chapter 7: tax incidence and inefficiency 7 - 1 chapter 7 tax incidence and inefficiency copyright...

Chapter 7: Tax Incidence and Inefficiency

7 - 1

Chapter 7

Tax Incidence and Inefficiency

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Introduction

Incidence: Who bears the burden

People, not firms, ultimately bear all tax burdens

A tax on capital income

Inefficiency

A tax on wage income

The efficiency loss from a tax on a good

The efficiency loss from a tax on wage income

The efficiency loss from a tax on capital income


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People, Not Firms, Ultimately Bear all Tax Burdens

People, in their roles as

Two examples

• consumers• workers • stockholders • and managers

…will ultimately bear the burden of taxes levied on business firms.

• Tax on gasoline• Payroll tax


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P

D

S

Q

S’

100

$3.30

$2.50$2.30

90

$1

Figure 7.1A

Who bears the burden of a $1 tax?

In this case, • Supply is elastic• Demand is inelastic

• It depends on relative elasticities

So the consumers bear more of a burden.

The Distribution of the Burden Depends on the Relative Elasticities

A tax on gasoline

Tax is levied on producers.


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$2.70

$2.50

$1.70

P

D

S

Q

S’

100QT

$1

Figure 7.1B

In this case, • Supply is inelastic• Demand is elastic

So the producers bear more of a burden.

The Distribution of the Burden Depends on the Relative Elasticities

A tax on gasoline

Elasticity• In the short run• In the long run



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P

D

S

QD’

100

$3.30

$2.50$2.30

90

$1

Figure 7.1C

The Distribution of the Burden Doesn’t Depend on Who Writes the Check

Who bears the burden of a $1 tax?

• In this case, the consumer writes the check…

• It doesn’t depend on who writes the check

And the outcome is the same as if the producer wrote the check.

Tax is levied on consumers.


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P

D

S

Q100

$3.30

$2.50$2.30

90

A

B

Figure 7.1D


The tax wedge short cut

Tax revenue

• Equal to the amount of the tax = BA

• Equal to the tax per unit multiplied by the number of units


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P

D

S

Q

S’

$106

$101$100

6%

Figure 7.2

QT QN


A sales tax• Is an ad valorem tax

Who bears the burden of a sales tax?

• Again, it depends on relative elasticities



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A Tax on Wage Income

$16$15

$12

W

D

S

L

S’

10095

$4

Figure 7.3A

A wage tax

• S = employees• D = employers

Who bears the burden of a wage tax?

• Again, it depends on relative elasticities

Tax is levied on employees.


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D

S

D’

Figure 7.3B

$16$15

$12

W

10095

$4

L


Who bears the burden of a wage tax?

Tax is levied on employers.

A wage tax

The outcome is the same as if the tax was levied on the employees.


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D

S

Figure 7.3C

$16$15

$12

W

10095L

The tax wedge short cut


• The employee’s share of total tax revenue• The employer’s share of total tax revenue


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D

S

Figure 7.4

$106.20$103.80

$93.80

W

LLT LN

$100.00

The payroll tax for Social Security

• Split between employees and employers

Use the tax wedge short cut to identify who bears the burden of a payroll tax


• The employee’s share of total tax revenue• The employer’s share of total tax revenue


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How elastic is labor supply?• The substitution effect• The income effect

How do you measure employees’ responses to changing taxes?


• Time series data and analysis• Cross-section data and analysis

• Primary earners• Secondary earners

Important to distinguish the type of earner

Estimates?


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A Tax on Capital Income

r

D

S

Saving

S’

5%

4%

3%

Figure 7.5

ST SN

A capital income tax

• S = lenders• D = borrowers

• Substitution effect• Income effect

How elastic is saving supply?

The tax is levied on capital income which lenders earn.


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General Equilibrium Tax Incidence

D

S

Figure 7.6W

LLT LN

D’

The impact of a capital income tax on the wage

• If the tax reduces the capital stock, employees’ productivity decreases• Employees bear some burden from a capital income tax


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D

S

S’

$30

Figure 7.7A Figure 7.7BWH

High-Skilled Labor

O

F

D

S

S’

$10

WL

O

G

D’Low-Skilled Labor

General Equilibrium Tax Incidence

The impact of a capital income tax on the wage


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Inefficiency

A tax usually causes an efficiency loss by causing an unfavorable change in the mix of goods.

• Deadweight loss• Welfare loss• Welfare cost• Excess burden

Inefficiency resulting from a tax is also called:

Efficiency, along with fairness and ease of administration, are criteria for judging taxes.


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The Efficiency Loss from a Tax on a Good

P

D

S

Q

$20

$16

$4

Figure 7.8

(MC)

(MB)

110100

A

B

D

Efficiency loss

= (1/2)T(∆Q) = BAD

e ≡ (%∆Q)/(%∆P)L = (1/2)t2 ePQL/R = (1/2)te

Efficiency loss depends on the elasticity of demand.


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Optimal Commodity Taxation

Varying price elasticities for goods leads to different efficiency losses.

• Elasticity is difficult to determine• May encourage wasteful lobbying• Would raise compliance and administrative costs• Citizens may find this unfair

Four drawbacks

Ramsey inverse elasticity rule


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The Efficiency Loss from a Tax on Wage Income

P

D

S

L (Annual Hours)

$20

$16

Figure 7.9

(MRPL)

22,00020,000

A

B

D

Wage = MRPL

= (1/2)T(∆H)

Efficiency loss = BAD

ε ≡ (%∆H)/(%∆W)L = (1/2)t2 εWHL/R = (1/2)tε

Efficiency loss depends on the elasticity of labor supply.


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r

D

S

Saving

5%

3%

Figure 7.10

$120,000$100,000

A

B

D

The Efficiency Loss from a Tax on Capital Income

Efficiency loss = BAD

Again, efficiency loss depends on the elasticity.


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A Lump-Sum Tax and the Marginal Tax Rate

• A lump-sum tax is a tax where the amount owed doesn’t vary with the taxpayer's behavior.

• Importance of average tax rates (ATR) and marginal tax rates (MTR) to determine inefficiency

• There is no efficiency loss with lump-sum taxes.


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The Revenue-Rate Curve

Tax Revenue

Tax Rate

Figure 7.11

100%tM

There is some tax rate between 0% and 100% which maximizes tax revenue

• Laffer’s hypothesis• The location of tM

depends on your economic perspective


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Summary

Incidence: Who bears the burden

People, not firms, ultimately bear all tax burdens

A tax on capital income

Inefficiency

A tax on wage income

The efficiency loss from a tax on a good

The efficiency loss from a tax on wage income

The efficiency loss from a tax on capital income


7 - 25

Preview of Chapter 8:

Mechanics of the U.S. income tax

Concepts underlying the income tax

Issues in taxing labor income

Issues in taxing capital income

Income Taxes

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