Tax Shifting and Incidence

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Tax Shifting and Incidence

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois

Econ 214
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Topics for today

• Who bears the tax burden?
• Taxes on buyers compared with taxes on sellers
• Unit taxes compared with ad valorem taxes
• Tax shifting under monopoly

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Tax incidence

• Tax incidence is the study of who really bears
  the burden of a tax
• statutory incidence
• economic incidence
• tax shifting

Shifting economic incidence - statutory
incidence
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Types of shifting

• Forward shifting -- transfer of tax burden from
  sellers to buyers
• Example tax on cigarettes is shifted forward
  from sellers (who are legally liable for the tax)
  to buyers assuming demand is perfectly inelastic
• Backward shifting -- transfer of tax burden from
  buyers to sellers
• Example payroll tax is shifted backward from
  employers to sellers (workers) assuming labor
  supply is perfectly inelastic

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Unit tax on sellers
Price (P)
Is this tax shifted? What is its incidence?
S
Buyers
Pe
Sellers
D
Pizza (Q)
Qe
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Tax shifting and elasticities
Price
S T
D

• The more inelastic the demand or elastic the
  supply of the taxed commodity, the greater the
  tax burden on the buyer.

S
T
PG
Buyers
PePN
Salt
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Problem 1
Price per gallon
2.00
D

• Who bears the burden of a .50/gal tax on
  gasoline, the buyer or the seller?

MC
1.00
200
100
Gasoline
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Unit tax on buyers
ST
Price (P)
How would the incidence change if the tax were on
the buyer instead of the seller?
S
T
PG
Buyers
Revenue
Pe
Sellers
PN
D
Pizza (Q)
Qe
Q1
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Problem 2
Price per gallon

• How would the incidence change if the tax were on
  the buyer rather than on the seller?

2.00
D
MC
1.00
ANS Assuming a perfectly competitive market and
equal yield taxes, the incidence of the two taxes
would be the same -- on the buyer.
200
100
Gasoline
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Tax principle

• In competitive markets, tax incidence is
  independent of the legal liability for the tax
• A unit tax on the buyer has the same effect on
  price and output as an equal yield unit tax on
  the seller
• A unit tax on the buyer will be fully shifted
  forward to the buyer if the demand is perfectly
  inelastic or the supply is perfectly elastic.

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Who bears the burden of the payroll tax?
S
Wage
D
The SS payroll tax is imposed equally on the
employer and employee.
We
Hours worked
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Ad valorem taxes
Price
S(1.07)

• An ad valorem tax is applied to the value -- at
  a rate.
• Example retail sales tax

D
S
PG
Buyers
Pe
Sellers
PN
Q1 Qe
Sales taxed items
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Ad valorem vs. unit tax
How would the incidence change if the tax were an
ad valorem instead of a unit tax?
S T
Price (P)
S
T
PG
Buyers
Pe
Sellers
PN
D
Pizza (Q)
Q1
Qe
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Problem 3
Price per gallon

• What rate of ad valorem tax would be needed to
  raise the same revenue as raised by the unit tax
  on gasoline?
• How would the incidence of the unit and ad
  valorem taxes differ?

2.00
D
MC
1.00
ANS The rate of ad valorem tax would be .50.
The unit and ad valorem taxes would have the same
incidence on the buyer.
200
100
Gasoline
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Tax principle

• In competitive markets, economic tax incidence
  does not depend on whether the tax is a unit tax
  or an ad valorem tax
• Equal yield unit and ad valorem taxes will have
  the same effect on price, quantity, and excess
  burden

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Shifting under monopoly

• A monopolist would shift less of a given unit tax
  forward to the buyer than would be the case if
  the output were produced by a competitive
  industry. PMT - PM lt PCT - PC

Price
ST
PCT
S
PC
DAR
QCT
Output
QC
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Problem 4
Price per gallon

• How would the incidence of this tax change if
  there were a single seller of gasoline?

2.00
D
MC
1.00
ANS Under perfect competition, there is full
forward shifting. Under monopoly, only half the
tax is shifted forward to the buyer.
200
100
Gasoline
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Tax shifting in the US Best guesses

• Income taxes are borne by taxpayer.
• Payroll taxes are borne by labor.
• Corporate taxes borne by shareholders.
• Consumption taxes forward shifted to consumers.
• Wealth taxes borne by the holder of wealth.

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Taxes and income distribution

• Studies of the US tax system show that taxes
  reduce the Gini coefficient only slightly.
• Would you conclude that US taxes are progressive,
  proportional or regressive?

100
Line of Equality
Cumulative of income
A
B
100
Cumulative of families
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Application The State Lottery
Is the lottery a progressive, proportional, or
regressive tax?
P
D
The amount spent per household on lottery tickets
does not vary much with income.
MC
State Lottery Revenue
State Profit per Ticket
MC of operations
Lottery Tickets
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Soap Box
For the Soap Box this week, let's hear it on the
issue of a tax free Internet.  Do you think
Internet sales should be free from sales taxation
and tariffs?  Try to make a good economic
argument either for or against taxing Internet
sales.
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Next time
Thursday Consumption and Sales Taxes Ch
16 Papers due Thursday November 30