Dr.

Aneel Salman
Institute of Business Administration
Karachi
 A Lump-sum tax is a fixed tax that is owed by
everyone and is not subject to something
taxpayers can change.
It is independent of income, consumption, or
wealth.
An example is a Head Tax, which is constant
for everyone.
 Inefficiency in taxation results from the ability
to avoid taxes by avoiding a taxed activity.

Because lump-sum taxes are unavoidable,

they serve as the benchmark by which other
taxes are measured.

They only have income effects

 No price distortion
Reduce buying power without affecting
MSB=MSC

Doesnt affect the attainment of efficient

outcomes

Efficient allocation of resources with the pattern

of demand originating from new demand due to
new income distribution
 A price distorting tax is a tax that alters the
relative price of goods.
Example: Tax on Gasoline
The budget line pivots on the y-axis shifts on x-
axis
The purchase price increased for consumers
Also shows a scenario if a Lump-sum tax was
applied instead
 A

T
Expenditure on Other Goods

Y* L
per Year (Dollars)

T
YT
E' E
Y1
E''

U1 U2 U3

B' L' B
0 QT QL Q1
Gasoline per Year (Gallons)
 Individuals utility level declines in case of
price distorting subsidy
Individual is much better off in case of lump-
sum tax
There is no substitution effect since the product is
not expensive relative to other goods
 A unit tax adds to the price by a fixed
amount. Examples include the 32 cents per
pack of cigarettes and 24 cents per gallon of
gasoline in federal taxes.
 The Gross Price (PG) is the price paid by
consumers.
The Net Price (PN) is the price received by
producers after the tax is paid.
PN = PG T
 Example: Unit tax on Gasoline
The supply curve would shift left showing
increased price at existing demand curve

The marginal social cost now includes tax.

Excess burden is created

 ST = MSC +$0.25
S = MSC
Tax Revenue
1.15 = PG C
Price (Dollars)

Excess Burden
1.00 B
0.90 = PN A

T = $0.25

DQ D = MSB

0 Q1Q*
Gasoline per Year (Gallons)
 Ad-Valorem Taxes add a fixed percentage to
the price of a good.
The primary example is sales taxes.
Higher the price of the good, greater is the
tax per unit
T=tP
The tax increases automatically with increase
in the price of the good
 Excess S
Burden
A
WG = 5.20
Wages (Dollars)

5.00 E

WN = 4.16 E'
Tax Revenue D = Gross Wage

Net Wage = WG (I t)

0 Q1 Q*
Labor Hours per Year
 The Legal Incidence is the burden of a tax as
determined by who is legally obligated to pay
the tax.
The Economic Incidence is the burden of a tax
as determined by how much the parties are
affected in terms of paying higher prices, or
receiving lower prices.
 Forward Shifting is the transfer of the burden
of the tax from the seller, who is legally
obligated to pay it, to the buyer.
Gasoline example
Backward Shifting is the transfer of the
burden of the tax from the buyer, who is
legally obligated to pay it, to the seller.
Payroll tax if income decreases
 S = MSC

PG + T =1.15 C
1.00 B
Price (Dollars)

PG = 0.90 A

D = MSB
D' = MSB T

0 Q1Q*
Price per Year (Gallons)
 The result is exactly the same distribution of
tax burden that prevailed when tax was
collected from sellers.
 It does not matter whether the buyer or seller
is legally liable for a tax.
The economic incidence of the tax is
determined by supply and demand
elasticities, the amount of the tax, and the
original equilibrium price and quantity.
 Generally the supply of goods and services is
more elastic in the long run than in the short
run.
Therefore, buyers are more likely to pay the
taxes in the long run.
Industries where resources can be easily
shifted for other use have elastic supply
curves in long run.
 When one good is taxed and another good is
not taxed, the impact of the tax is not
confined to the taxed good.
Because a tax on one good lowers the profit
that can be made to firms producing it, they
may shift their productive resources to the
other good so as to maximize their after-tax
rate-of-return in both markets.
This has the effect of equalizing the after-tax
rate-of-return.
 Complex inter-related markets
Tax in one markets affects other

Tax on electricity consumption

Electrical appliances
Natural Gas
Products whose production needs electricity as an
input
 Efficiency loss can be minimized
Goods are taxed at rates that decrease with
elasticity of demand

More inelastic demand needs higher tax

Efficient system of taxes will have to face

political opposition