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

PREPARED BY

Dan Sacks

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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

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
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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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

19.1
The Statutory Burden of a Tax Does Not Describe
Who Really Bears the Tax, and Is Irrelevant to the
Tax Burden

(a) Tax on producers S2 (b) Tax on consumers

Price per Price per
gallon (P) gallon (P)
S1 S
Tax =
B $0.50
P2 = $2.00
Consumer D E
P3 = $1.80 $1.80
burden =
C Consumer
$0.30 P1 = $1.50 A P1 = $1.50 A
burden =
Producer $0.30 C
burden = $1.30 P3 = $1.30
E Producer
$0.20 D Tax =
burden = P2 = $1.00
$0.20 B $0.50
D D1
D2
0 Q2 = 80 Q3 = 90 Q1 = 100 Quantity in 0 Q1 = 100 Quantity in
billions of billions of
gallons (Q) gallons (Q)

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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

19.1
Perfectly Inelastic Demand

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19.1
Perfectly Elastic Demand

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19.1
Supply Elasticities

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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

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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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

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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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

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.
• Doesn’t this fall in consumption hurt consumers?
• If so, shouldn’t 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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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

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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 CHAPTER 19 ■ THE EQUITY IMPLICATIONS OF TAXATION: TAX INCIDENCE

19.2
Impediments to Wage Adjustment

(a) Tax on workers (b) Tax on firms

Wage S2 Wage
(W) (W)
S1
Firm S1
Tax = B
burden = W2 = $8.25
$0.50 $1.00 Firm
W2 = $7.75 B burden =
$1.00 C’ A
A WM = $7.25
WM = $7.25
C
W3 = $6.75 $6.75
C Tax =
Worker $1.00
burden =
D1 D2 D1
$0.50
0 H2 H1 Hours of 0 H3 H2 H1 Hours of
labor (H) 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.

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19.2
Background: Equilibrium in Monopoly Markets

Price

S= MC

A’
P1
B’
P2

A
B

Tax
D1
MR1
MR2 D2
0 Q2 Q1 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

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19.3
General Equilibrium Tax Incidence

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19.3
Spillovers between Product Markets

Consider a tax on restaurant. A higher after-tax 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
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 individual’s current resources.
o Lifetime tax incidence: The incidence of a tax in
relation to an individual’s 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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