Public Economics Tax Incidence

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So far, we have considered incidence in onlya single market, such as the gas market.

Partial equilibrium tax incidence:

Analysis that considers the impact of a taxon a market in isolation.

General equilibrium tax incidence:Analysis that considers the eects on

related markets of a tax imposed on onemarket.

Taxes in one market aect prices in others,complicating the analysis.

General Equilibrium Tax Incidence

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Effects of a Restaurant Tax ! General Equilibrium

Exam"le

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General Equilibrium Tax Incidence

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!actors that are inelastically demanded orsupplied in "oth the short and long run "eartaxes in the long run.

#nvestments are irreversi"le, so the supplyof capital is inelastic in the short run.

#nvestors have many opportunities, so inthe long run, elasticity of capital may "e

high.

Effect of Time #eriod on Tax Incidence $%ort Run

&ersus 'on( Run

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Tax incidence depends on how "roadly thetax is applied.

Taxes that are "roader "ased are harder to

avoid than taxes that are narrower, so theresponse of producers and consumers tothe tax will "e smaller and more inelastic.

A tax on local restaurants has a dierent

incidence than a tax on all restaurants.

Effect of Tax $co"e on Tax Incidence

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&onsider a tax on restaurant. A higher after'tax price has three eects on other goods aswell(

1.#ncome eect from lower real income.2.Su"stitution eect toward goods that aresu"stitutes for restaurants.

.&omplementary eect( &onsumers may

reduce their consumption of goods or servicesthat are complements to restaurant meals.

$"illo&ers bet)een #roduct *ar+ets

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The *fairness+ of any tax reform is one ofthe primary considerations in policymakers positions on tax policy.

Therefore, it is crucial for pu"lic -nanceeconomists to have a deep understandingof who really "ears the "urden of taxationso that we can "est inform thesedistri"utional de"ates over the fairness of a

proposed or existing tax.

-onclusion

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1Taxation and /conomic /0ciency

2ptimal &ommodity Taxation3 ptimal #ncome Taxes

4Tax'ene-t 3inkages and the !inancing ofSocial #nsurance 4rograms

Tax Inefficiencies and Their Implications for Optimal

Taxation

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Tax Inefficiencies and T%eir Im"lications for ."timal

Taxation 6sually, the market produces e0cientoutcomes.

Taxes interfere in the market and reduce

e0ciency. 4eople su"stitute away from the taxed

product, using less'e0cient alternatives.

o /ight'person motorcycles in #ndonesia

Some taxes have much larger e0ciencycosts than others.

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B

C

Price pergallon (P)

Quantity inbillion o!

gallon (Q)

8

S

1

D1

P19

:1.%8

Q19 188

S2

E

"ax #$%.&%

Q29

78

P29:1.58

P9

:1.8

F

G

D A

Taxation and Economic Efficienc Gra"%ical !""roac%

1

'eadeigtlo* DWL

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Taxation and Economic Efficienc

A"sent taxes(

price 9 social marginal "ene-t 9 socialmarginal cost

The tax drives a wedge "etween SMB andSMC, preventing mutually "ene-cial tradesfrom occurring.

The units "etween 78 and 188 would have

generated a consumer and producersurplus.

The foregone surplus from taxation is calledthe deadweight loss ;DWL


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B

Price pergallon (P)

Quantityin

billiono!

gallon(Q)

8

(a) +nelaticdemand

S

1

D

1

P1

Q

1

(b) ,laticdemandS

2

P2

Q

2

"ax

A

B

C

DWL

Price pergallon (P)

Quantity inbillion o!

gallon (Q)

8

S

1

D

1

P1

Q

1

S

2

P2

Q

2

"ax

A

DWL

C

Elasticities etermine Tax Inefficienc

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>eadweight loss is caused "y individualsand -rms making ine0cient consumptionand production choices in order to avoidtaxation.

The ine0ciency of any tax is determined "ythe extent to which consumers andproducers change their "ehavior to avoidthe tax.

The more elastic is demand or supply, thelarger the DWL.

1

Elasticities etermine Tax Inefficienc

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eterminants of ead)ei(%t 'oss

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B

C

Priceo! ga

Quantity o!ga

8

S

1

D1

P1

Q1

E

"ax #$%.1%

Q2

P2

P

D

DWL

Q

"ax #

$%.1%

S

2

S3

A

*ar(inal ' Rises )it% Tax Rate

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Since marginal DWL rises with the tax rate,pre'existing distortions aect the e0ciencyof a new tax.

o

Preexiting ditortion:?arketfailures, such as externalities orimperfect competition, that are in place"efore any government intervention.

o

/xternalities #mperfect competition,existing taxes.

! Tax $stems Efficienc Is !ffected b a *ar+ets

#reexistin( istortions

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! Tax $stems Efficienc Is !ffected b a *ar+ets

#reexistin( istortions

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#ro(ressi&e Tax $stems -an e 'ess Efficient

Gra"%ical !""roac%

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Ramse Taxation T%e T%eor of ."timal

-ommodit Taxation

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In&erse Elasticit Rule

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#magine that the government had only twogoods it could tax, @ and (

/lasticity of demand for is much higherthan that for @.

The inverse elasticity rule would suggestthat the government tax @ much morehighly than .

This means taxing the good consumed "y

poor people more heavily.

This might hurt vertical eBuality.

Equit Im"lications of t%e Ramse *odel

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&ommodities are taxed or su"sidi=edthroughout the developing world.

>eaton ;177< studied the demand forsu"sidi=ed goods in 4akistan, looking at

their elasticity, and the income of peoplewho consume it.

!##'I-!TI.4 #rice Reform in #a+istan

Good -ubidy ,laticity onumedby/

Cheat $8D E8.)$ 4oorFice $8D E2.85 All

ilG!at E%D E2. 4oor

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!##'I-!TI.4 Efficienc -onsequences of Taxes

and $ubsidies in #a+istan %eat 5Inelastic emand

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!##'I-!TI.4 Efficienc -onsequences of

$ubsidies in #a+istan %eat 5Inelastic emand

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!##'I-!TI.4 Efficienc -onsequences of $ubsidies

in #a+istan Rice 5Elastic emand

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!##'I-!TI.4 Efficienc -onsequences of Taxation

in #a+istan .ils and 7ats 5Elastic emand

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?ost tax revenue in the 6nited States andother developed countries is from incometaxes.

0ptimal income taxation:&hoosing thetax rates across income groups tomaximi=e social welfare su"Hect to agovernment revenue reBuirement.

Social welfare function guides the trade'o"etween progressivity and e0ciency.

."timal Income Taxes

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T%e 'affer -ur&e

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The 3aer curve gets its name from economist Arthur3aer even though a 1$th century #slamic scholar named#"n Jhaldun -rst conceived it.

The Laffer Curve describes the relationship between the tax rate

and the tax revenue it generates

The Laffer Curve implies there is an optimal tax rate, a tax rate

that maximizes tax revenue.

The Laffer Curve

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Hence,

Tax evenue ! "

#f no one wor$s and nothing is produce, the econom%

generates no income.

&eople will not wor$ and firms will not produce an%thing if the tax

rate is '""(.

0

08

180

18

280

28

0 20 ,0 60 :0 100tax rate )percent*

Tax evenue)in trillions of +*

&eople pa% no income taxes when the tax rate is "(.

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#f tax revenue is "when the tax rate is "(or '""(, there is a tax

ratewhere tax revenues reach a maximum value.

0

08

180

18

280

28



#f tax revenue is "when the tax rate is "(or '""(, there is a tax rate

where tax revenues reach a maximum value.

Thistax rate generates $2.5trillion in tax revenue.ccording to the diagram below, the optimal tax rate is 30%.

2.5

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tax revenue is$1.7 trillion.

0

08

180

18

280



#f the tax rate is 60%,

2.5

30

tax revenue increases to$2.5 trillion.

60

1.7

#f the tax rate is cut to 30%,

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tax revenue is$2.5 trillion.

0

08

180

18

280



#f the tax rate is 30%,

2.5

30

tax revenue decreases to$1.7 trillion.

60

1.7

#f the tax rate is raised to 60%,

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08

180

18

280



The Laffer Curve also suggests that when tax rates are too low, a

tax cut lowers tax revenue.

2.3

20

28

1.6

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So far we have ignored tax'"ene-t linkages.

"axbenet linage:>irect ties "etweentaxes paid and "ene-ts received.

#ntroducing these linkages enricheschanges the story, since many payroll taxesare directly linked to "ene-ts.

Tax;enefit 'in+a(es and t%e 7inancin( of $ocial

Insurance #ro(rams

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enet

5age

Quantity o! labor(L)

8

S1#

SMC

D2

W1

L1

W2

L2

"axe

A

B

C

D1#

SMB

Tax;enefit 'in+a(es Gra"%ical Re"resentation

S2

DE

F

G

L

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Tax;enefit 'in+a(es Gra"%ical Re"resentation

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#erfect 'in+a(e Eliminates t%e DWL

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Public Economics Tax Incidence