tax incidence webinar slides

Institute of Chartered Accountants of

PakistanWebinar Series

Tax Incidence and Tax PolicyPresented by: William P. Kittredge,

PhD

Key Learning Objectives

Understand the difference between the legislative, or statutory, incidence of a tax and the actual tax incidence.

Gain insight into the economic impacts and economic development effects of various tax schemes.

Survey the three rules of tax incidence, general equilibrium tax incidence and review the empirical evidence related to tax incidence.

Understand why the statutory burden of a tax does not describe who really bears the tax and why this may be important to government officials and corporate officers.

Introduction A central question of tax incidence is

who bears the burden of a tax? Tax incidence is assessing which party

(consumers or producers) bear the true burden of a tax. When New Jersey raised the corporate

income tax, companies claimed that the tax would just hurt their employees, while the governor claimed the tax would affect the wealth owners of the company.

Introduction Although the legal incidence of a tax is

pretty obvious, markets do respond to taxes, so that the ultimate burden is not nearly so clear.

As Figure 1Figure 1 illustrates, the share of taxes paid by corporations has fallen by roughly two-thirds.

Figure 1

In 1960, corporations paid nearly one-quarter of all taxes.

By 2003, corporations paid less than 8 percent of total

taxes.

Introduction Although this change in the share of

taxes paid by corporations may be viewed as unfair, it is important to recall that corporate taxes are paid by the individuals who own, work for, and buy from corporations.

Introduction The goal of this webinar is to examine

the equity implications of taxation. Three rules of tax incidence General equilibrium tax incidence Empirical evidence

THE THREE RULES OF TAX INCIDENCE

There are three basic rules for figuring out who ultimately bears the burden of paying a tax. 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 the burden of a tax.

The three rules of tax incidence: The statutory burden does not describe

who really bears the tax Statutory incidence is the burden of the tax

borne by the party that sends the check to the government. For example, the government could impose a

50¢ per gallon tax on suppliers of gasoline. Economic incidence is the burden of taxation

measured by the change in resources available to any economic agent as a result of taxation. If gas stations raise gasoline prices by 25¢ per

gallon, then consumers are bearing half of the tax.


who really bears the tax When a tax is imposed on producers, they

will raise prices to some extent to offset this tax burden. Producer tax burden = (pretax price –

posttax price) + tax payments of producers When a tax is imposed on consumers, they

are not willing to pay as much for a good, so prices fall. The tax burden for consumers is: Consumer tax burden = (posttax price –

pretax price) + tax payments of consumers


who really bears the tax Figure 2Figure 2 illustrates the impact of a 50¢

per gallon tax on suppliers of gasoline.

Price pergallon (P)

P1 = $1.50

Quantity in billionsof gallons (Q)

Q1 = 100

A

D

S1

(a) (b)

A

D

S1

S2

CP2 = $1.80

Q2 = 90

$0.50

$2.00

Consumer burden = $0.30

Supplier burden = $0.20

Price pergallon (P)


B

P1 = $1.50

Figure 2

Initially, equilibrium entails a price of $1.50 and a quantity of

100 units.

A 50 cent tax shifts the effective

supply curve.

The burden of the tax is split between

consumers and producers


who really bears the tax The initial market equilibrium is 100

billion gallons sold at $1.50 per gallon. The 50¢ tax raises the marginal costs of

production for the firm, shifting the supply curve up to S2.

At the original market price, there is now excess demand of 20 billion gallons; the price is bid up to $1.80, where there is neither a shortage nor a surplus.


who really bears the tax The gasoline tax has two effects:

It changes the market price Producers must now pay a tax to the government

Recall that Consumer tax burden = (posttax price – pretax

price) + tax payments of consumers Consumer tax burden = ($1.80 - $1.50) + 0 =

30¢ Producer tax burden = (pretax price – posttax

price) + tax payments of producers Producer tax burden = ($1.50 - $1.80) + $0.50 =

20¢


who really bears the tax This analysis reveals that the true burden

on producers is not 50¢, but some smaller number, because part of the burden is borne by consumers in the form of a higher price.

The tax wedge is the difference between what consumers pay and what producers receive from a transaction. The wedge in this case is the difference

between the $1.80 consumers pay and the $1.30 producers receive.


who really bears the tax The second question to examine is

whether imposing the tax on the consumers, rather than producers, will change the analysis.

Figure 3Figure 3 illustrates the impact of a 50¢ per gallon tax on demanders of gasoline.

P2 = $1.30

P1 = $1.50

Q1 = 100Q2 = 90

D1

S

D2

$1.00$0.50

A

B

CSupplier burden

Consumer burden

Price pergallon (P)


Figure 3

Imagine imposing the tax on

demanders rather than suppliers.

The new equilibrium price is $1.30, and the

quantity is 90.

The quantity is identical to the

case when the tax was imposed on

the supplier.

The economic burden of the tax is identical to the previous case.


who really bears the tax The initial market equilibrium is 100 billion

gallons sold at $1.50 per gallon. Although the overall willingness to pay for a

unit of gasoline is unchanged, the 50¢ tax lowers the consumers’ willingness to pay producers by 50¢ (since consumers must pay the government). Thus, the demand curve shifts to D2.

At the original market price, there is now excess supply of gasoline; producers lower their price until $1.30, where there is neither a shortage nor a surplus.


who really bears the tax As before, the new gasoline tax has two effects:

It changes the market price Consumers must now pay a tax to the

government Consumer tax burden = (posttax price – pretax

price) + tax payments of consumers Consumer tax burden = ($1.30 - $1.50) + $0.50

= 30¢ Producer tax burden = (pretax price – posttax

price) + tax payments of producers Producer tax burden = ($1.50 - $1.30) + 0 = 20¢

The three rules of tax incidence: The side of the market on which the tax is

imposed is irrelevant Note that these tax burdens are

identical to the burdens when the tax was levied on producers.

This illustrates an important lesson – the side on which the tax is imposed is irrelevant for the distribution of tax burdens.

The three rules of tax incidence: The side of the market on which the tax is

imposed is irrelevant While there is only one market price

when a tax is imposed, there are two different prices that economists track.

The gross price is the price in the market.

The after-tax price is 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).

The three rules of tax incidence: Inelastic versus elastic supply and

demand The third question to examine is how

the tax burden varies with the elasticities of supply and demand.

In all cases, elastic parties avoid taxes and inelastic parties bear them.

Consider Figure 4Figure 4, with perfectly inelastic demand for gasoline.

P2 = $2.00

P1 = $1.50

Q1 = 100

DS1

S2

$0.50


Price pergallon (P)

Consumer burden

Figure 4

With perfectly inelastic demand, consumers bear the full burden.


demand The new equilibrium market price is $2.00,

a full 50¢ higher than the original price. Consumer tax burden = (posttax price –

pretax price) + tax payments of consumers Consumer tax burden = ($2.00 - $1.50) + 0

= 50¢ Producer tax burden = (pretax price –

posttax price) + tax payments of producers Producer tax burden = ($1.50 - $2.00) +

50¢ = 0


demand Note that even though the tax was

legally imposed on the producer, the full burden of the tax is borne by the consumer.

Full shifting is when one party in a transaction bears all of the tax burden. With perfectly inelastic demand,

consumers bear all of the tax burden.


demand Now consider Figure 5Figure 5, with perfectly

elastic demand for gasoline.

P1 = $1.50

Q1 = 100Q2 = 90

D

S1S2

$0.50

Price pergallon (P)


$1.00

Supplier burden

Figure 5

With perfectly elastic demand, producers bear the full burden.


demand The new equilibrium market price is $1.50,

the same as the original price. Consumer tax burden = (posttax price –

pretax price) + tax payments of consumers Consumer tax burden = ($1.50 - $1.50) + 0

= 0 Producer tax burden = (pretax price –

posttax price) + tax payments of producers Producer tax burden = ($1.50 - $1.50) +

50¢ = 50¢


demand In this case, the producer bears the full burden of

the tax, because consumers will simply stop purchasing the product if prices are raised.

These extreme cases illustrate a general point: Parties with inelastic supply or demand bear taxes;

parties with elastic supply or demand avoid them. Demand is more elastic when there are many good

substitutes (for example, fast food at restaurants). Demand is less elastic when there are few substitutes (for example, insulin medication).

Supply is more elastic when suppliers have more alternative uses to which their resources can be put.


demand Figure 6Figure 6 illustrates these cases –

holding demand constant, more inelastic supply leads to a greater tax burden on producers.

D

P

Q

S1

S2

(a) Tax on steel producer

Q1Q2

P1

P2

D

P

Q

S1

S2

(b) Tax on street vendor

Q1Q2

P1

P2

A

B

A

B

Tax

TaxConsumer burden Consumer burden

Figure 6 More inelastic supply, smaller consumer burden.More elastic supply, larger

consumer burden.


demand As illustrated in Figure 6aFigure 6a, when a tax

is levied on an inelastic supplier – the steel firm that is committed to a level of production by its fixed capital investment – the consumer pays very little of the tax, and the producer almost all of it.

In the second panel, with elastic supply, the consumer bears almost all of the tax.

The three rules of tax incidence: Tax incidence is about prices, not quantities

Finally, it is important to note that even though quantities change dramatically with perfectly elastic demand, the focus of tax incidence is on prices, not quantities.

We ignore quantities because at both the old and new equilibria, consumers are indifferent between buying the taxed good and spending the money elsewhere.

TAX INCIDENCE EXTENSIONS

We extend the analysis by examining: Factors of production Imperfectly competitive markets Accounting for the expenditure side

Tax incidence extensionsTax incidence in factor

markets Many taxes are levied on the factors of

production, such as labor. Consider the labor market illustrated in

Figure 7aFigure 7a, before and after a tax on workers (the suppliers of labor) is imposed.

Hours oflabor (H)

Wage (W)

S1

D1

A

H1

W1=$5.15

S2

BW2=$5.65

W3=$4.65C

Firmburden

Workerburden

H2

Tax

Figure 7a Tax on workers

A tax on workers (the “suppliers” of labor), lowers wages.


markets The $1 per hour tax lowers the return

to work at every amount of labor. Thus, individuals require a $1 rise in

their wages to supply any amount of labor, and the supply curve shifts upward.

With labor demand unchanged, the new equilibrium wage is $5.65. In this case, the tax is borne equally by workers and firms.


markets Now consider the labor market

illustrated in Figure 7bFigure 7b, where a tax on firms (the demanders of labor) is imposed.

Hours oflabor (H)

Wage (W)

S1

D1

A

H1

W1=$5.15

BW2=$5.65

W3=$4.65C

Firmburden

Workerburden

H2

Tax

D2

Figure 7b Tax on firms

A tax on firms (the “demanders” of labor), also lowers wages.


markets With the tax on firms, the demand curve shifts

downward to D2, and market wages fall to $4.65. The firm pays workers 50¢ less than the original

$5.15, but must send $1 to the government. In effect, they are paying a wage of $5.65.

As in output markets, the tax incidence of a payroll tax shows that it makes no difference on which side of the market it is levied, and the economic burden can differ from the statutory burden.


markets This analysis will not be correct if there

are impediments to wage adjustments, however.

The minimum wage is a legally mandated minimum amount that workers must be paid for each hour of work. The current US federal minimum wage

is $10.10 per hour.


markets With a minimum wage, wages cannot

fully adjust, so the incidence will be different.

Consider, first, Figure 8aFigure 8a, which imposes the tax on workers.

Hours oflabor (H)

Wage (W)

S1

D1

A

H1

Wm=$5.15

S2

BW2=$5.65

W3=$4.65C

H2

Firmburden

Workerburden

Tax

Figure 8a Tax on workers

A binding minimum wage changes the analysis, however.

When imposed on employees, the

analysis is similar to before.


markets With a tax on workers, the labor supply

curve shifts upward as before. Workers are paid $10.10 per hour, but are forced to pay $1 of that to the government for taxes.

The incidence is borne in the same manner as when there was no minimum wage.


markets Now consider, Figure 8bFigure 8b, which

imposes the tax on firms.

Hours oflabor (H)

Wage (W)

S1

D1

AWm=$10.10

BW2=$11.10

D2

$9.60

C’

H2H3

Tax

H1

C

Firmburden

Figure 8b Tax on firms

When imposed on employers, the

incidence differs!

Employers cannot fully wage shift with

the binding minimum wage.

With fully shifting wages, would end

up at C.

Without wage shifting, would end

up at C’.

In this case, the firm bears the economic

burden.


markets With a tax on firms, the labor demand curve

shifts downward. Without wage impediments, the market wage would fall from $10.10 to $9.60, and the firm would also pay $1 to the government. Hours of work would be H2.

With the minimum wage, wages cannot adjust downward, so the firm instead demands H3<H2 hours of labor, pays $10.10 per hour, and also pays $1 to the government. The economic burden of the tax falls on the firm.


markets When there are barriers to reaching the

competitive market equilibrium, the side of the market on which the tax is levied can matter. Minimum wages Workplace norms Union rules

There are more frequent in input markets than output markets.

Tax incidence extensionsTax incidence in imperfectly

competitive markets The analysis has so far focused on

competitive markets. Monopoly markets are markets in

which there is only one supplier of a good. Monopolists are price makers, not price

takers – this includes government enterprises.

Figure 9aFigure 9a shows the determination of equilibrium in monopoly markets.

P

Q

P1

P*

Q1

D1

S

MR1

A

A’

Figure 9a Monopolist

Monopolist sets MR=MC, chooses

quantity Q1.


competitive markets Unlike a perfect competitor, the

monopolist faces a downward sloping marginal revenue curve, because it must lower its price on all units to sell another unit.

The marginal revenue curve, MR1, is therefore everywhere below the demand curve. Setting MR1=MC, the quantity Q1 initially maximizes profits.

Now consider a tax on consumers, illustrated in Figure 9bFigure 9b.

P

Q

P1

Q1

D2

S

MR2

B

Q2

P2

D1

S

MR1

A

B’

Figure 9b Tax on consumers

With a tax, both D and MR change, as does the quantity.


competitive markets The tax on consumers shifts the demand

curve downward to D2, and the associated marginal revenue curve to MR2.

Setting MR2=MC, the quantity Q2 now maximizes profits.

The monopolist’s price falls from P1 to P2, so it bears some of the tax, just as a competitive firm does.

The three rules of tax incidence continue to apply for a monopolist.


competitive markets Most markets fall somewhere between

perfect competition and monopoly. Oligopoly markets are markets in which

firms have some market power in setting prices, but not as much as a monopolist. There is less consensus on how to model

these markets. Economists tend to assume the tax

incidence results apply in these markets as well.

Tax incidence extensionsBalanced budget tax incidence One final extension asks how the money

that is raised will be spent. Balanced budget incidence is tax

incidence analysis that account for both the tax and the benefits it brings. It is inconvenient, however, to worry

about both the taxation and expenditure side at the same time.

GENERAL EQUILIBRIUM TAX INCIDENCE

Our models so far have focused on partial equilibrium. Partial equilibrium tax incidence is

analysis that considers the impact of a tax on a market in isolation.

To study the effects on related markets, we use general equilibrium analysis. General equilibrium tax incidence is

analysis that considers the effects on related markets of a tax imposed on one market.

General equilibrium tax incidence

Effects of a restaurant tax Consider the demand for restaurant

meals in a single town, as illustrated in Figure 10Figure 10.

The demand for such meals is likely to be highly elastic.

P1 = $20

Q1 = 1000Q2 = 950

D

S1S2

$1

Price permeal (P)

Meals soldper day (Q)

B A

Figure 10

In this case demand for meals is perfectly

elastic.


Effects of a restaurant tax In such a case, a $1 tax on firms shifts the

supply curve, and the firm bears the full burden of the tax.

But in reality, firms are not self-functioning entities, but are a technology for combining capital and labor to produce an output. With a restaurant, capital is best viewed as

financial capital – the money that buys physical capital inputs like the building, the ovens, tables, etc.


Effects of a restaurant tax The $1 tax on meals is borne by the

firm, meaning that it is borne by the factors of production (labor and capital).

We move back to the input market in Figure 11Figure 11.

Wage (W)

Hours of labor (H)

Rate ofreturn (r)

Investment (I)

(a) Labor (b) Capital

W1 = $8

D1D2

H1 = 1,000H2 = 900

SAB

S

D1

D2

I1 = $50 million

r1 = 10%

r2 = 8%

A

B

Figure 11The incidence is

“shifted backward” to labor and capital.

We assume the supply of labor in the locality is perfectly

elastic.

Labor therefore does not bear any of

the tax burden.

Capital is inelastically

supplied.

Capital bears the

tax.

General equilibrium tax incidenceIssues to consider in GE incidence

analysis As illustrated, the supply of labor (restaurant

workers) is perfectly elastic, because those workers can easily find a job in another locality.

The tax on output, restaurant meals, would reduce the firm’s demand for labor, reducing the number of workers hired, but not their wage rate.

On the other hand, in the short-run, the supply of capital is likely to be fixed. The firm’s demand for capital shifts in, lowering the rate of return on capital. In the short run, the owners of capital bear the tax

in the form of a lower return on their investment.


analysis In the longer-run, the supply of capital

is not inelastic. Investors can close or sell the

restaurant, take their money, and invest it elsewhere.

In the long-run, capital is likely to be perfectly elastic as there are many good substitutes for investing in a particular restaurant in a particular town.


analysis If both labor and capital are highly elastic

in the long run, who bears the tax? The one additional inelastic factor in the

restaurant production process is land. The supply is clearly fixed. When both labor and capital can avoid the

tax, the only way restaurants can stay open is if they pay a lower rent on their land.


analysis The scope of a tax matters for tax incidence as well.

Consider imposing a restaurant tax on the entire state rather than just a city.

Demand in the output market is less elastic; consumers bear some of the burden.

Labor supply is less elastic as well. The scope of the tax matters to incidence analysis

because it determines which elasticities are relevant to the analysis: 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.


analysis There are also potentially spillovers into other

output markets from the restaurant tax, not just input markets.

Consider the statewide restaurant tax that raises the price of meals: It has an income effect for consumers. It increases consumption of goods that are

substitutes for restaurant meals, such as meals at home.

It decreases consumption of goods that are complements for restaurant meals, such as valets.

A complete general equilibrium analysis must account for the effects in these other markets.

THE INCIDENCE OF TAXATION IN THE UNITED STATES

CBO incidence assumptions The Congressional Budget Office (CBO) has

examined the incidence of taxation in the U.S.

The CBO assumes: Income taxes are fully borne by the

households that pay them. Payroll taxes are fully borne by workers,

regardless of the statutory incidence. Excise taxes are fully shifted forward to

prices. Corporate taxes are fully shifted forward to

the owners of capital.

The incidence of taxation in the United States

CBO incidence assumptions These assumptions are generally

consistent with empirical evidence. For example, Poterba (1996) shows full

shifting to prices from increases in the sales tax.

The most questionable assumption relates to the corporate income tax. It is likely that consumers and workers bear some of the tax. The corporate tax will be discussed in detail in Chapter 24.


Results of CBO incidence analysis Table 1Table 1 shows the effective tax rates

over time, by income quintile. The effective tax rate is taxes paid

relative to total income.

Table 1Effective Tax Rates (in percent)

1979 1985 1990 1995 2001

Total effective tax rateAll households 22.2 20.9 21.5 22.6 21.5Bottom quintile 8.0 9.8 8.9 6.3 5.4Top quintile 27.5 24.0 25.1 27.8 26.8

Effective Income Tax RateAll households 11.0 10.2 10.1 10.2 10.4Bottom quintile 0.0 0.5 -1.0 -4.4 -5.6Top quintile 15.7 14.0 14.4 15.5 16.3

Effective Payroll Tax RateAll households 6.9 7.9 8.4 8.5 8.4Bottom quintile 5.3 6.6 7.3 7.6 8.3Top quintile 5.4 6.5 6.9 7.2 7.1

Effective Corporate Tax RateAll households 3.4 1.8 2.2 2.8 1.8Bottom quintile 1.1 0.6 0.6 0.7 0.3Top quintile 5.7 2.8 3.3 4.4 2.9

Effective Excise Tax RateAll households 1.0 0.9 0.9 1.0 0.9Bottom quintile 1.6 2.2 2.0 2.4 2.4Top quintile 0.7 0.7 0.6 0.7 0.6

Effective tax rates for the poor have fallen over time.

Effective tax rates for the rich have risen since 1985.


Results of CBO incidence analysis The table shows that effective tax rates for

the poor in the US have fallen since 1985, while the effective rate for the rich have risen.

The distribution of various components of the tax system varies, however. The payroll tax, for example, is regressive.

Effective corporate tax rates are small relative to income and payroll tax rates, and have fallen at both the top and bottom of the income distribution.


Results of CBO incidence analysis Table 2Table 2 shows the top and bottom

quintile’s share of income and tax liabilities.

Table 2

Top and Bottom Quintile’s Share of Incomeand Tax Liabilities (in percent)

1979 1985 1990 19952001

Top QuintileShare of income 45.5 48.6 49.5 50.2 52.4Share of tax liabilities 56.4 55.8 57.9 61.9 65.3

Bottom QuintileShare of income 5.8 4.8 4.6 4.6 4.2Share of tax liabilities 2.1 2.3 1.9 1.3 1.1

The share of taxes paid by the top

quintile has risen over time.

While that of the poor has always been low, and falling over time.


Results of CBO incidence analysis The bottom quintile of taxpayers has

always paid a very small share of taxes, and that share has fallen over time.

The top quintile has always paid the majority of taxes, and that share has risen over time. The top 20% earn more than half of all

income, and pay almost two-thirds of the taxes.


Current versus lifetime income incidence Tax incidence can be based on current or

lifetime income, and the results can differ greatly for some types of taxes.

Current tax incidence is the incidence of a tax in relation to an individual’s current resources.

Lifetime tax incidence is the incidence of a tax in relation to an individual’s lifetime resources.

Recent estimates show that 60% of Americans change income quintiles within a decade.


Current versus lifetime income incidence This income mobility, and the use of lifetime

incidence, has a number of implications for tax policy. Imagine that there was a tax on college

textbooks. On the surface, this seems extremely regressive using current income, since college students have very low incomes.

On a lifetime basis, however, college graduates have income twice as those who did not attend college. On a lifetime basis, the tax incidence is progressive.

Recap of The Equity Implications of Taxation: Tax

Incidence The Three Rules of Tax Incidence Tax Incidence Extensions General Equilibrium Tax Incidence The Incidence of Taxation in the United

States

References Fullerton, Don & Metcalf, Gilbert E., 2002. "Tax incidence,"

Handbook of Public Economics, in: A. J. Auerbach & M. Feldstein (ed.), Handbook of Public Economics, edition 1, volume 4, chapter 26, pages 1787-1872 Elsevier.

Malik, M. H., & Najam us Saqib. (1989). Tax Incidence by Income Classes in Pakistan. The Pakistan Development Review, 28(1), 13–25. Retrieved from http://www.jstor.org/stable/41259210

Refaqat, S., & International Monetary Fund. (2003). Social incidence of the general sales tax in Pakistan (IMF working paper, WP/03/216; IMF working paper, WP/03/216). Washington, D.C.: International Monetary Fund. http://bibpurl.oclc.org/web/24285/2003/wp03216.pdf http://www.imf.org/external/pubs/ft/wp/2003/wp03216.pdf

http://www.jstor.org/stable/41259210

http://www.imf.org/external/pubs/ft/wp/2003/wp03216.pdf

tax incidence webinar slides

Economy & Finance