General Equilibrium Tax Incidence

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General Equilibrium Tax Incidence

• Professor Jane H. Leuthold
• Department of Economics
• University of Illinois at Urbana-Champaign

Econ 415 Fall 2000
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Topics for today

• Who bears the tax burden?
• Partial equilibrium view (review)
• General equilibrium view
• Why is tax incidence in developing countries
  likely to differ from tax incidence in developed
  economies?
• CGE modeling as a way of assessing tax incidence

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Defining tax incidence

• Statutory incidence - legal resting place of tax
• Economic incidence - final resting place of tax
• Tax shifting economic incidence - statutory
  incidence

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Partial equilibrium tax incidence

• Assumes markets are independent
• Usually assumes markets are perfectly competitive

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Partial equilibrium tax incidence
Buyers tax share ES / (ES ED)
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General equilibrium analysis

• Assumes markets are interdependent
• Usually retains the assumption of perfect
  competition

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Harberger general equilibrium model with taxes
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General Equilibrium Tax Incidence
r
KNC KC K
r
MPC
MPNC
KC
KNC
KC
KNC
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General Equilibrium Tax Incidence
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Harberger results

• A tax on capital (the corporate tax) is fully
  borne by the owners of capital in both the taxed
  (corporate) sector and the noncorporate sector
  (real estate and agriculture).
• Attempts to make the model more realistic make it
  difficult or impossible to solve analytically.

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Early general equilibrium models
Typical assumptions for a developed economy might
be 1. Personal income tax not shifted 2.
Corporate income tax either borne by capital or
shared between consumer and capital 3. Sales
taxes shifted to consumers 4. Payroll taxes borne
by employees
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Lorenz Curve
Gini coefficient A A B
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Shaw-Whalley assumptions

• Personal income tax -- evasion may reduce
  effective progression tax may be partially
  shifted to the traditional sector through
  intersectoral wage effects

M modernT traditional
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Shaw-Whalley assumptions cont.

• Corporate tax -- may be shifted out of the
  country if the tax falls primarily on large
  international companies.
• Sales tax -- price controls may mean tax borne by
  fixed factors in taxed sectors. Taxes not
  written into the price control law cannot be
  forward shifted. Their burden may be on the
  owners of fixed factors, making them progressive.

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Tax Incidence with Price Controls
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Shaw-Whalley assumptions cont.

• Payroll tax -- may be partially borne by rural
  sector
• Trade taxes -- smuggling, trade quotas, etc may
  affect shifting

D
SD
P
PWt
PW
Imports
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Implications
Implication of Shaw-Whalley assumptions taxes
in developing economies may be more progressive
than originally thought.
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Computable General Equilibrium (CGE) Models

• Use computer to numerically solve the general
  equilibrium model
• Start with an initial equilibrium and use an
  algorithm to search for the final after-tax
  equilibrium.

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Steps

• Choosing a model -- number of sectors, consumer
  groups
• Selecting functional forms for the utility and
  production functions
• Assigning parameter values
• Solving for the counter-factual equilibrium

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Weaknesses with CGE models

• Difficulties of choosing appropriate elasticities
  and other parameter values
• Intractability
• Convergence is not guaranteed.
• Uniqueness is not guaranteed

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General Algebraic Modeling System GAMS
GAMS website http//www.gams.com Download
student version of GAMS software http//www.gams.
de/5download/cd.htm
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Lab 7

• Run and experiment with a CGE model with two
  sectors and two goods.
• No paper due this week.

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Next Time
Thurs Lab 8 A CGE Model for a Developing
Economy Chat How do you think the existence of
a black or parallel market would affect the
incidence of an excise tax on cigarettes?
Support your view. Following week Exam on
TuesdayLab 9 Building a Tax Homepage