Gruber4e ch19

Public Finance and Public Policy Jonathan
CopyrightGruber
2010 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 35
The Equity Implications of

Taxation: Tax Incidence
19
19.1 The Three Rules of Tax Incidence

19.2 Tax Incidence Extensions
19.3 General Equilibrium Tax Incidence
19.4 The Incidence of Taxation in the United
States
19.5 Conclusion
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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19.1
C H AP T E R 1 9 T H E E Q U I T Y I M P L I C AT I O N S O F TAXAT I O N : TAX I N C I D E N C E
Tax Incidence
ources of federal government revenue, 1960 and 2008

Category:
Income taxes
Corporate taxes
Payroll tax
Excise taxes
Other
1960
44.5%
2008
43.7%
22.8
17.0
12.8
11.3
37.8
2.6
2.9
4.5
Tax incidence: Assessing which party

(consumers or producers) bears the true
burden of a tax.
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19.1
The Statutory Burden of a Tax Does Not Describe

Who Really Bears the Tax
Statutory incidence: The burden of a tax
borne by the party that sends the check to
the government.
Economic incidence: The burden of
taxation measured by the change in the
resources available to any economic agent
as a result of taxation.
Economic incidence includes tax payments
paid and any price changes caused by the
tax.
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19.1

Who Really Bears the Tax
The tax burden for consumers is:
Consumer tax burden =
(post-tax price pre-tax price) + per-unit
consumer tax
For producers the tax burden is
Producer tax burden =
(pre-tax price post-tax price) + per-unit
producer tax
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19.1
Burden of the Tax on Consumers and Producers
Tax wedge: The difference between what

consumers pay and what producers receive
(net of tax) from a transaction.
If the consumer burden is $0.30 and the
producer burden is $0.20, the tax wedge is
$0.50.
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19.1

Who Really Bears the Tax, and Is Irrelevant to the
Tax Burden
(a) Tax on
producers
Price per
gallon (P)
Consum
er
burden
=
Producer
$0.30
burden =
$0.20
P2 = $2.00
P3 = $1.80
P1 = $1.50
Tax =
$0.50
S
2
$1.30
A
E
D
C
(b) Tax on
consumers
Price per
gallon (P)
Consum
er
burden
=
Producer
$0.30
burden =
$0.20
$1.80
P1 = $1.50
P3 = $1.30
P2 = $1.00
A
C
D
Tax =
B $0.50
D
0
Q2 =
80
Q3 =
90
Q1 = Quantity in
100
billions of
gallons (Q)
D
0
D
1
Q1 = Quantity
2
in
100 billions of
gallons (Q)
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19.1
Gross versus After-Tax Prices
Gross price: The price in the market.

After-tax price: 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).
Different statutory rules produce different
gross prices for the same after-tax price.
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19.1
Parties with Inelastic Supply or Demand Bear Taxes;

Parties with Elastic Supply or Demand Avoid Them
The economic incidence of taxation does
not depend on the statutory incidence.
It is ultimately determined by the
elasticities of supply and demand, that is,
how responsive the quantity supplied or
demanded is to price changes.
If one side of the market is perfectly
inelastic, then it bears there is full shifting
of the tax burden to it.
o Full shifting: When one party in a
transaction bears all of the tax burden.
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19.1
Perfectly Inelastic Demand
10 of 35
19.1
Perfectly Elastic Demand
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19.1
General Case
In general, the less elastic is demand

relative to supply, the larger share of the
incidence falls on demand.
Demand for goods is more elastic when
there are many substitutes.
For products with an inelastic demand, the
burden of the tax is borne almost entirely
by the consumer.
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19.1
Supply Elasticities
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19.1
Reminder: Tax Incidence Is About Prices, Not

Quantities
When the demand for gas is perfectly
elastic, consumers bear none of the burden
of taxation, yet the quantity of gas
consumed fell dramatically.
Doesnt this fall in consumption hurt
consumers?
If so, shouldnt tax incidence take that into
account?
Perfectly inelastic demand means
consumers are indifferent between the gas
and other goods, so they are not hurt by
the fall in gas consumption.
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19.2
Tax Incidence Extensions
To recap:
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 taxes; parties with elastic supply or
demand avoid them.
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19.2
Tax Incidence in Factor Markets
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19.2
Impediments to Wage Adjustment
Tax incidence analysis assumes that prices

can freely adjust.
But wages cannot fall below the minimum
wage.
Minimum wage: Legally mandated
minimum amount that workers must be
paid for each hour of work.
Barriers to price adjustment change the
incidence.
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19.2
Impediments to Wage Adjustment
Wage
(W)
(a) Tax on
workers
Tax =
$1.00
S
1
B
A
WM = $7.25
Worker
burden
=
$0.50
Wage
(W)
Firm
burden
=
$0.50
W2 = $7.75
W3 = $6.75
(b) Tax on
firms
Firm
burden
=
$1.00
W2 = $8.25
WM = $7.25
S
B
$6.7
5
A
C
Tax =
$1.00
D
0
H2
H1
Hours of
labor (H)
D
0
H3
H2
H1
D
1
Hours of
labor (H)
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19.2
Tax Incidence in Imperfectly Competitive Markets
Monopoly markets are an extreme case of

imperfectly competitive markets.
o Monopoly markets: Markets in which
there is only one supplier of a good.
o For price-taking firms, marginal revenue
(MR) is equal to price.
o Monopolists must lower the price to sell
more, though, so marginal revenue falls
faster than price.
o Monopolist produces such that MR = MC.
19 of 35
19.2
Background: Equilibrium in Monopoly Markets

Price
S= MC
P1
P2
Tax
MR
0
Q1
MR
1
D1
D2
Quantity
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19.2
Tax Incidence in Imperfectly Competitive Markets
Even in monopoly markets, a tax on either

side of the market results in the same
sharing of the tax burden.
Monopolists cannot exploit their market
power to avoid the rules of tax incidence.
Economists tend to assume that the same
rules of incidence apply in more general
oligopoly markets.
o Oligopoly markets: Markets in which
firms have some market power in setting
prices, but not as much as a monopolist.
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19.2
Balanced Budget Tax Incidence
Tax incidence analysis typically only

accounts for who pays the tax.
Balanced budget incidence: Tax
incidence analysis that accounts for both
the tax and the benefits it brings.
Balanced budget incidence is difficult
because it is hard to determine who benefits
from a given tax increase.
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19.3
General Equilibrium Tax Incidence
So far, we have considered incidence in only

a single market, such as the gas market.
Partial equilibrium tax incidence:
Analysis that considers the impact of a tax
on a market in isolation.
General equilibrium tax incidence:
Analysis that considers the effects on
related markets of a tax imposed on one
market.
Taxes in one market affect prices in others,
complicating the analysis.
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19.3
Effects of a Restaurant Tax: A General Equilibrium

Example
24 of 35
19.3
General Equilibrium Tax Incidence
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19.3
Effect of Time Period on Tax Incidence: Short Run

versus Long Run
Factors that are inelastically demanded or
supplied in both the short and long run bear
taxes in the long run.
Investments are irreversible, so the supply
of capital is inelastic in the short run.
Investors have many opportunities, so in
the long run, elasticity of capital may be
high.
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19.3
Effect of Tax Scope on Tax Incidence
Tax incidence depends on how broadly the

tax is applied.
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.
A tax on local restaurants has a different
incidence than a tax on all restaurants.
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19.3
Spillovers between Product Markets
Consider a tax on restaurant. A higher aftertax price has three effects on other goods as
well:
1. Income effect from lower real income.
2. Substitution effect toward goods that are
substitutes for restaurants.
3. Complementary effect: Consumers may
reduce their consumption of goods or
services that are complements to
restaurant meals.
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19.4
EVIDENCE: The Incidence of Excise Taxation
Excises tax on cigarettes varies widely

across the United States.
o Low of $0.025/pack per pack in VA.
o High of $1.51/pack in CT and MA.
o Since 1990, NJ increased its tax rate
nearly sixfold.
o Arizona has increased its tax nearly
eightfold.
Many studies examine how taxes affect
prices.
These studies uniformly conclude that the
price of cigarettes rises by the full amount
Public Finance
Publicexcise
Policy Jonathan
Gruber Fourth Edition Copyright 2012 Worth Publishers
of and
the
tax.
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19.4
Incidence in the United States
The CBO analyzes tax incidence in the United

States, assuming:
1. Income taxes are borne fully by
households.
2. Payroll taxes are borne fully by workers.
3. Excise taxes fully shifted to prices and so
are borne by individuals in proportion to
their consumption of the taxed item.
4. Corporate taxes are fully shifted to the
owners of capital and so are borne in
proportion to each individuals capital
income.
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19.4
Total Effective Tax Rate in the United States,

19792011
All
households
Bottom
quintile
Top quintile
1979
1990
2000
201
1
22.2%
21.5%
23.0% 18.6
%
8.0
8.9
6.4
1.1
27.5
25.1
28.0
23.8
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19.4
Top and Bottom Quintiles Share of Income and Tax

Liabilities
1979 1990
200
0
2012
49.5
%
54.8
%
56.2
%
56.4
57.9
Bottom Quintile
66.6
70
3.9
1.1
3.6
0.3
Top Quintile
Share of income
Share of tax
Share of income
Share of tax
45.5
%
4.8
2.1
4.6
1.9
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19.4
Current vs. Lifetime Income Incidence
Tax incidence is usually evaluated by

current rather than lifetime income.
o Current tax incidence: The incidence
of a tax in relation to an individuals
current resources.
o Lifetime tax incidence: The incidence
of a tax in relation to an individuals
lifetime resources.
Poterba (1989a) showed that gasoline and
cigarette taxes are much less regressive
from a lifetime than current income
perspective.
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19.5
Conclusion
The fairness of any tax reform is one of

the primary considerations in policy
makers positions on tax policy.
Therefore, it is crucial for public finance
economists to have a deep understanding
of who really bears the burden of taxation
so that we can best inform these
distributional debates over the fairness of a
proposed or existing tax.
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Public Finance and Public Policy Jonathan

The Equity Implications of

19.1 The Three Rules of Tax Incidence

ources of federal government revenue, 1960 and 2008

Tax incidence: Assessing which party

The Statutory Burden of a Tax Does Not Describe

The Statutory Burden of a Tax Does Not Describe

Burden of the Tax on Consumers and Producers

Tax wedge: The difference between what

The Statutory Burden of a Tax Does Not Describe

Gross versus After-Tax Prices

Gross price: The price in the market.

Parties with Inelastic Supply or Demand Bear Taxes;

Perfectly Inelastic Demand

Perfectly Elastic Demand

In general, the less elastic is demand

Reminder: Tax Incidence Is About Prices, Not

Tax Incidence Extensions

Tax Incidence in Factor Markets

Impediments to Wage Adjustment

Tax incidence analysis assumes that prices

Impediments to Wage Adjustment

Tax Incidence in Imperfectly Competitive Markets

Monopoly markets are an extreme case of

Background: Equilibrium in Monopoly Markets

Tax Incidence in Imperfectly Competitive Markets

Even in monopoly markets, a tax on either

Balanced Budget Tax Incidence

Tax incidence analysis typically only

General Equilibrium Tax Incidence

So far, we have considered incidence in only

Effects of a Restaurant Tax: A General Equilibrium

General Equilibrium Tax Incidence

Effect of Time Period on Tax Incidence: Short Run

Effect of Tax Scope on Tax Incidence

Tax incidence depends on how broadly the

Spillovers between Product Markets

EVIDENCE: The Incidence of Excise Taxation

Excises tax on cigarettes varies widely

Incidence in the United States

The CBO analyzes tax incidence in the United

Total Effective Tax Rate in the United States,

Top and Bottom Quintiles Share of Income and Tax

Current vs. Lifetime Income Incidence

Tax incidence is usually evaluated by

The fairness of any tax reform is one of

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