tax is levied on producers• consumer burden = Pn − Po

• producer burden = t − (Pn − Po)

• Note that• In both cases, total burden is tax• The total price change faced by producers and consumers is

equal regardless of the side of the market with the tax (moreclear in factor market analysis)


Consider Burdens

• When tax is levied on consumers• consumer burden = t − (Po − Pn)• producer burden

= Po − Pn






Consider Burdens

• When tax is levied on consumers• consumer burden = t − (Po − Pn)• producer burden = Po − Pn






Visual Comparison of Burdens



S

D

S’

tax

Qo

Po

Pn

Qn

consumer’s burden

producer’sburden



S

Dt

Qo

PoPn

Qn

consumer’s burden

D’

producer’sburden


Tax Wedge

• Tax wedge is sum of consumer and producer burdens

• Does the wedge change if the tax is levied on consumers?


In-Class Problem

The demand for rutabagas is Q = 1, 900− 100P, and the supply ofrutabagas is Q = 300P − 100.

1. Re-write one of the curves if the producer bears the statutoryincidence of a $4/unit tax on the sale of rutabagas.

2. Who bears the economic incidence of this tax?


3. Inelastic Party Bears Tax Burden

• Return to statutory tax burden levied on producers

• Consider inelastic demand

• Consider elastic demand


Inelastic DemandWhat Does Inelastic Demand Look Like?



S


Inelastic DemandWhat is the Original Equilibrium P and Q?



SD


Inelastic DemandHow Does the Tax Shift Production?



SD

Qo

Po


Inelastic DemandWhat Are the New Equilibrium P and Q?



SD

S’

tax

Qo

Po


Inelastic DemandWhat is the Consumer’s Burden?



SD

S’

tax

Qo=Qn

Po

Pn


Inelastic DemandConsumer Cannot Run Away From Tax



SD

S’

tax

Qo=Qn

Po

Pnconsumer’s burden


Elastic DemandWhat Does Elastic Demand Look Like?



S

Po


Elastic DemandHow Does Tax on Producer Shift Supply?



S

DPo

Qo


Elastic DemandWhat are the New Equilibrium P and Q?



S

D

S’

tax

Po

Qo


Elastic DemandProducer Bears Entire Burden



S

D

S’

tax

Pn=Po

QoQn


And the Same is True for Supply


Tax Incidence Extensions


Three Extensions

1. Tax incidence in factor markets

2. (skip) Tax incidence in imperfectly competitive markets

3. (skip) Balanced budget tax incidence


Tax Incidence in Factor Markets

• Suppose a tax is levied on a factor of production• tax on labor• tax on capital, such as land or steel

• Do wages decrease? Or do product prices increase?

• Who bears the burden of the tax?


Tax on Workers

• Suppose the government decides to levy a tax on workers

• It can either charge workers via a payroll tax

• Or it can charge employers via a payroll tax

• Does it matter?


Tax on Workers (Producers) vs. Tax on Firms (Consumers)How Does Tax on Workers (=Producers) Shift Supply?

tax on workers

D

S

Qo

Po

tax on firms

D

S

Qo

Po


Tax on Workers (Producers) vs. Tax on Firms (Consumers)What Are the New Equilibrium P and Q?

tax on workers

D

S

Qo

Po

t

S’

tax on firms

D

S

Qo

Po


Tax on Workers (Producers) vs. Tax on Firms (Consumers)What is the Consumer (Labor Purchaser) Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po


Tax on Workers (Producers) vs. Tax on Firms (Consumers)What is the Producer (Worker/Supplier) Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po


Tax on Workers (Producers) vs. Tax on Firms (Consumers)What if Firms Pay the Payroll Tax?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po


Tax on Workers (Producers) vs. Tax on Firms (Consumers)New Equilibrium P and Q?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t


Tax on Workers (Producers) vs. Tax on Firms (Consumers)Producer (Worker) Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

Pn

Qn


Tax on Workers (Producers) vs. Tax on Firms (Consumers)Consumer (Labor Purchaser) Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

Pn

Qn


Tax on Workers (Producers) vs. Tax on Firms (Consumers)Doesn’t Matter Who Pays the Tax

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

Pn

Qn


But What If There is an Impediment to Adjustment?

• Suppose that there is a minimum wage

• Compare payroll tax levied on workers

• To payroll tax levied on employers


Tax with a Minimum WageHow Does Tax on Workers=Producers Shift Supply?

tax on workers

D

S

Qo

Po

tax on firms

D

S

Qo

Po

min wage


Tax with a Minimum WageWhat Are the New Equilibrium P and Q?

tax on workers

D

S

Qo

Po

t

S’

tax on firms

D

S

Qo

Po

min wage


Tax with a Minimum WageWhat is the Consumer (Labor Purchaser) Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

min wage


Tax with a Minimum WageWhat is the Producer (Worker Supplier) Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

min wage


Tax with a Minimum WageWhat if Firms Pay the Payroll Tax?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

min wage


Tax with a Minimum WageNew Equilibrium P and Q?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

min wage


Tax with a Minimum WageWhat Quantity of Workers Can Firms Get?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

Pdesired

min wage


Tax with a Minimum WageWho Bears the Burden?

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

Pdesired

Qmw

min wage


Tax with a Minimum WageConsumers of Labor (Firms) Bear the Burden

tax on workers

D

S

Qo

Po

t

Qn

Pn

S’

tax on firms

D

S

Qo

Po

D’

t

Pdesired

Qmw

min wage


Summary of Taxes on Inputs

• Barriers to reaching the competitive market equilibrium canmatter for tax incidence

• Other barriers include workplace norms, such as norm for notcutting nominal wages

• More likely to see these features in input, rather than outputmarkets

• Therefore, the party on whom the tax is levied may mattermore in input than output markets


General Equilibrium

Tax Incidence


General Equilibrium Considerations

1. Illustrative example

2. Issues to consider• time period• scope• spillovers between product markets


Taxing Restaurants in Lexington, MA

• Suppose that the city of Lexington, MA passes a restauranttax

• Suppose that demand is perfectly elastic – you can go to thenext town to eat dinner

• Who bears the tax: restaurants or diners?

the restaurants

• And what happens to the quantity of restaurant mealsconsumed? declines





• Who bears the tax: restaurants or diners? the restaurants

• And what happens to the quantity of restaurant mealsconsumed?

declines





• Who bears the tax: restaurants or diners? the restaurants

• And what happens to the quantity of restaurant mealsconsumed? declines


But That’s Not the End

• A restaurant doesn’t pay taxes. In the end, people pay taxes.

• Restaurants use capital and labor – who bears the burden?

• Perhaps in the short run, labor is more elastic than capital, socapital bears the burden =⇒ restaurant owner makes lessmoney

• In the long run? restaurants leave, and landowners make lessmoney

• In economics, land is the one absolutely fixed thing






• In the long run?

restaurants leave, and landowners make lessmoney







• In the long run? restaurants leave, and landowners make lessmoney



General Equilibrium Issues: Time Period

Overarching rule for general equilibrium tax incidence is to followthe incidence until you get to a person.

• Long and short-run elasticities should differ – examples?

• In general, the longer the period, the more elastic all factorsare

• Except for land!


General Equilibrium Issues: Scope

• Scope of tax matters: elasticity of response to tax onrestaurants in Lexington is different than tax on restaurants inMassachusetts

• Is the supply of workers for the state-wide tax more or lesselastic?

less elastic

• Compare tax on soda to tax on sugar


General Equilibrium Issues: Scope

• Scope of tax matters: elasticity of response to tax onrestaurants in Lexington is different than tax on restaurants inMassachusetts

• Is the supply of workers for the state-wide tax more or lesselastic? less elastic

• Compare tax on soda to tax on sugar


General Equilibrium Issues: Cross-Product Market Effects

• Tax from one market could spill over in another – examples?

• Textbook uses restaurant meals and babysitters

• Think tax on internet and Netflix usage


Tax Incidence in the United States


Distributional Analysis of Taxes Depends on AssumptionsAbout Incidence

Here’s what two major non-partisan organizations assume

Tax Type Incidence

Income by households that pay themPayroll by workers (even the employer part)Excise shifted to prices, so in proportion to consumption

Corporateshifted to owners of capital, so in proportion tocapital income


Today: Tax Incidence

• Tax incidence: who bears the burden of the tax

1. Statutory incidence 6= economic incidence2. Without impediments, side of the market on which the tax is

levied does not impact incidence3. Less elastic factor bears the burden of the tax

• When there are impediments to reaching market equilibrium,which side of the market bears the tax matters

• General equilibrium tax incidence: the most inelastic factorbears the burden

• Rules of thumb for welfare analysis


Next Class

• Last lecture

• Gruber Chapter 12: Social insurance

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