Chapter 12 Taxation and Income Distribution

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Chapter 12 Taxation and Income Distribution
- In this chapter we analyze generally how taxes
affect economic behavior, paying close attention
to who gets the burden of taxes. Tax Incidence
determines how prices respond to taxes. - Suppose
the price of a bottle wine was 10. The
government announces to impose a tax of 1 per
bottle. How will the prices change? - One
possibility is that the price of wine increases
to 11/bottle. In this case, the seller receives,
as before, 10/bottle. Thus consumers bear the
whole burden. Is this realistic? - Most probably
not. The bottle of wine will probably rise to
somewhere between 10 and 11. Why? A. General
Remarks - Only people can bear the tax. Firms are
not people and do not really pay taxes they have
no pockets, or wallets!!!! - The incidence of
taxes depend on how prices are determined, i.e.
competitive market vs. monopoly, and also on the
elasticities of supply and demand. - In the LR
responses are usually larger. - In a general
equilibrium model, the incidence of taxes depend
on not only the taxes and their effects on the
immediate market, but also on other markets,
including the effects of government spending.
- A lump-sum tax is one where the liability of a
consumer does not depend upon the behavior of the
consumer at all. Note that such a tax usually
does not affect prices, etc, and therefore has
minimal effects on the market dynamics.
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- In this textbook, a progressive tax system is
one where the average tax rate increases with
income. Alternative definitions are sometimes
mistakenly used. See Table 12.1. B. Partial
Equilibrium Models Unit Taxes - We first focus
on unit taxes, where the tax is fixed per unit of
a commodity sold or bought. The taxes impose a
tax wedge between the price paid by consumers and
price received by producers. - We analyze the
effects of a tax on a pack of cigarettes.
- Before the tax was imposed, the equilibrium is
at P0 and Q0. - In the figure, the taxes shift
the demand curve down just as much as tax u. (Why
down?) - At the new equilibrium, consumers pay Pg
though the producers only receive Pn Pg - u.
- The same result would follow if we instead
shifted the supply curve up. (Why up?) Convince
yourself that this is true see Fig 12.3 in the
book. - This means that the incidence is
independent of whether the tax is imposed on
sellers or buyers as long as both curves are
elastic.
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- But what does the incidence depend on
then? - The answer is elasticities of demand and
supply curves. The tax is borne relatively more
by the consumers if the demand curve is
relatively more inelastic, i.e. if supply is
perfectly elastic or comparatively more elastic
than the demand curve. Conversely, the tax is
borne relatively more by the producers if supply
is relatively more inelastic, i.e. if demand is
perfectly elastic or comparatively more elastic
than the supply curve. (These should be intuitive
to all of you see Figs 12.4 and 12.5 if you are
having problems.) C. Partial Equilibrium Models
Ad valorem Taxes - Ad valorem taxes are different
than unit taxes. The tax is now a proportion of
the price, such as various forms of payroll
taxes, sales taxes, etc.
- Let the sales tax for cigarettes be given by ad
valorem tax of v. - In the figure, the taxes
shift the demand curve down as much as v
? price. - After taxes, consumers pay Pg though
the producers only receive Pn (1 v) ? Pg
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- For the demand curve, the incidence is larger
for lower quantities since consumers are willing
to pay a larger price for such quantities. For
the supply curve, the incidence would have been
larger for larger quantities since producers are
willing to sell only for a higher price at such
quantities. (This is important since the shift in
supply is opposite of shift in demand not just in
direction but also in magnitude!) - Again, the
incidence is independent of on whom the tax is
levied. Remember the discussion from Social
Security Payroll taxes. As we identified there,
the distinction between workers and bosses is
irrelevant since the incidence of payroll tax is
determined only by the implied tax wedge between
what employers pay and workers receive. - Also,
elasticities have exactly the same effects on
incidence as for unit taxes. Nothing specific can
be known about the incidence of taxes without
knowing the elasticities of both curves. - Some
studies suggest that in the US the elasticity of
labor supply is quite close to zero, implying an
inelastic supply. What does this mean about the
incidence of a payroll tax? Who gets the
burden? - In closed economy supply of capital
slopes up while demand of capital slopes down.
Then, the incidence of a capital tax is
distributed among owners and demanders of
capital. - In an open economy where capital is
perfectly mobile, however, owners of capital will
accept no price lower than the worldwide rate of
return. In effect, then, the supply of capital
must be horizontal or fully elastic. What will
happen if one country imposes capital taxes? Who
bears the burden?