Principles of Economics, Case and Fair,8e

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Overview

• Effects of market outcomes of taxes General
  Results
• How elasticity of supply and demand determine the
  distribution of the burden (tax incidence)
• Tax levied on suppliers
• Tax levied on consumers
• Examples (In class exercises)

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THE ECONOMICS OF TAXATION

• The primary vehicle that the government uses to
  finance itself is taxation.
• Taxes may be imposed on transactions (sales tax),
  property (property tax), incomes (income tax),
  profits (profit tax) and other things.
• Taxes levied on both consumers and producers
  (firms) or both.

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THE ECONOMICS OF TAXATION Results

• Result 1
• Doesnt matter who actually pays the tax (hands
  the money over to the government), the outcomes
  will be the same if the tax is levied on the
  consumer or on the producer.
• No matter who pays the tax
• The change in the price consumers pay will be the
  same
• The change in the price suppliers get will be the
  same
• The decrease in quantity will be the same
• The tax revenue raised will be the same
• Both consumers and producers will share the
  burden.

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THE ECONOMICS OF TAXATION Results

• Result 2
• Distribution of the tax burden will be determined
  by the (price) elasticity of demand versus the
  (price) elasticity of supply.
• If Demand is more inelastic than supply,
  consumers pay more of the burden.
• If Supply is more inelastic than demand,
  producers (firms) pay more of the burden.
• Burden is manifested in loss of consumer and
  producer surplus (dead weight loss).

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THE ECONOMICS OF TAXATION Types of Taxes

• Unit tax
• Ad valorem tax

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THE ECONOMICS OF TAXATION Types of Taxes

• Unit tax tax levied per unit sold or bought
• Example 2 unit tax levied per unit of gasoline
• If I purchase 5 gallons of
  gasoline, I pay 10 in taxes.
• Ad valorem tax a tax in accordance with a
  percent of the value of a good
• Example a 10 tax levied on cigarettes. If the
  price of a pack of cigarettes is 3.00, the tax
  will be 103.0030 cents.
• In this class we will only consider unit taxes.

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THE ECONOMICS OF TAXATION Types of Taxes

• No matter which type of tax (per unit or ad
  valorem)
• A tax will always drive a wedge between the price
  that demanders pay and the price that suppliers
  get to keep per unit sold.

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THE ECONOMICS OF TAXATION Types of Taxes

• Let PS is the price that suppliers get to
  keep
• PD is the price that demanders pay
• T is the amount of the tax
• If the tax is levied on suppliers
• firm collects a total of PD from the consumer
  and hands over T dollars to the government, and
  then gets to keep the rest
• PSPD-T
• If the tax is levied on consumers
• the total price consumers pay PD will be what is
  paid to suppliers and to the government
• PDPST

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THE ECONOMICS OF TAXATION Tax levied on suppliers

• Suppose that a 2 tax per unit of cigarettes is
  levied on suppliers.
• Every time a supplier sells a pack of cigarettes,
  must hand over 2.00 to the government.
• Firms will raise the price of cigarettes to help
  pay for this increase in costs.
• Because the price increases, consumer share in
  the burden of this tax.
• What is the effect of this on the market for
  cigarettes?

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THE ECONOMICS OF TAXATION Tax levied on suppliers

• We know that taxes drive a wedge between the
  price that suppliers get to keep and the price
  that demanders pay.
• For a per unit tax levied on suppliers,
• PS PD-T
• where PS is the price that suppliers get to keep
• PD is the price that demanders pay
• T is the amount of the tax
• Suppliers charge a price of PD. From this they
  take out T dollars and give this to the
  government, and are left with PS.

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THE ECONOMICS OF TAXATION Tax levied on suppliers

• A unit tax on suppliers
• increases the costs of each unit produced and
  sold by the amount of the tax
• causes a decrease (vertical shift up) in the
  supply by the amount of the tax
• The new supply curve
• represents the quantity that suppliers are
  willing to sell to demanders for each price that
  demanders pay (PD)
• Consider the case when a per unit tax of T
  dollars is levied on suppliers. The effect on the
  market is shown by the following drawing.

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THE ECONOMICS OF TAXATION Tax levied on suppliers
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THE ECONOMICS OF TAXATION Tax levied on suppliers

• There is a 2 tax per unit of cigarettes levied
  on suppliers. Assume that the original
  equilibrium quantity was 100 packs sold per day,
  and the original equilibrium price was 4.00 per
  pack.
• PS PD-2
• Find the effect of this tax on the market for
  cigarettes.

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THE ECONOMICS OF TAXATION Tax levied on suppliers
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THE ECONOMICS OF TAXATION Tax levied on suppliers

• Notice
• The price demanders pay went up by 1.75 (not
  2.00, the full amount of the tax)
• The price suppliers receive only went down by 25
  cents .
• Both consumers and producers share in the burden
  of the tax.

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THE ECONOMICS OF TAXATION Tax levied on suppliers

• Notice
• These change in prices reflect the distribution
  of the burden of the tax.
• Suppliers pay .25 of the 2 tax.
• Demanders pay 1.75 of the 2 tax.
• Demanders pay a greater share of the burden.

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Example Tax levied on suppliers

• Why do demanders pay more of the tax?
• Price Elasticity of Demand versus Supply.
• Demanders have a relatively inelastic demand
  curve compared to suppliers.
• Because cigarettes are addictive and have few
  substitutes, the quantity demanded does not
  decrease much when price increases.
• Demanders end up paying more of the burden of the
  tax because of their reluctance to decrease their
  consumption, relative to suppliers willingness
  to decrease supply in this market.

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Example Tax levied on suppliers

• tax incidence The ultimate distribution of a tax
  burden.
• In this example, demanders have a higher tax
  incidence than suppliers.
• One can also calculate the dead weight loss of
  the tax. This is the NET loss in Consumer Surplus
  (CS) plus the NET loss in Producer Surplus (PS)
  that results from the tax. (not counting what is
  paid as tax revenue)
• Because in this example consumers pay most of the
  tax, the loss in consumer surplus will outweigh
  the loss in producer surplus.

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Tips on calculating DWL for tax problems

• Total social surplus (TS)CSPSTAX REVENUE
• CSarea below the demand curve, to the left of
  quantity bought, and above the price paid
• PSarea below the price received, above the
  supply curve, and the left of the quantity sold
• Tax RevenueQuantity(bought/sold) per unit Tax
• DWL due to a tax ?TS

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Example Tax levied on suppliers
Of the DWL of 10 8.75 represents a loss in CS
and 1.25 represents a loss in PS.
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THE ECONOMICS OF TAXATION Tax levied on demanders

• Again taxes drive a wedge between the price that
  suppliers get to keep and the price that
  demanders pay.
• The total price per unit bought paid by a
  consumer is what is paid to suppliers plus what
  is paid to the government.
• PD PS T
• where PS is the price that suppliers get to
  keep
• PD is the total price that demanders pay
• T is the amount of the tax
• .

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THE ECONOMICS OF TAXATION Tax levied on demanders

• When consumer hand over the money, the result is
  a decrease in the demand curve by the amount of
  the tax.
• The new demand curve represents what demanders
  are willing to pay suppliers for a given quantity
  of goods.

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THE ECONOMICS OF TAXATION Tax levied on demanders
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Example Tax levied on DEMANDERS

• There is a 2 tax per unit of cigarettes levied
  on consumers. Assume that the original
  equilibrium quantity was 100 packs sold per day,
  and the original equilibrium price was 4.00 per
  pack.
• PS PD-2
• Find the effect of this tax on the market for
  cigarettes.

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Example Tax levied on DEMANDERS
Of the DWL of 10 8.75 represents a loss in CS
and 1.25 represents a loss in PS.
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ECONOMICS OF TAXATION Results

• Whether the tax is levied on demanders or
  suppliers does not matter.
• Under either situation
• The distribution of the tax incidence is the same
• The DWL is the same
• The price demanders pay will be the same
• The price suppliers get will be the same
• The quantity sold is the same
• The tax revenue is the same

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ECONOMICS OF TAXATION Results

• The distribution of the tax burden is determined
  by price elasticity of supply and demand.
• If demand is relatively inelastic (less
  responsive to changes in prices than supply),
  then consumers pay most of the burden of the tax.
• If supply is relatively inelastic, then firms
  will pay most of the burden of the tax.

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Application Who pays the burden of the payroll
tax?
Suppose the government decides to impose a per
unit tax on payroll. For each hour that a worker
works, the government requires that the firm pays
a tax of T dollars. (In graph below assumed that
workers (suppliers) pay the tax)
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TAX INCIDENCE WHO PAYS?
THE INCIDENCE OF PAYROLL TAXES
FIGURE 17.2 Equilibrium in a Competitive Labor
MarketNo Taxes
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TAX INCIDENCE WHO PAYS?
Imposing a Payroll Tax Who Pays?
FIGURE 17.3 Incidence of a Per-Unit Payroll Tax
in a Perfectly Competitive Labor Market
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TAX INCIDENCE WHO PAYS?
FIGURE 17.4 Payroll Tax with Elastic (a) and
Inelastic (b) Labor Supply
Workers bear the bulk of the burden of a payroll
tax if labor supply is relatively inelastic, and
firms bear the bulk of the burden of a payroll
tax if labor supply is relatively elastic.
Most of the payroll tax in the United States if
probably borne by workers.
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