Gruber4e_ch19

1 of 35Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth PublishersCopyright © 2010 Worth Publishers

2 of 35Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

19

Dan Sacks

P R E P A R E D B Y

19.1 The Three Rules of Tax Incidence

19.2 Tax Incidence Extensions

19.3 General Equilibrium Tax Incidence

19.4 The Incidence of Taxation in the United States

19.5 Conclusion

The Equity Implications of Taxation: Tax Incidence

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C H A P T E R 1 9 ■ T H E E Q U I T Y I M P L I C A T I O N S O F T A X A T I O N : T A X I N C I D E N C E

Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright © 2012 Worth Publishers

19.1

Tax Incidence

• Tax incidence: Assessing which party (consumers or producers) bears the true burden of a tax.

Category: 1960 2008Income taxes 44.5% 43.7%Corporate taxes 22.8 11.3Payroll tax 17.0 37.8Excise taxes 12.8 2.6Other 2.9 4.5

Sources of federal government revenue, 1960 and 2008:

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19.1

• Statutory incidence: The burden of a tax borne by the party that sends the check to the government.

• Economic incidence: The burden of taxation measured by the change in the resources available to any economic agent as a result of taxation.

• Economic incidence includes tax payments paid and any price changes caused by the tax.

The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax

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19.1

• The tax burden for consumers is:

Consumer tax burden =

(post-tax price – pre-tax price) + per-unit consumer tax

• For producers the tax burden is

Producer tax burden =

(pre-tax price – post-tax price) + per-unit producer tax

The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax

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19.1

• Tax wedge: The difference between what consumers pay and what producers receive (net of tax) from a transaction.

• If the consumer burden is $0.30 and the producer burden is $0.20, the tax wedge is $0.50.

Burden of the Tax on Consumers and Producers

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Q2 = 80

B

C

D

Price pergallon (P)

Quantity inbillions of

gallons (Q)

0

A

S1

D

P1 = $1.50

Q1 = 100

(a) Tax on producers S2

E

Tax =$0.50

Q3 = 90

P2 = $2.00

P3 = $1.80

$1.30

Consumerburden =

$0.30Producerburden =

$0.20

The Statutory Burden of a Tax Does Not Describe Who Really Bears the Tax, and Is Irrelevant to the Tax Burden

19.1

Price pergallon (P)

Quantity inbillions of

gallons (Q)

0

A

S

D1

P1 = $1.50

Q1 = 100

(b) Tax on consumers

D2

Tax =$0.50

C

B

D

E $1.80

P3 = $1.30

P2 = $1.00Producerburden =

$0.20

Consumerburden =

$0.30

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19.1

• Gross price: The price in the market.

• After-tax price: The gross price minus the amount of the tax (if producers pay the tax) or plus the amount of the tax (if consumers pay the tax).

• Different statutory rules produce different gross prices for the same after-tax price.

Gross versus After-Tax Prices

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19.1

• The economic incidence of taxation does not depend on the statutory incidence.

• It is ultimately determined by the elasticities of supply and demand, that is, how responsive the quantity supplied or demanded is to price changes.

• If one side of the market is perfectly inelastic, then it bears there is full shifting of the tax burden to it.

o Full shifting: When one party in a transaction bears all of the tax burden.

Parties with Inelastic Supply or Demand Bear Taxes;

Parties with Elastic Supply or Demand Avoid Them

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19.1

Perfectly Inelastic Demand

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19.1

Perfectly Elastic Demand

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19.1

• In general, the less elastic is demand relative to supply, the larger share of the incidence falls on demand.

• Demand for goods is more elastic when there are many substitutes.

• For products with an inelastic demand, the burden of the tax is borne almost entirely by the consumer.

General Case

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19.1

Supply Elasticities

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19.1

• When the demand for gas is perfectly elastic, consumers bear none of the burden of taxation, yet the quantity of gas consumed fell dramatically.

• Doesn’t this fall in consumption hurt consumers?

• If so, shouldn’t tax incidence take that into account?

• Perfectly inelastic demand means consumers are indifferent between the gas and other goods, so they are not hurt by the fall in gas consumption.

Reminder: Tax Incidence Is About Prices, Not Quantities

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19.2

To recap:

• 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 taxes; parties with elastic supply or demand avoid them.

Tax Incidence Extensions

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19.2

Tax Incidence in Factor Markets

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• Tax incidence analysis assumes that prices can freely adjust.

• But wages cannot fall below the minimum wage.

• Minimum wage: Legally mandated minimum amount that workers must be paid for each hour of work.

• Barriers to price adjustment change the incidence.

19.2

Impediments to Wage Adjustment

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W2 = $8.25

Wage(W)

Hours oflabor (H)

0

(a) Tax on workers

A

B

C’

S1

D1

H1

Wage(W)

Hours oflabor (H)

0

A

S1

D1

$6.75

H1

(b) Tax on firms

S2

C

Tax =$1.00

H2H3

WM = $7.25

Firmburden =

$0.50

Workerburden =

$0.50

WM = $7.25

W2 = $7.75

W3 = $6.75

H2

B

C

Firmburden =

$1.00

Tax =$1.00

D2

Impediments to Wage Adjustment19.2

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19.2

• Monopoly markets are an extreme case of imperfectly competitive markets.

o Monopoly markets: Markets in which there is only one supplier of a good.

o For price-taking firms, marginal revenue (MR) is equal to price.

o Monopolists must lower the price to sell more, though, so marginal revenue falls faster than price.

o Monopolist produces such that MR = MC.

Tax Incidence in Imperfectly Competitive Markets

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A’

B

Price

Quantity0

P1

Q1Q2

P2

D1

D2

S= MC

MR1MR2

A

Tax

B’

Background: Equilibrium in Monopoly Markets19.2

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19.2

• Even in monopoly markets, a tax on either side of the market results in the same sharing of the tax burden.

• Monopolists cannot “exploit their market power” to avoid the rules of tax incidence.

• Economists tend to assume that the same rules of incidence apply in more general oligopoly markets.o Oligopoly markets: Markets in which firms have

some market power in setting prices, but not as much as a monopolist.

Tax Incidence in Imperfectly Competitive Markets

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19.2

• Tax incidence analysis typically only accounts for who pays the tax.

• Balanced budget incidence: Tax incidence analysis that accounts for both the tax and the benefits it brings.

• Balanced budget incidence is difficult because it is hard to determine who benefits from a given tax increase.

Balanced Budget Tax Incidence

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19.3

• So far, we have considered incidence in only a single market, such as the gas market.

• Partial equilibrium tax incidence: Analysis that considers the impact of a tax on a market in isolation.

• General equilibrium tax incidence: Analysis that considers the effects on related markets of a tax imposed on one market.

• Taxes in one market affect prices in others, complicating the analysis.

General Equilibrium Tax Incidence

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19.3

Effects of a Restaurant Tax: A General Equilibrium Example

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19.3

General Equilibrium Tax Incidence

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19.3

• Factors that are inelastically demanded or supplied in both the short and long run bear taxes in the long run.

• Investments are irreversible, so the supply of capital is inelastic in the short run.

• Investors have many opportunities, so in the long run, elasticity of capital may be high.

Effect of Time Period on Tax Incidence: Short Run versus Long Run

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19.3

• Tax incidence depends on how broadly the tax is applied.

• 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.

• A tax on local restaurants has a different incidence than a tax on all restaurants.

Effect of Tax Scope on Tax Incidence

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19.3

Consider a tax on restaurant. A higher after-tax price has three effects on other goods as well:

1. Income effect from lower real income.

2. Substitution effect toward goods that are substitutes for restaurants.

3. Complementary effect: Consumers may reduce their consumption of goods or services that are complements to restaurant meals.

Spillovers between Product Markets

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19.4

• Excises tax on cigarettes varies widely across the United States.

o Low of $0.025/pack per pack in VA.

o High of $1.51/pack in CT and MA.

o Since 1990, NJ increased its tax rate nearly sixfold.

o Arizona has increased its tax nearly eightfold.

• Many studies examine how taxes affect prices.

• These studies uniformly conclude that the price of cigarettes rises by the full amount of the excise tax.

EVIDENCE: The Incidence of Excise Taxation

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19.4

The CBO analyzes tax incidence in the United States, assuming:

1. Income taxes are borne fully by households.

2. Payroll taxes are borne fully by workers.

3. Excise taxes fully shifted to prices and so are borne by individuals in proportion to their consumption of the taxed item.

4. Corporate taxes are fully shifted to the owners of capital and so are borne in proportion to each individual’s capital income.

Incidence in the United States

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19.4

Total Effective Tax Rate in the United States,

1979−2011

1979 1990 2000 2011All households 22.2% 21.5% 23.0% 18.6%Bottom quintile 8.0 8.9 6.4 1.1Top quintile 27.5 25.1 28.0 23.8

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19.4

Top and Bottom Quintile’s Share of Income and Tax Liabilities

1979 1990 2000 2012Top Quintile

Share of income 45.5% 49.5% 54.8% 56.2%Share of tax 56.4 57.9 66.6 70

Bottom QuintileShare of income 4.8 4.6 3.9 3.6Share of tax 2.1 1.9 1.1 0.3

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19.4

• Tax incidence is usually evaluated by current rather than lifetime income.

o Current tax incidence: The incidence of a tax in relation to an individual’s current resources.

o Lifetime tax incidence: The incidence of a tax in relation to an individual’s lifetime resources.

• Poterba (1989a) showed that gasoline and cigarette taxes are much less regressive from a lifetime than current income perspective.

Current vs. Lifetime Income Incidence

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19.5

• The “fairness” of any tax reform is one of the primary considerations in policy makers’ positions on tax policy.

• Therefore, it is crucial for public finance economists to have a deep understanding of who really bears the burden of taxation so that we can best inform these distributional debates over the fairness of a proposed or existing tax.

Conclusion

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