Chapter 19: The Equity Implications of Taxation

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Chapter 19 The Equity Implications of Taxation
Tax Incidence

• A central question of tax incidence is who bears
  the burden of a tax?
• Tax incidence is assessing which party (consumers
  or producers) bear the true burden of a tax.
• Although the legal incidence of a tax is pretty
  obvious, markets respond to taxes, so that the
  ultimate burden is not nearly so clear.
• In this lecture I will discuss.
• Three rules of tax incidence
• General equilibrium tax incidence
• Empirical evidence

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THE THREE RULES OF TAX INCIDENCE

• There are three basic rules for figuring out who
  ultimately bears the burden of paying a tax.
• The statutory burden of a tax does not describe
  who really bears the tax.
• The side of the market on which the tax is
  imposed is irrelevant to the distribution of tax
  burdens.
• Parties with inelastic supply or demand bear the
  burden of a tax.
• The burden of a tax is measured by changes in
  prices (and not quantities).

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The three rules of tax incidence The statutory
burden does not describe who really bears the tax

• Statutory incidence is the burden of the tax
  borne by the party that sends the check to the
  government.
• For example, the government could impose a 50
  per gallon tax on suppliers of gasoline.
• Economic incidence is the burden of taxation
  measured by the change in resources available to
  any economic agent as a result of taxation.
• If gas stations raise gasoline prices by 25 per
  gallon as a result, then consumers are bearing
  half of the tax.

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The burden of the tax is split between consumers
and producers
(a)
(b)
Price per gallon (P)
Price per gallon (P)
A 50 cent tax shifts the effective supply curve.
S2
Initially, equilibrium entails a price of 1.50
and a quantity of 100 units.
S1
S1
B
2.00
C
Consumer burden 0.30
P2 1.80
P1 1.50
P1 1.50
A
A
0.50
Supplier burden 0.20
D
D
Q1 100
Q2 90
Quantity in billions of gallons (Q)
Quantity in billions of gallons (Q)
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The economic incidence of the tax does not depend
on who the tax is levied on (the statutory
incidence)
The economic burden of the tax is identical to
the previous case.
Price per gallon (P)
S
Imagine imposing the tax on demanders rather than
suppliers.
The new equilibrium price is 1.30, and the
quantity is 90.
The quantity is identical to the case when the
tax was imposed on the supplier.
Consumer burden
A
P1 1.50
Supplier burden
P2 1.30
C
B
1.00
0.50
D2
D1
Quantity in billions of gallons (Q)
Q1 100
Q2 90
These tax burdens are identical to the burdens
when the tax was levied on producers.
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Elastic parties avoid taxes and inelastic parties
bear them.
Price per gallon (P)
D
S2
S1
P2 2.00
With perfectly inelastic demand, consumers bear
the full burden.
Consumer burden
P1 1.50
0.50
Quantity in billions of gallons (Q)
Q1 100
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Price per gallon (P)
S2
S1
0.50
With perfectly elastic demand, producers bear the
full burden.
D
P1 1.50
Supplier burden
1.00
Quantity in billions of gallons (Q)
Q1 100
Q2 90
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The three rules of tax incidence Inelastic
versus elastic supply and demand

• In this case, the producer bears the full burden
  of the tax, because consumers will simply stop
  purchasing the product if prices are raised.
• These extreme cases illustrate a general point
• Parties with inelastic supply or demand bear
  taxes parties with elastic supply or demand
  avoid them.
• Demand is more elastic when there are many good
  substitutes (for example, fast food at
  restaurants). Demand is less elastic when there
  are few substitutes (for example, insulin
  medication).
• Supply is more elastic when suppliers have more
  alternative uses to which their resources can be
  put.

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More inelastic supply, smaller consumer burden.
More elastic supply, larger consumer burden.
(a) Tax on steel producer
(b) Tax on street vendor
P
P
S2
S1
Tax
S2
B
B
P2
P2
Tax
Consumer burden
Consumer burden
S1
A
P1
A
P1
D
D
Q
Q
Q1
Q2
Q1
Q2
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• With a minimum wage, wages cannot fully adjust,
  so the incidence may be
• different.

Wage (W)
S2
A binding minimum wage changes the analysis,
however.
When imposed on employees, the analysis is
similar to before.
S1
Tax
B
W25.65
Firm burden
A
Wm5.15
Worker burden
W34.65
C
D1
Hours of labor (H)
H1
H2

• The incidence is borne in the same manner as when
  there was no minimum wage.

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Without wage shifting, would end up at C.
In this case, the firm bears the economic burden.
Wage (W)
Employers cannot fully wage shift with the
binding minimum wage.
When imposed on employers, the incidence differs!
S1
B
With fully shifting wages, would end up at C.
W26.15
Firm burden
A
C
Wm5.15
4.65
C
Tax
D1
D2
Hours of labor (H)
H2
H3
H1
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With a tax, both D and MR change, as does the
quantity.
P

• The tax on consumers shifts the demand curve
  downward to D2, and the associated marginal
  revenue curve to MR2.
• Setting MR2MC, the quantity Q2 now maximizes
  profits.
• The monopolists price falls from P1 to P2, so it
  bears some of the tax, just as a competitive firm
  does.
• The three rules of tax incidence continue to
  apply for a monopolist.

P1
S
S
B
P2
D1
A
B
D2
MR1
MR2
Q2
Q
Q1
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GENERAL EQUILIBRIUM TAX INCIDENCE

• Our models so far have focused on partial
  equilibrium.
• Partial equilibrium tax incidence is analysis
  that considers the impact of a tax on a market in
  isolation.
• To study the effects on related markets, we use
  general equilibrium analysis.
• General equilibrium tax incidence is analysis
  that considers the effects on related markets of
  a tax imposed on one market.

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The demand for restaurant meals in a single town
Price per meal (P)
S2
S1
In this case demand for meals is perfectly
elastic.
1
B
A
D
P1 20
Meals sold per day (Q)
Q1 1000
Q2 950

• The 1 tax on meals is borne by the firm, meaning
  that it is borne by the factors of
• production (labor and capital).

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Incidence on input markets
The incidence is shifted backward to labor and
capital.
Capital is inelastically supplied.
(a) Labor
(b) Capital
Rate of return (r)
Wage (W)
S
We assume the supply of labor in the locality is
perfectly elastic.
Labor therefore does not bear any of the tax
burden.
D1
Capital bears the tax.
D2
A
B
A
W1 8
S
r1 10
B
r2 8
D1
D2
Hours of labor (H)
Investment (I)
H1 1,000
H2 900
I1 50 million
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General equilibrium tax incidenceIssues to
consider in GE incidence analysis

• As illustrated, the supply of labor (restaurant
  workers) is perfectly elastic, because those
  workers can easily find a job in another
  locality.
• The tax on output, restaurant meals, would reduce
  the firms demand for labor, reducing the number
  of workers hired, but not their wage rate.
• On the other hand, in the short-run, the supply
  of capital is likely to be fixed. The firms
  demand for capital shifts in, lowering the rate
  of return on capital.
• In the short run, the owners of capital bear the
  tax in the form of a lower return on their
  investment.

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General equilibrium tax incidenceIssues to
consider in GE incidence analysis

• In the longer-run, the supply of capital is not
  inelastic.
• Investors can close or sell the restaurant, take
  their money, and invest it elsewhere.
• In the long-run, capital is likely to be
  perfectly elastic as there are many good
  substitutes for investing in a particular
  restaurant in a particular town.

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General equilibrium tax incidenceIssues to
consider in GE incidence analysis

• If both labor and capital are highly elastic in
  the long run, who bears the tax?
• The one additional inelastic factor in the
  restaurant production process is land.
• The supply is clearly fixed.
• When both labor and capital can avoid the tax,
  the only way restaurants can stay open is if they
  pay a lower rent on their land.

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General equilibrium tax incidenceIssues to
consider in GE incidence analysis

• The scope of a tax matters for tax incidence as
  well. Consider imposing a restaurant tax on the
  entire state rather than just a city.
• Demand in the output market is less elastic
  consumers bear some of the burden.
• Labor supply is less elastic as well.
• The scope of the tax matters to incidence
  analysis because it determines which elasticities
  are relevant to the analysis taxes that are
  broader based are harder to avoid than taxes that
  are narrower, so the response of producers and
  consumers to the tax will be smaller and more
  inelastic.

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General equilibrium tax incidenceIssues to
consider in GE incidence analysis

• There are also potentially spillovers into other
  output markets from the restaurant tax, not just
  input markets.
• Consider the statewide restaurant tax that raises
  the price of meals
• It has an income effect for consumers.
• It increases consumption of goods that are
  substitutes for restaurant meals, such as meals
  at home.
• It decreases consumption of goods that are
  complements for restaurant meals, such as valets.
• A complete general equilibrium analysis must
  account for the effects in these other markets.

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THE INCIDENCE OF TAXATION IN THE UNITED
STATESCBO incidence assumptions

• The Congressional Budget Office (CBO) has
  examined the incidence of taxation in the U.S.
• The CBO assumes
• Income taxes are fully borne by the households
  that pay them.
• Payroll taxes are fully borne by workers,
  regardless of the statutory incidence.
• Excise taxes are fully shifted forward to prices.
• Corporate taxes are fully shifted forward to the
  owners of capital.
• This is very similar to the State of Wisconsin
  tax incidence study that is (briefly) described
  in the class readings.

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Effective Tax Rates (in percent) Effective Tax Rates (in percent) Effective Tax Rates (in percent) Effective Tax Rates (in percent) Effective Tax Rates (in percent) Effective Tax Rates (in percent)
1979 1985 1990 1995 2001
Total effective tax rate Total effective tax rate Total effective tax rate Total effective tax rate Total effective tax rate
All households 22.2 20.9 21.5 22.6 21.5
Bottom quintile 8.0 9.8 8.9 6.3 5.4
Top quintile 27.5 24.0 25.1 27.8 26.8
Effective Income Tax Rate Effective Income Tax Rate Effective Income Tax Rate Effective Income Tax Rate Effective Income Tax Rate
All households 11.0 10.2 10.1 10.2 10.4
Bottom quintile 0.0 0.5 -1.0 -4.4 -5.6
Top quintile 15.7 14.0 14.4 15.5 16.3
Effective Payroll Tax Rate Effective Payroll Tax Rate Effective Payroll Tax Rate Effective Payroll Tax Rate Effective Payroll Tax Rate
All households 6.9 7.9 8.4 8.5 8.4
Bottom quintile 5.3 6.6 7.3 7.6 8.3
Top quintile 5.4 6.5 6.9 7.2 7.1
Effective Corporate Tax Rate Effective Corporate Tax Rate Effective Corporate Tax Rate Effective Corporate Tax Rate Effective Corporate Tax Rate
All households 3.4 1.8 2.2 2.8 1.8
Bottom quintile 1.1 0.6 0.6 0.7 0.3
Top quintile 5.7 2.8 3.3 4.4 2.9
Effective Excise Tax Rate Effective Excise Tax Rate Effective Excise Tax Rate Effective Excise Tax Rate Effective Excise Tax Rate
All households 1.0 0.9 0.9 1.0 0.9
Bottom quintile 1.6 2.2 2.0 2.4 2.4
Top quintile 0.7 0.7 0.6 0.7 0.6