The Equity Implication of Taxation: Tax Incidence

The incidence of a tax is also affected by the share of the product market to which it applies.

If tax a town versus an entire state we expect people will react differently. Demand for all restaurant meals in an entire state is less elastic because it is harder to find substitutes. Thus consumers will bear some of the burden. In the short run, the remainder of the tax is again shared by labor and capital. However, workers are less able to move to a non-taxed restaurant which means labor will pay more of the tax. Capital is inelastic in the short run, so it will continue to bear much of the burden.

The demand for rutabagas is Q=2,000-100P and the supply of rutabagas is Q=-100+200P. If there is a $2 imposed on rutabagas, what is the incidence of the tax? Ie. Who pays the tax?

If the tax is on the sale of rutabagas, the buyer bears the statutory incidence, since the "sticker price" of rutabagas does not include the tax. Economic incidence is determined by relative elasticities. In this case, the quantity supplied is more responsive to a change in price, so the less elastic consumers will bear most of the economic incidence. To calculate the relative burdens, solve the equilibrium condition with and without the tax. Without the tax: 2,000 - 100P = - 100 + 200P. Price = $7.00. With the tax, the price the supplier receives is reduced by $2.00. The equilibrium condition is 2,000 - 100P = 200(P - 2) - 100 2,000 - 100P = 200P - 500 2,500 = 300P, Price = $8.33. The consumers' tax burden = (posttax price - pretax price) + tax payments by con- sumers, here $8.33 - $7.00 + 0 ≈ $1.33. The producers' tax burden = (pretax price - posttax price) + tax payments by producers, here $7.00 - $8.33 + $2.00 ≈ $.67. In this case the consumer bears a larger share of the tax burden than the producer.

Assumptions of tax incidence

Income taxes are borne fully by the households that pay them Payroll taxes are borne fully by workers, regardless of whether these taxes are paid by the workers or by the firm Excise taxes are fully shifted to prices and so are borne by individuals in proportion to their consumption of the taxed item Corporate taxes are fully shifted to the owners of capital and so are borne in proportion to each individual's capital income Generally consistent with theory and empirical evidence

Effect of time period on tax incidence

Results from above likely to hold in short run but not long run. Over time, capital investments is no longer perfectly inelastic - more likely to be perfectly elastic So if workers will avoid the tax, and capital will avoid the tax, who will pay it? The owners of the land. Factors that are always inelastically demanded or supplied in the short and long run bear taxes in the long run.

You have determined that producers, rather than consumers, will bear the lion's share of the burden associated with a new tax. How does the elasticity of labor supply influence whether this tax burden will, in turn, be borne more by workers or by property owners?

The more elastic the labor supply is the more easily it will be able to escape the tax bur- den. If workers can easily move to an untaxed jurisdiction, a producer will not be able to shift the tax burden to them. Property owners may be less able to move to avoid the tax. In the extreme, if the property in question is fixed real estate, it will be immobile and com- pletely inelastic. In that case, property owners will bear the entire tax burden. If the property in question is more mobile, such as investment in capital equipment, then over time it, too, is elastic and property owners will be able to avoid much of the tax burden. As always, the least elastic component is saddled with most of the tax burden.

The government is considering imposing taxes on the sellers of certain classes of products. The first tax they are considering is a tax on 2% milk. The second is a tax on all dairy products. The third is a tax on all food products. Which of these three taxes would you expect to have the largest impact on the sticker prices of the taxed products?

We expect food to have the highest sticker price increase, since the elasticity of demand for food is the lowest. The demand for 2% milk is likely to be quite elastic, since 1% milk and whole milk are close substitutes. Sellers of 2% milk will have a difficult time shifting the burden of the tax onto consumers, and the sticker price will be little changed. The demand for all dairy products will be somewhat elastic, since there are some substitutes available for these products: meats, soy and rice milk, and peanut butter can replace some dairy products in some parts of a person's diet, for example. But the demand for dairy products is less elastic than the demand for 2% milk, so consumers will see some rise in the sticker prices of dairy products. Finally, there are no good substitutes for "all food." Food is a necessity, so the de- mand for it is quite inelastic. Most of the tax burden will be shifted to consumers in the case of a tax on food, and consumers will see a significant increase in food sticker prices.

Spillover between product markets

When consumers of a good bear any of the tax on that good, this burden will affect their consumption of other goods by shifting their budget constraint. This spillover to other goods markets means that a tax in one market can have a burden or benefit on the consumers and producers in other markets too. Ex. Price of restaurants increases so purchase fewer units of all goods (income effect). Increase consumption of substitute goods and reduce consumption of complementary goods

Parties with Elastic Supply or Demand

avoid taxes

Parties with Inelastic Demand or Supply

bear taxes

Bottom quintile pays much more

in payroll taxes than in income taxes

Balanced budget tax incidence

in the real world taxes raise money that is spend so we should care about who pays and who benefits o Ex. Suppose there is an excise tax on gas. Suppose demand is very inelastic or supply is very elastic. We would conclude the consumers of gas (drivers) bear the full burden. However, if the money goes to improve the road then they also receive the benefit.

Average corporate tax rates are small relative to

income and payroll tax rates and have fallen at both the top and bottom of the income distribution

Statutory incidence

the burden of a tax borne by the party that sends the check to the government Statutory incidence ignores the fact that market react to taxation

Economic incidence

the burden of taxation measured by the change in the resources available to any economic agent as a result of taxation How much more do consumers have to pay as a result of the tax? How much less do producers receive as a result of the tax?

The Rule of Tax Incidence

this apply for specific excise taxes (fixed amount on a specific commodity) and ad valorem taxes (fixed percentage)

Full shifting:

when one party in a transaction bears all of the tax burden Graph of perfectly inelastic demand Graph of perfectly elastic demand supply is more inelastic in the short run Tax incidence is about price, not quantity

Tax incidence

who bears the burden of the tax?

the statutory burden does not tell us

who pays the economic burden of the tax