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Tax Incidence
An Application of Supply and Demand
A sales tax is a tax on a wide variety of goods. An excise tax is a tax on a specific good.
An ad valorem tax is expressed as a percentage of a good’s price or value.
A unit tax is a fixed amount per unit of a good.
Statutory tax incidence is concerned with who is legally required to pay a tax.
Economic 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.
0.200.400.600.801.001.201.401.601.80
10 20 30 40 50 60 70 80 90
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 $0.60 per gallon tax on the sellers of gasoline.
0.200.400.600.801.001.201.401.601.80
10 20 30 40 50 60 70 80 90
P$ 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 $0.20.
Changes in market prices typically result in the ultimate burden of a tax (i.e., the economic incidence) being at least partially shifted away from those statutorily required to pay the tax.
0.200.400.600.801.001.201.401.601.80
10 20 30 40 50 60 70 80 90
P$ 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 $0.60.
Unit Tax (statutorily) Imposed on Buyers
D0.200.400.600.801.001.201.401.601.80
10 20 30 40 50 60 70 80 90
P$ 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’
$0.60
The economic incidence is the same whether buyers or sellers are statutorily liable for the tax.
0.20
0.40
0.600.801.00
1.20
1.40
1.60
1.80
10 20 30 40 50 60 70 80 90
P$ per gallon
Q(millions of gallons)
S
D
S’
$0.60
D
0.20
0.40
0.600.801.00
1.20
1.40
1.60
1.80
10 20 30 40 50 60 70 80 90
P$ per gallon
Q(millions of gallons)
S
D’
$0.60
P
Q
D
S
P0
Q0
Pg1
Pn1
Q1
S’
u
(Pg1 - P0) + (P0 - Pn
1) = Pg1 - Pn
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.
P
Q
D
S
P0
Q0
Pg1
Pn1
Q1
S’
utax revenue: R = u • Q1
P
Q
D
S
P0
Q0
Pg1
Pn1
Q1
S’
utax revenue: R = u • Q1
(Pg1 - P0) • Q1
(P0 - Pn1) • Q1
Buyers’ share of the tax burden: u
PP
Qu
QPPK
gg
B)()( 01
1
101
Sellers’ share of the tax burden: u
PP
Qu
QPPK
nn
S)()( 10
1
110
Who bears the burden of a tax crucially depends upon the price elasticities of demand
and supply.
P
Q
S
P0
Q0
D2
S’
Pg2
Pn2
Q2
P
Q
D1
S
P0
Q0
Pg1
Pn1
Q1
S’
P
Q
D1
S
P0
Q0
D2
Pg1
Pn1
Q1
S’
Pg2
Pn2
Q2
P
Q
D1
S
P0
Q0
D2
Pg1
Pn1
Q1
S’
Pg2
Pn2
Q2
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 (D2), the gross price paid by buyers is higher.
With the less elastic demand (D2), the net price received by sellers is higher.
P
Q
D
S1
P0
Q0
Pg1
Pn1
Q1
D’
P
Q
D
P0
Q0
D’
S2
Q2
Pg2
Pn2
P
Q
D
S1
P0
Q0
Pg1
Pn1
Q1
D’
S2
Q2
Pg2
Pn2
P
Q
D
S1
P0
Q0
Pg1
Pn1
Q1
D’
S2
Q2
Pg2
Pn2
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 (S1), the gross price paid by buyers is higher.
With the more elastic supply (S1), the net price received by sellers is higher.
The portion of a unit tax borne by buyers, KB, can be shown
to equal .1
1
s
dEEsd
sB EE
EK
The portion of a unit tax borne by sellers, KS, can be shown
to equal . d
sEEsd
dS EE
EK
1
1
Thus, the economic incidence of a tax depends upon the magnitude of Ed relative to the magnitude of Es, as the ratio Ed / Es determines the shares of the tax burden borne by buyers and sellers.
1
1
s
dEEsd
sB EE
EK
d
sEEsd
dS EE
EK
1
1
As Ed / Es 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 Ed / Es 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.
Price Ceilings & Price Floors
Price Ceiling A legally established maximum price at which a
good can be sold.
Price Floor A legally established minimum price at which a
good can be sold.
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.
A Price Ceiling That Is Not Binding...
$4
3
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
Demand
Supply
Priceceiling
Equilibriumprice
100Equilibrium
quantity
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Price Ceiling That Is Binding...
$3
Quantity ofIce-Cream
Cones
0
Price ofIce-Cream
Cone
2
Demand
Supply
Equilibriumprice
Priceceiling
Shortage
125Quantity
demanded
75Quantitysupplied
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Rent Control
Rent controls are ceilings placed on the rents that landlords may charge their tenants.
The goal of rent control policy is to help the poor by making housing more affordable.
One economist called rent control “the best way to destroy a city, other than bombing.”
Rent Control in the Short Run...
Quantity ofApartments
0
Rental Price of
Apartment
Demand
Supply
Controlled rent
Shortage
Supply and demand for apartments
are relatively inelastic
Rent Control in the Long Run...
Quantity ofApartments
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
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