Econ 441 Public Economics

Chapter 6

Dan Silverman
ASU Economics1
Fall 2016

1 These

notes are adapted from Public Policy, by Professor Nicola Persico,

Northwestern University.

Contents
1 Tax Incidence (Gruber, Ch. 19, Hyman pp. 446-461)
1.1 Incidence in a Single Market . . . . . . . . . . . . . . .
1.1.1 Incidence is Independent of Statutory Burden .
1.1.2 What About Quantities? . . . . . . . . . . . . .
1.1.3 Elasticities Matter . . . . . . . . . . . . . . . .
1.2 Incidence with Imperfect Competition . . . . . . . . . .
1.3 Incidence and E ciency with Multiple Markets . . . .

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Chapter 1
Tax Incidence (Gruber, Ch. 19,
Hyman pp. 446-461)
1.1

Incidence in a Single Market

In the last chapter we undertook a brief investigation of the di culties that

governments face when trying to achieve greater equality without sacricing
e ciency. In that discussion we touch briey on questions about the distributional consequences of taxation. (Recall the capital ight example.) In this
chapter we will pay greater attention to the distributional eects of taxation
so-called tax incidence analysis. The basic question of tax incidence is who
really pays, i.e. who bears the economic burden, when a tax is imposed on
one form of production, or one form of income, or one form of consumption.
As Gruber notes in his textbook, questions of tax incidence importantly
energize public debate. Unfortunately, much of that debate takes tax rates
or total payments at face value and does not consider incidence. For example, many people in the U.S. are deeply disturbed by the fact that individual
income taxes (never mind payroll) represent nearly 50% of total federal tax
receipts, and corporate income taxes respresent less than 10% of the total.
That seems wrong, since most individuals have much less wealth and income
than most corporations. Such oense may be proper, but it should be based
on the incidence of taxes, not just who is legally required to pay them. To
illustrate, consider two cases. In one case, corporate taxation is light and
that translates largely into larger dividends for very wealthy stock holders.
In another case, corporate taxation is light and that translates into higher
1

2CHAPTER 1 TAX INCIDENCE (GRUBER, CH. 19, HYMAN PP. 446-461)

wages and retirement benets for relatively low income workers. Depending on which case applies, the implications for equity of lower tax rates on
corporations are very dierent.

1.1.1

Incidence is Independent of Statutory Burden

We begin incidence analysis, by showing how tax incidence is independent

of who is legally obligated to pay the tax i.e. the statutory incidence. An
important example you might have in the back of your mind are payroll taxes
in the U.S. These taxes are remitted by employers. They send the checks
to the IRS. And, technically, these taxes are split between employers and
employees. The employer pays half of the taxes on the employees earnings,
and the employee pays the other half.
To capture something like this example, we consider a labor market described in the gure below. First suppose workers must remit, themselves,
a social security tax (SST) of $t per hour worked. This shifts up the supply
curve by t since a worker needs $t more to work for the same hours as he
would without tax. The new outcome is l0 and w0 : Since the worker pays tax,
the net wage is w0 t = w00 :
Now suppose it is the rm that has to pay the SST of $t for each hour of
labor it hires. Since the rm is willing to pay $t less than he would without
tax, this shifts down the demand by t: Equilibrium labor is again l0 and the
workers get w00 : The rm pays w00 + t = w0 : Therefore, the tax incidence
does not depend on the statutory identity of taxpayer. In either case, the
worker pays w
w00 and the rm pays w0 w compared to the initial wage
w : Hence, when we analyze the eect of tax, we can shift either demand or
supply at convenience.

1.1 INCIDENCE IN A SINGLE MARKET

wage
S+t
S

W
W*
W

D-t

labor
l

1.1.2

l*

What About Quantities?

In the preceding discussion, we described the incidence of the tax purely in

terms of (after-tax) prices. But if we are talking about the economic burdens
of taxation, shouldnt we also consider quantities? For example, when the tax
was imposed on rms in the preceding, labor demand declines. Equilibrum
wages and hours go down. Shouldnt we think of workers as being made
worse o by working few hours? Shouldnt that be taken into account when
considering incidence?
In general, the answer to these questions is yes.Quantities do, indeed,
matter for calculating the welfare consequences of a tax change. However,
when analyzing incidence, it is conventional to assume that the proposed
changes in the tax rates are small relative to prices. If so, then the change
in eective prices is a very good approximation to the welfare burden of
taxation.
Why is the change in price, alone, a good approximation to incidence
when tax changes are small? A small change in the after-tax price of a good
causes only certain people to stop buying the good. Those people are the
ones for whom the value of the good is almost the same as the value of the
net best alternative use of their money or time. I.E., their consumer surplus
is very close to zero. They are, thus, largely unaected by the eective
price change. For everyone else, who continues to buy the good, their loss is
well-approximated by the change in eective price.

4CHAPTER 1 TAX INCIDENCE (GRUBER, CH. 19, HYMAN PP. 446-461)

1.1.3

Elasticities Matter

While the economic incidence of the tax does not depend on who is legally
obliged to pay it, the incidence does depend importantly on other features
of the market; in particular it depends on demand and supply elasticities.
Consider, for example, the eect of subsidy (a negative tax) for housing
purchases like the one the Obama administration initiated in the midst of
the recent nancial crisis. The subsidy, which at most amounted to $8,000
for rst-time homebuyers, took the form of a tax credit and was higher for
lower-income families. First-time home-buyers would get a big break on their
taxes in 2009 and the break was refundable. The stated goal of the policy
was to buoy housing markets and, also, to benet (relatively low-income)
people trying to buy a house in di cult times.
It seems straightforward to think of the subsidy to rst-time home buyers
as shifting the demand for housing upward. How to model supply? This
is a short-term subsidy. Everyone understood that at the time. In many
places, the supply of houses is (over such a short horizon) quite inelastic.
It takes considerable time to build new housing. Note too that this is a
national policy, so home-owners cant get up and move from a zone with the
subsidy into one without it. Moreover, shifting from owner-occupied into
rental housing is costly and takes time. It thus seems sensible to model
housing supply as quite steep.
In this situation, the incidence question is to what extent the subsidy falls
to home buyers rather than sellers. As the rst gure below shows, the big
winners are in fact home sellers. With an inelastic supply curve, the price
does not much aect whether a seller will actually put a house on the market.
It follows that price goes up almost by the amount of subsidy and quantity
barely increases. The reason for this is the steepness of the supply curve.
With a more elastic supply curve, such a subsidy can indeed benet consumers. In the second gure below, we see that when the subsidy shifts
demand, since the supply is elastic, quantity increases a lot. Home buyers,
as a group, are substantially better o.

1.1 INCIDENCE IN A SINGLE MARKET

P

P
S

subsidy

subsidy

D with

subsidy

Here we have analyzed the incidence of taxes and subsidies. More generally, one can investigate the incidence of a wide variety of market interventions including government regulation and mandate. For example, one might
ask who pays for the costs of pollution abatement regulations, or other forms
consumer protection is it producers or consumers? Like in the cases above,
the answer will depend on the relevant demand and supply elasticities. Consider yet another example of a market intervention, in this case a social
intervention.

Example 1 (Child Labor) Protests against child labor may have an eect
that is similar to a tax on the employment of children as workers, i.e., they
may simply decrease the demand for child labor as rms fear the consequences
for public relations of hiring child workers. We analyze the eect of protest
against child labor in the gure below. Consider the case where, just like the
supply of houses, the supply of child labor is very steep because poor parents
will send their children to work almost no matter what. Then, the protest does
not benet the children. Instead, their wages fall and they are still working
almost the same amount. Again, who ends up bearing the cost of tax depends
on the elasticity of the supply curve. If it were elastic (e.g. if they had outside
opportunities), children would leave the workforce and wage wouldnt fall as
much. If all of this were true, what might be a better approach to helping
improve the living standards of poor children?

D with
subsidy

6CHAPTER 1 TAX INCIDENCE (GRUBER, CH. 19, HYMAN PP. 446-461)

wage

D
D with protest
Child labor

1.2

Incidence with Imperfect Competition

We have so far examined the incidence of taxation in a competitive market,

and we saw that incidence depends importantly on the price elasticities of
supply and demand. These relationships are somewhat more complicated
when competition is imperfect. To get a bit of a sense of how this works, we
investigate the case of a monopoly subject to a per-unit tax on production.
The gure below presents our usual depiction of a market served by a
monopolist. The marginal cost curve shifts up by the amount of the tax t as,
at every level of production the monopolist faces an additional cost. As we
would expect, this upward shift in supply leads to lower production (Qmt )
and higher prices (Pmt ). Whats interesting is to compare these changes in
equilibrium prices and quantities to those that would result from imposing
the same tax on a competitive market with the same fundamentals (marginal
costs and marginal willingness to pay).
If the market were competitive, initial prices (Pc ) would be lower and
quantities (Qc ) higher. But the changes in prices and quantities associated
with the tax would be greater in the competitive environment. This is true
because the marginal revenue curve is steeper than the marginal cost curve.
Thus supply is less elastic in this non-competitve environment than in the
competitive setting. The logic of the previous section suggests that when
supply is more elastic, consumer bear more of the incidence of the tax. Indeed
this is the reason why, in the competitive setting, consumers pay more of the
tax than they do under a non-competitive regime. This is not to say that

1.3 INCIDENCE AND EFFICIENCY WITH MULTIPLE MARKETS7

consumers are, overall, better o being served by a monopoly (note that
prices remain higher and quantities lower with the monopoly, regardless).
Rather, the point of this example is to show that market structure plays an
important role in determining tax incidence.
P
MC + t
MC
Pmt
Pm

MR

Pct
Pc

Demand

Q
Qmt Qm Qct

1.3

Qc

Incidence and E ciency with Multiple Markets

Our focus thus far is has been on the incidence (and indeed the e ciency) of
taxes in a single market. The existence of multiple markets has two important consequences for tax analysis. First, the existence of multiple markets
with varying fundamentals allows government an opportunity to minimize
the ine ciencies created by taxation. Second, the interaction of markets for
various goods and services complicates the evaluation of incidence. For example, the inputs of one industry may be the outputs of another. Certain
goods are complements or substitutes for each other, etc. The important
consequence of these simple facts is that taxes on one good or industry may
eect supply or demand in many others. Thus, the incidence of a tax on one
good or industry may actually fall on the consumers or producers of entirely
dierent goods.
To gain insight into the rst important consequence of multiple markets,

8CHAPTER 1 TAX INCIDENCE (GRUBER, CH. 19, HYMAN PP. 446-461)

consider the following example from Hymans pages 460-461. A government is
seeking to minimize the ine ciencies of a system of sales taxes in an economy
with two goods, food and clothing. Demand for food is less elastic than
demand for clothing, and the supply of each good is perfectly elastic. Suppose
the government levied a at sales tax of rate t on both food and clothing. The
e ciency cost of the tax is much higher in the clothing market than the food
market as consumers, with their elastic demand, distort their consumption
away from clothes in a big way. Food consumption, on the other hand, is
little changed by the change in price. Thus, the e ciency cost of the tax
on this good is slight. The implication of this simple analysis is that goods
with inelastic demand should be more heavily taxed than those with elastic
demand. The reason is that the distortions of the tax are lower when the
tax scheme thus favors goods with elastic demand. This is quite a robust
prediction, and note that it calls for higher levels of taxation on necessities.
Governments, in fact, dont often pursue this policy (e.g., no sales tax on
food but a tax on clothing and an even bigger tax on sales of luxury items).
What might account for the dierence between what theory suggests and
what governments do?
P

Efficiency cost of the tax

Efficiency cost of the tax

S+t

S+t

Dc
Df

Finally, we briey consider a second important consequence of multiple,

interacting markets: that the incidence of a tax on one good or service may
be borne by consumers or producers of goods in entirely dierent markets.
To explore some of these ideas, consider a simple two-good economy with cars
and computers. Suppose the government imposes a tax on cars sales in an
eort to curb carbon-based emissions. The tax on cars decreases the supply
of this good and thus the price of cars rise, and the demand for cars falls (a
movement along the demand curve, not a shift). Note, however, that cars and

1.3 INCIDENCE AND EFFICIENCY WITH MULTIPLE MARKETS9

computers both use skilled labor and certain electronic components as inputs.
The lower equilibrium quantity of cars sold, also reduces demand for these
inputs. We would expect this to cause the price of these inputs to fall and
their owners then bear some of the tax incidence. As important, the cheaper
inputs will increase supply in the computer sector and thus lower prices
and increase quantity there. So, from the perspective of consumers, those
who would have purchased cars bear some cost of the tax, but consumers of
computers are indirectly subsidized by it. This makes the incidence analysis
potentially quite complex. Indeed, many economists are forced to turn to
computational (simulated) models of the economy to assess multi-market
incidence. It also suggests a method for minimizing the burdens of taxation.
If, however, many markets all use the same inputs, then the eect on untaxed
markets may be slight, and concentration on a single market analysis may
be a good approximation to the general equilibrium eects.

10CHAPTER 1 TAX INCIDENCE (GRUBER, CH. 19, HYMAN PP. 446-461)

Practice Problems
Exercise 6.1
There is only one rm whose cost of producing q units of a good is C (q) =
c q, where c is a positive number. The demand curve for the good in question
is downward sloping. Assume that the rm behaves competitively, and not
monopolistically.
a) If at the competitive equilibrium the rm produces a positive and nite
amount, what are the rms prots?
b) Suppose we impose an excise tax on the rm0 s sales that the rm
pays.The rm is required to pay t dollars for every unit it produces (and
sells). How does the competitive equilibrium price change because of the
tax? How do the rms prots change?
Exercise 6.2
Suppose that the demand for a good is described by the inverse demand
function p = 10 3 q and the supply of the good is given by the inverse
supply function p = 2 + 2 q:
(a) What is the equilibrium price and quantity of the good in this market?
(b) Suppose the government imposes a $1 per unit tax on suppliers. Now
what is the equilibrium price and quantity of the good in this market.
(c) Determine the incidence of the tax, who bears what shares of the tax?
(d) Calculate the elasticities of demand and supply at the equilibrium
allocation in the absence of the tax. Explain how these elasticities work to
determine the incidence of the tax.
Exercise 6.3
True, False, or Uncertain (You must explain your answer):
In terms of the incidence of a per unit tax on the production of gasoline,
consumers are always better o when the market for gasoline is perfectly
competitive.
Exercise 6.4

1.3 INCIDENCE AND EFFICIENCY WITH MULTIPLE MARKETS11

The following gure, taken from above, describes a market for housing
with and without a government subsidy to home-buyers.
P
S

subsidy

D with
subsidy

(a) Explain for why the supply curve in this gure appears quite steep.
Is this a short-run or a long-run model of housing supply?
(b) Show, by re-drawing the diagram, who bears most of the incidence of
this subsidy, home-buyers or home-sellers.
(c) Suppose the subsidy was intended to benet home-buyers by making
homes more aordable after the subsidy, how might government adjust this
simple policy to increase its incidence on home-buyers.
Exercise 6.5 (Adapted from Gruber)
The government has imposed a new tax on all airline travel. The market
has two types of travelers: business and leisure. Business travelers have a
price elasticity of demand of -1.2, leisure travelers have a price elasticity of
demand equal to -3.0. Airlines can price discriminate between these two
groups (i.e. charge dierent prices to each type). Which type of traveler will
bear the larger burden of the tax. Explain.
Exercise 6.6 (Adapted from Gruber)
In New York workers face a state income tax rate of about 6.5%. In
addition, workers who reside in New York City also face a city income tax of
3.5%.

12CHAPTER 1 TAX INCIDENCE (GRUBER, CH. 19, HYMAN PP. 446-461)

(a) In the long run, for which tax do workers bear a larger share of the
incidence? Explain.
(b) How would your answer to part (a) change if the City tax were temporary (lasting just a year). Explain.
(c) How would your answers to parts (a) and (b) change if the City tax
were on those who earned their money in New York City, and did not depend
on city of residence?