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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
Chapter 7: Tax Incidence and Inefficiency
7 - 2
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
Chapter 7: Tax Incidence and Inefficiency
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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
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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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
Tax is levied on producers.
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
7 - 7
P
D
S
Q100
$3.30
$2.50$2.30
90
A
B
Figure 7.1D
The Distribution of the Burden Doesn’t Depend on Who Writes the Check
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
Chapter 7: Tax Incidence and Inefficiency
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P
D
S
Q
S’
$106
$101$100
6%
Figure 7.2
QT QN
The Distribution of the Burden Doesn’t Depend on Who Writes the Check
A sales tax• Is an ad valorem tax
Who bears the burden of a sales tax?
• Again, it depends on relative elasticities
Tax is levied on producers.
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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D
S
D’
Figure 7.3B
$16$15
$12
W
10095
$4
L
A Tax on Wage Income
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.
Chapter 7: Tax Incidence and Inefficiency
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D
S
Figure 7.3C
$16$15
$12
W
10095L
The tax wedge short cut
A Tax on Wage Income
• The employee’s share of total tax revenue• The employer’s share of total tax revenue
Chapter 7: Tax Incidence and Inefficiency
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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
A Tax on Wage Income
• The employee’s share of total tax revenue• The employer’s share of total tax revenue
Chapter 7: Tax Incidence and Inefficiency
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How elastic is labor supply?• The substitution effect• The income effect
How do you measure employees’ responses to changing taxes?
A Tax on Wage Income
• Time series data and analysis• Cross-section data and analysis
• Primary earners• Secondary earners
Important to distinguish the type of earner
Estimates?
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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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
Chapter 7: Tax Incidence and Inefficiency
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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
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
7 - 19
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
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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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.
Chapter 7: Tax Incidence and Inefficiency
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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
Chapter 7: Tax Incidence and Inefficiency
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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
Chapter 7: Tax Incidence and Inefficiency
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